When you visit the auto repair shop, do you ever wonder if the mechanic is recommending expensive fixes because you really need them or because the fixes will increase the shop’s income? There are many situations like this when we are forced to rely on others to act in our best interest. If the incentives of both parties aren’t closely aligned, and often they are not, conflicts may arise. Economists call this the “principal-agent problem.” This occurs when one party, the agent, is empowered to make decisions that directly affect another party, the principal. Politics, where voters (principals) empower politicians (agents) to represent their interests, may provide another example of the difficulties of principal-agent relationships.
In the context of investing, shareholders (principals) hire a company’s CEO and other managers (agents) to run the company for them. The challenge for shareholders is to create incentives for managers to behave like shareholders. One option would be for CEOs to be large shareholders themselves. That would seem to eliminate most potential conflicts. But would it really make a meaningful difference?
Ulf von Lillenfeld-Toal of the University of Luxembourg and Stefan Reunzi of the University of Mannheim reviewed the performance of hypothetical portfolios organized by various levels of CEO ownership. In a paper published last year in the Journal of Finance, they determined that U.S. stocks with high levels of CEO ownership resulted in higher stock returns for the period they studied, 1998-2010. Portfolios comprised of stocks where CEOs owned at least 5% of shares outstanding outperformed portfolios with a similar risk profile by an average of 5.7% annually. At the 10% ownership threshold, the outperformance was 6.2%, annually. Reunzi and von Lillenfeld-Toal concluded that high-ownership CEO companies were more efficient than the average company and that high-ownership CEOs tended to make better use of capital and avoid wasteful errors—such as making numerous large acquisitions that have the effect of growing the CEO’s empire without improving profitability or shareholder returns.
While there are substantial risks to relying on a single factor (like CEO ownership) to make investment decisions, as the researchers did in their hypothetical portfolios, we have long appreciated the value of a management team whose incentives are strongly aligned with shareholders. … Certainly, a number of different factors combine to make a successful investment, and we apply these factors every day in our search for the best investment opportunities. That said, it can be very rewarding to invest with a good management team that has lots of incentives to act in the best interests of shareholders.