By Ben Haimowitz, Academy of Management
What happens when the romance of corporate leadership collides with the romance of stock analysis? With a massive literature devoted to leadership and American companies reportedly spending $14 billion a year to teach it, one might expect a CEO’s reputation for superior governance to prove dominant over even sharp-eyed analysis. Yet, some new research finds otherwise.
According to a study in the current issue of the Academy of Management Journal, “a downgrade by a star analyst causes tremendous valuation changes, which are not offset by the CEO’s reputation….CEO reputation buffers the stock market reaction to downgrades by regular analysts, but, when a downgrade is issued by a star analyst, the CEO’s reputation has almost no effect on the market reaction.”
In short, “star analysts’ reputation is more powerful when it comes to how the market reacts to downgrades, even when star analysts are downgrading firms run by star CEOs.”
Specifically, the researchers found the stock market’s reaction to a downgrade by a star analyst (someone ranked among the top one sixth or thereabouts of the breed) led to an average market-adjusted, two-day decline of a stock of 3.5 to 3.6 percent whether the CEO had won as many as five prestigious leadership awards over the previous five years or had been honored with one or two or none at all. In marked contrast, the impact of a downgrade by analysts outside that select circle varied considerably depending on the reputation of the CEO. While leading to an average market-adjusted decline of 1.93 percent for firms headed by five-time leadership honorees, it produced a 2.74 percent decline for those headed by non-honorees (presumably run-of-the-mill types), a drop of 42 percent more.
Comments Steven Boivie of Texas A&M University’s Mays Business School, who conducted the research with Scott D. Graffin of the University of Georgia and Richard J. Gentry of the University of Mississippi, “There has been much documentation of the advantages a firm enjoys when the CEO has a reputation for excellent leadership (an advantage our study confirms), but little research has been done on how this plays out in interactions with highly reputed others. We’ve all heard about the romance of leadership, a belief verging on mysticism about what great chief executives can lead companies to achieve. But, although we don’t hear quite as much about it, there’s also a romance of stock analysts, who, as Harvard’s Boris Groysberg informs us, have been variously described by seasoned investors as ‘Diogenes with a lamp’ or ‘a Renaissance man’ or a ‘course fixed on truth.’ Our findings suggest that the romance of analysis exceeds the romance of leadership, at least where the investment community is concerned.”
The researchers found a pattern among upgrades that was a somewhat reduced mirror image of the pattern for downgrades. Once again, rating changes by star analysts had the greatest impact on the market. And, once again, the market response to star-analyst changes was about the same no matter the number of awards garnered by CEOs, the average market-adjusted response to their upgrades being between 3.27 percent and 3.29 percent, whether the CEO was a non-honoree or a five-timer.
In contrast, the mean response to upgrades by non-star analysts ranged from 1.86 percent for firms with five-time-honoree CEOs to 2.29 percent for companies of non-honorees, a 23 percent greater boost for the latter group. Why do firms of pedestrian CEOs receive this significantly greater bump? As the professors explain, “Increased expectations for future performance will cause shareholders to react less positively to upgrades by analysts because their expectations that star CEOs will continue to deliver high levels of performance are already reflected in the firm’s value.”
The study draws on large databases of corporate, financial, and market information compiled over a 13-year period. CEO reputation is determined by the number of leadership awards bestowed on a chief in the five years previous to a given year by seven leading business magazines. Analyst stardom is gauged by selection to one of the all-American teams published annually by Institutional Investor magazine through worldwide surveys of money managers at large investment and hedge funds, a select group that constitutes about 17 percent of analysts. The study’s total of about 19,500 downgrades and 17,400 upgrades each consisted of a change of one point or more in recommendations that ranged from 1/strong buy to 5/strong sell.
As would be expected, the researchers controlled for many factors that can influence the effects of changed recommendations, including those related to analysis (such as extent of analysts’ experience or number of a firm’s upgrades or downgrades in the prior two weeks); those related to firms themselves (such as size, diversification, past profitability, and percent of institutional ownership); and those associated with company management (such as board size, CEO duality, and CEO tenure).
CEOs were recipients on average of 1.25 prestigious awards for leadership over five previous years, the study reveals. For the entire sample, each prior award reduced market reaction to a downgrade by an average of 3% and (because of higher market expectations for superior leadership) reduced reaction to an upgrade by 4%. In addition to finding that recommendation changes by star analysts amplified changes in market response compared to those resulting from changes by non-stars, the professors found that “firms being covered by star analysts received more upgrades and downgrades,” a finding that suggests that “star analysts may simply have more discretion in changing the recommendations they issue, and may also have a greater incentive in making changes in order to maintain their recommendation’s accuracy.”
It was also discovered that firms led by CEOs who had received one or more awards generally elicited more recommendation changes than others, which, the professors speculate, may be attributable to analysts’ seeking to “garner attention.” At the same time, “having a large number of CEO awards decreased the number of downgrades a firm received by star analysts.” The two findings lead the authors to observe that “firms led by star CEOs receive greater scrutiny in general…but CEO reputation may offset that scrutiny for star analysts.”
In conclusion, the authors wonder if, given that “star analysts move markets dramatically and are generally more likely to issue recommendation changes…it might be worthwhile [re]considering to what types of firms they are assigned. Markets may function more effectively if these influential analysts are distributed more evenly across all firm sizes and types.”
Adds Boivie: “Instead of having so much insight, and influence clustered around a relatively small number of the sexiest firms, maybe that talent can be of more service covering a more varied group. Instead of having three or four all-stars covering Google or Apple, maybe we could do as well with one or two.”
The paper, “Understanding the Direction, Magnitude, and Joint Effects of Reputation when Multiple Actors’ Reputations Collide” is in the February/March issue of the Academy of Management Journal. This peer-reviewed publication is published every other month by the academy, which, with more than 18,000 members in 123 countries, is the largest organization in the world devoted to management research and teaching. The Academy’s other publications are Academy of Management Review, Academy of Management Perspectives, Academy of Management Learning and Education, Academy of Management Annals and Academy of Management Discoveries.