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Behavioral CEOs
- 1. Behavioral CEOs: THE ROLEOF MANAGERIAL OVERCONFIDENCE Kristen J. Freiburger – Laurence J. Pino FIN7009: Corporate finance DBA Class of 2020
- 2. The Authors: Specialistsin Overconfidence Ulrike Malmendier Geoffrey Tate • Professor of Finance • Kenan-Flagler Business School, University of North Carolina • PhD, Economics • Harvard University • Professor of Economics & Finance • Haas School of Business, University of California, Berkeley • PhD, Business Economics • Harvard University 2
- 3. Research Motivation 3 The authors, specialistsin managerial biases, are interested in assessing whether executive overconfidence influences decisions on internal or external capital investments and credit allocations.
- 4. Managerial Biases Comein All Shapes and Sizes Baker, Pan, and Wurgler (2012) consider the role of reference points and anchoring and show that prior stock price peaks affect mergers and acquisitions through offer prices, deal success, and bidders’ announcement effects. Baker and Wurgler (2013) survey literature on how bounded rationality could explain the adoption of capital budgeting criteria, and how loss aversion could explain investment patterns such as “throwing good money after bad.” 44
- 5. Managerial Biases Other researchon managerial biases and distortions in decision-making Managerial risk aversion (Lewellen 2006) Military experience (Malmendier, Tate, and Yan 2011; Benmelech and Frydman 2015) Industry expertise (Custodio and Metzger 2013) General ability and execution skills (Kaplan, Klebanov, and Sorensen 2012) Age and closeness to retirement (Jenter and Lewellen forthcoming; Yim 2013) MBA degree and working experience (Beber and Fabbri 2012) Personal frugality (Davidson, Dey, and Smith 2013; Cronqvist, Makhija, and Yonker 2012) 55
- 6. Overconfident Executives 6 Overconfidentexecutives overestimate the future performance of their firms and are therefore more willing to hold options, expecting to profit from future stock price appreciation. Building on this logic, in Malmendier and Tate (2005), the authors proposed the systematic tendency to hold options longer before exercise as a measure of overconfidence. Fundamental Premise of Research Studies
- 7. Bueno 7 I’d RatherBe Flying
- 8. No Bueno 8 OverconfidentCEO Crashes and Burns. News at 11:00 PM. 104°
- 9. Short Course onOption Grants $100 – 0% Return $120 – 20% Return 140 – 40% Return 160 – 60% Return Etc. – Etc. ☺ 9 100,000 Shares Strike Price $100 Price at Issuance $70 Price at Exercise
- 10. Exercise Price asAuthors’ Canonical Measure of CEO Overconfidence 10% - ? 20% - ? 30% - ? 40% - ? 50% - ? 10Considerations? Economy? Market? Union? Blue Moon? Black Swan? Industry?? Business?? Kids Private School?? Divorce?? Overconfidence
- 11. Refining the Measure11 Attempting to address the shortcomings of the previous measures, the authors attempt to incorporate capital allocation decisions to refine the measure for the current study The Rational CEO • Indifferent to various options for financing • Believes that the prices of both equity and debt are set at the fair market price • Investment decisions based solely on a project’s ability to create value for shareholders The Over-Confident CEO • Beliefs that the market undervalues the firm’s equity cause an aversion to equity financing • Overconfident CEOs are likely to turn to internal cash as their primary source of investment (or, perhaps, risk-free debt)
- 12. Alternative Measures ofCEO Overconfidence 12 Portrayal in the business press as a way to measure CEO beliefs. A common Managerial forecasts of earnings as a possible lens through which Researchers can observe overconfident beliefs. Otto (2014) measures CEO overconfidence by using the fraction of a firm’s voluntary earnings forecasts that later turned out to exceed the realized earnings. He shows that this measure is positively correlated with options-based measures of overconfidence. approach, first used in Malmendier and Tate (2008), is to count articles in prominent business publications like the Wall Street Journal or BusinessWeek that refer to CEOs using words that suggest overconfidence (“confident” / “confidence,” “optimistic” / “optimism”) relative to the number of articles that refer to CEOs with words that are unlikely to suggest overconfidence (“cautious,” “conservative,” “practical,” “reliable,” and “steady”). 1 2
- 13. Alternative Measures ofCEO Overconfidence 13 Survey instruments to elicit a direct measure of overconfidence. Ben-David, 3 Graham, and Harvey (2013) measure 45 executive biases using 10 years of a quarterly survey conducted by Duke University between 2001 and 2011, which contains projections by US chief financial officers. They use the 80 percent confidence interval of the CFOs’ predictions of one- and ten-year market-wide stock returns to illustrate the miscalibration of senior executives’ beliefs.
- 14. Overconfidence 14 Overestimation ofthe value a manager believes he or she can bring to his or her company OCM* believes the Company’s current assets are undervalued by the market. OCM overestimates the value of future potential investments. *Overconfident Manager (or CEO)
- 15. Literature on “Bad”Overconfidence 15 Malmendier and Tate 2008 Overconfident CEOs have a higher tendency to undertake mergers and, particularly, diversifying deals, especially with access to internal financing. Malmendier, Tate, and Yan 2011 OCMs use less external finance and, conditional on accessing external capital, issue less equity (more debt) than their peers Schrand and Zechman 2012 Overconfident CEOs exhibit optimism which produces unintentional earnings misses. Deshmukh, Goel, and Howe 2013 Overconfident CEOs generally pay out smaller dividends. Bouwman, Ahmed and Duellman 2013 2014 Overconfident CEOs overestimate future earnings, borrow more aggressively against future earnings to avoid current earnings misses, and delay recognition of losses. STUDY DATE FINDINGS
- 16. Literature on “Good”Overconfidence 16 Goel and Thakor 2008 Moderate biases can increase firm value by mitigating the effects of risk aversion. Campbell, Gallmeyer, Johnson, Rutherford, and Stanley 2011 CEOs with relatively low or relatively high optimism face a higher probability of forced turnover than moderately optimistic CEOs Galasso and Simcoe Hirshleifer, Low, and Teoh 2011 2012 Managerial overconfidence is generally beneficial for a firm’s innovation performance, and especially in competitive and innovative industries. Otto 2014 Firms can profit from overconfident CEOs by offering fewer grants and few bonus payment. Banerjee, Dai, Humphery- Jenner, and Nanda 2015a Firms choose overconfident CEOs at times when the predictable consequences of overconfidence on policies are likely to benefit the firm. STUDY DATE FINDINGS
- 17. Literature on “+/-”Overconfidence 17 Sunder, Sunder, and Tan 2010 The inclusion of covenants in debt contracts evidence that creditors appear to recognize behavioral biases of managers Adam, Burg, Scheinert, and Streitz 2014 Overconfidence is associated with corporate choice as to issuance of performance-sensitive debt. STUDY DATE FINDINGS
- 18. What Do AuthorsThink They Are Testing For? 18 Predictions for Study #1 Prediction 1 The investment of overconfident CEOs is more sensitive to the availability of internal cash flow than the investment of CEOs who are not overconfident. Prediction 2 The investment–cash flow sensitivity of overconfident CEOs is more pronounced in equity-dependent firms.
- 19. CEO Decision Matrix19 Internal Capital Expenditure External Merger Internal Cash Flow or Riskless Debt External Equity Capital LEVEL F I N A N C I N G
- 20. Data and Methodologyfor Study #1 20 Firm Fundamentals – Compustat Stock Prices – CRSP Database DV – Corporate investment, measured using capital expenditures scaled by the tagged value of net property, plant and equipment. Tobin’s q – measured as the ratio of market value to book value Firm Size – measured as the natural log of total assets CEO Stock Ownership – Measured as a percentage of company stock held by the CEO CEO Vested Stock Options – Measured as the number of CEO vested options scaled by the number of outstanding shares. Indicator Variable of “1” if the Board of Directors has four to twelve members. Data (1997 – 2012)
- 21. Data and Methodologyfor Study #1 21 Study regresses Tobin’s q, size, stock ownership, vested options, and efficient Board size (4-12), in levels and against cash flow. All regressors are lagged to ensure that their value predates investment choices. Study includes year fixed effects and their interaction with cash flow to capture variation in macroeconomic conditions during the 17-year sample and unobserved time-invariant differences among firms. Outliers in the upper and lower 1% of the distributions of cash flow, Tobin’s q, and investment are dropped and standard errors are clustered at the firm level. Methodology
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- 23. CEO Overconfidence and the Sensitivity ofCorporate Investment to Cash Flow (cont.) 23
- 24. Analysis of theRegression Model for Study #1 24 Predictions are supported (although modestly) in that investment cash flow sensitivity is heightened among overconfident CEOs. Firms with higher values of Tobin’s q and firms with higher cash flows invest significantly more than other firms When taking the interaction between firm fixed effects and cash flow in to account, the magnitude of these findings increases by 2 to 4 times.
- 25. What Do AuthorsThink They Are Testing For? 25 Prediction for Study #2 Prediction The investment of overconfident CEOs is more sensitive to the availability of internal cash flow than the investment of CEOs who are not overconfident. Purpose In this study, the authors attempt to address criticisms of the endogeneity of cash flow in typical investment-cash flow regression by examining an exogenous event impacting the availability of debt financing
- 26. Data and Methodologyfor Study #2 26 Data: 1996- 2012 Thomson Reuters’ Insider Filings Database Compustat Execucomp data through 2006: Executive stock and options holdings Methodology Used the exogenous shock to the credit markets in 2007 and corresponding impact to the spreads on investment-grade debt in early 2008 ● “Treatment” was measured as firms at varied percentages of long term debt maturing in 2008 ● Difference-in-differences analysis of firms with over-confident CEOs vs. firms with rational CEOs DV- average quarterly capital expenditures relative to a lagged measure of the value of capital Difference is measured with an indicator variable – After – representing one time period after the DV
- 27. CEO Overconfidence in Responding to the2007 Credit Crisis 27
- 28. Analysis of RegressionModel for Study #2 28 Findings lend support to prediction that investment decisions by over-confident CEOs are more sensitive to the cost of external financing Firms with over-confident CEOs experienced a larger drop in investment expenditures post financing shock
- 29. Conclusions & Implications29 Overconfident CEOs do seem to prefer internal financing to external equity financing Overconfident CEOs of equity-dependent firms are more likely to experience investment cash flow sensitivity The authors have contributed to the theory that drives measures of over- confidence with the use of capital allocation The Agency Problem – even if managers operate with the intention of serving the best interests of the shareholders, overconfidence can result in the destruction of value Boards may want to consider additional means of deterring biased managers outside of equity compensation; potentially to include active monitoring of the firm
- 30. Limitations and FurtherResearch 30 Authors measure cash flow over the prior fiscal year- this breaks with previous research that uses the current year Adjusting the authors’ study to use the current year cash flow causes their findings on the relationships among overconfidence, cash flow, and firm investment to be statistically insignificant Validity of model formulation and general concerns about endogeneity of available internal financing Construct Validity of Overconfidence (a behavioral construct, after all) Discriminant validity between the construct of overconfidence and other constructs like risk aversion should be established or explored
- 31. Evaluation: Teleological The questionis fairly simple – Is the conclusion of overconfidence teleological? Does it simply depend on the outcomes? Said differently, does it depend on whether you came home or crashed and burned? 31
- 32. Who Knows? Dothe Authors? What do you think? 32