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1 February 2016 CFA Institute Journal Review

Learning about CEO Ability and Stock Return Volatility (Digest Summary)

  1. Derek Bilney, CFA

Stock return volatility tends to decline over a CEO’s tenure as the market becomes more certain of management quality. The rate of learning about a CEO decreases over time, with most of the learning occurring within the first three years.

What’s Inside?

The authors describe a framework to model the rate at which the market learns about the skills and abilities of a new CEO and the corresponding reduction in stock return volatility. They test this model using a sample of CEO turnovers that are based on exogenous events (e.g., CEO illness, death, or retirement) and show that stock price volatility tends to decrease throughout the tenure of a CEO. This relationship holds true after allowing for the increased level of such firm-level activities as expansions, divestitures, and the launch of new products and strategies that are typically associated with a new CEO. Learning is generally faster in highly competitive industries that have a greater emphasis on R&D.

How Is This Research Useful to Practitioners?

The authors present a unique method of identifying the component of stock price volatility of a firm related to the market’s uncertainty about the quality of a CEO. They also raise the possibility that firms with new CEOs are likely to be scrutinized in greater detail than other firms because of the greater uncertainty surrounding the new CEOs’ impact on future cash flows. Increased analysis typically leads to more efficient pricing, but it can take time until the market is confident and comfortable with a CEO’s performance. The authors highlight the relative importance for corporate governance analysis of CEOs in transparent, research-driven industries compared with those in less competitive industries, possibly justifying higher remuneration levels.

How Did the Authors Conduct This Research?

The appointment of a new CEO often occurs during periods of company turmoil and corresponding extreme levels of stock price volatility. Against this backdrop, stock price volatility can logically go in only one direction. The authors base their study, therefore, on three different CEO turnover scenarios that should not be correlated with high levels of fundamental uncertainty: (1) turnovers occurring because of medical issues (or death) and age-based retirement, (2) turnovers following strong levels of profitability and stock price performance, and (3) turnovers not coinciding with high levels of executive turnover.

CEOs are identified by using data from the ExecuComp database over the period 1992–2006. These data are supplemented with data from BoardEx. The Factiva news search is used to provide information on causes of CEO cessation. A sample of CEO turnovers caused by such exogenous causes as death, illness, or retirement is identified. Because retirements can be a disguised form of dismissal, CEO turnovers because of retirement are only identified as such when recent company performance is sound.

Stock price volatility is calculated using option-implied measures, realized return volatility, and idiosyncratic return volatility (using the Fama–French three-factor model).

The authors develop a Bayesian learning model to model and understand the rate at which the market learns about CEO ability. The model allows stock return volatility to be decomposed into a fundamental firm-based component and a component based on the market’s learning about the CEO’s ability.

Stock price volatility is estimated as a function of CEO tenure; a dummy variable capturing companies that subsequently announced firm-structuring initiatives (expansions/divestitures); and a series of general control variables, including return on equity, leverage, book to price, and dividend rate stability.

The Bayesian model correctly predicts that the impact of market learning should lead to volatility decreasing at a declining rate over time.

Abstractor’s Viewpoint

CEOs are under immense pressure to produce immediate and ongoing results to placate expectant investors. Failure to satisfy market expectations quickly leads to dismissal. A CEO may have an incentive to reduce stock return volatility because it generally leads to higher stock returns, which may be linked to higher performance bonuses.

CEOs are particularly in the spotlight during the reporting season because the broader investor community is focused on their performance at that time, which explains the considerable effort that goes into investor result presentations and conference calls to ensure that they are well scripted and present management in the best possible light. But question-and-answer sessions are fraught with the possibility of tricky questions leading to management going off script and investors losing confidence. The best CEOs successfully navigate through reporting periods, taking their investors along for the ride.

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