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The Adverse Effects of Overvalued Stock

When prices are inflated, and governance is weak, it’s easier to underperform.

(originally published by Booz & Company)

Title: Governing Misvalued Firms

Authors: Dalida Kadyrzhanova (University of Maryland) and Matthew Rhodes-Kropf (Harvard University)

Publisher: Harvard Business School Working Paper No. 13-037

Date Published: November 2012

Boards and shareholders should increase their vigilance when their company’s stock is significantly outperforming industry averages, according to this paper. At firms that are overvalued by the market, managers—especially those with pay-for-performance incentives—are more likely to act in ways that are at odds with shareholders’ interests, the authors find. They add, however, that strong governance can counteract the problem.

This paper tests an assumption put forth by many economists that inflation in a company’s stock price can have a negative impact on managers’ decisions and eventually on the firm’s performance. An executive whose company’s stock is irrationally soaring may have more opportunity or desire to act against the firm’s long-term interests—for example, by focusing on the short term, investing in a variety of projects that do not relate to an overarching strategy, or relaxing the discipline governing the firm’s practices. Overvaluation may also create an incentive for some managers to manipulate information, possibly by distorting investments and earnings, in an attempt to justify the inflated stock prices and the expectations they create.

Researchers on corporate governance have asserted that corporate misbehavior can be curbed, at least in part, by having a strong oversight structure and a directly involved board. But the idea that governance could be particularly crucial in periods of overvaluation—when managers may be more tempted to misbehave—has not been fully examined, according to the authors of this paper.

To fill the gap, the authors gathered a variety of data on more than 2,000 firms for the period between 1990 and 2006. Most of these companies had been in the Standard & Poor’s 1500, and all had gone through a period of overvaluation. The researchers examined how many antitakeover provisions the firms had in place, using this measure as a proxy for weak corporate governance. Previous research has found that these provisions—which include “poison pills,” staggered boards, and charter amendments—can insulate managers from the takeover market and create potential conflicts of interest. They can also make it more difficult to discipline poorly performing managers.

To the paper’s authors, a high number of antitakeover provisions suggested an anti-democratic structure, in the sense that top management acted autonomously with little controlling voice from the shareholders. They thus classified firms with five or fewer antitakeover provisions (indicating strong governance) as “democracies” and firms with 14 or more (indicating weak governance) as “dictatorships.” (The median number of antitakeover provisions in the company sample was nine; the highest was 19 and the lowest was two.)

The authors performed a regression analysis using financial and stock price valuations, examining the divergence in performance between strong and weak governance firms in the four years before and the four years after overvaluation. Each firm was matched to a sample of companies in the Compustat database that had the same industry, size, and governance style, but that were not as highly valued.

The authors found that weakly and strongly governed firms performed similarly in terms of their returns on assets (ROA) during their run-up to overvaluation. But the performance of firms with weak governance started to plunge the second year after their spike in stock price. By the fourth year, these “dictatorships” dipped below the industry average. In contrast, firms with strong governance were able to maintain a higher rate of performance during the four-year period after being overvalued.

One group tended to fare particularly poorly: highly valued firms with weak governance that also set up a relatively high number of pay-for-performance incentives. For example, the gap in operating performance between weakly and strongly governed firms whose CEOs had high-powered incentive packages was about 2.2 percentage points in ROA during periods of overvaluation—or nearly half the average ROA in the sample.

“Overall, this body of work suggests that overvalued companies with high pay-for-performance are ripe for managerial short-termism or misbehavior,” the authors write, implying that “firms with this combination should find better corporate governance and oversight.”

Indeed, they say, the “relationship between high price deviations and governance and firm ROA, incentives and stock performance are all remarkably consistent with the theoretical idea [that] the misvaluation causes bad behavior and better governance helps counter it.”

Bottom Line:
When a stock is overvalued, managers may have more incentives to act at odds with shareholders’ interests, dragging down a company’s overall performance. Strong governance, however, can offset that effect. Board vigilance is therefore crucial when soaring stock prices conflict with a firm’s fundamental value.

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