This is a summary of “Net Share Issuance and Asset Growth Effects: The Role of Managerial Incentives,” by Shingo Goto, Zhao Wang, and Shu Yan, published in the Financial Analysts Journal in the 1st quarter issue of 2020.
Listen to an audio version of this summary.
By considering executives’ stock holdings (incentives) alongside their decisions over equity buybacks/issuance and asset growth, investors can discern companies likely to outperform.
What’s the Investment Issue?
Considerable evidence shows that the stocks of companies that aggressively raise capital or spend vigorously to expand underperform their peers. The asset growth (AG) effect describes the detrimental effect on stock returns of aggressive company growth, or “empire building.” The net share issuance (NSI) effect describes the negative effect on stock returns of aggressively raising external capital by issuing more shares. Less clear is whether capital raising and spending are related to managerial incentives.
Equity incentives, such as stock ownership, options, and restricted shares, increase the sensitivity of top executives’ wealth to their company’s share price. The authors examine how this sensitivity affects the executives’ empire-building instincts (the AG effect) and their desire to raise share capital (the NSI effect).
This article takes a fresh look at how NSI and total AG can predict stock returns, refined by considering the extent to which top executives are exposed to changes in their company’s stock prices through their share incentives.
How Do the Authors Tackle the Issue?
The authors measure managerial equity incentives by calculating the sensitivity of the top five executives’ wealth (based on stock ownership, options, and restricted shares) to a 1% change in the company’s share price.
To determine the effects of managerial incentives, the authors create stock portfolios sorted by NSI and AG.
Returns of high NSI companies are compared with those of their low NSI peers, and the authors refine the results by considering the level of executive equity incentives. Similarly, the performance of high and low AG companies is compared and cross-referenced to managerial incentives.
The authors report returns from long–short portfolios based on these factors, taking into account transaction costs and other common equity factors.
What Are the Findings?
The authors find that low NSI companies produce excess returns for firms with the most highly incentivized executives. So high share incentives are associated with better market-timing decisions when it comes to buybacks and share issuance.
The authors also confirm that low AG companies produce excess returns when senior managers have relatively few stock holdings. They argue that share incentives moderate excessive empire building because managers with high equity incentivization are exposed to the detrimental effects.
In light of these results, the authors create a hybrid portfolio strategy that combines a) the NSI effect of firms with executives who have relatively high equity incentives and b) the AG effect of firms with executives who have relatively low equity incentives. This hybrid strategy generates significant alpha even after transaction costs. Because the two strategies have low correlation with each other, the hybrid strategy also limits downside risk.
What Are the Implications for Investors and Investment Managers?
The authors show that analysis of managerial incentives can and should inform stock selection. The established AG and NSI effects are more pronounced for firms whose managerial incentives are, respectively, less and more aligned with shareholders’ interests.
Because the stock market responds only slowly to the implications of these incentives, investors should, in practice, be able to exploit the hybrid strategy presented here to improve medium-term stock selection.