Options Do Not Raise Performance, Study Finds
By DAVID LEONHARDT
The downside to stock options has become spectacularly evident in the
last year or so. They can give executives an incentive to inflate their
company's earnings or make irresponsibly optimistic forecasts to keep their
stock prices high and their paychecks lavish.
With executive indictments continuing, the benefits of options are easily
forgotten. Enron and its brethren aside, however, isn't the economic rationale
for awarding managers stock to align their interests with those of shareholders
as solid as it has always been?
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No — and it was never really as solid as it seemed, says a new paper that will
be presented tomorrow at an academic conference in Denver. Combining
more than 200 studies over 30 years to create the largest possible sample, the
paper finds that the amount of equity executives own does not affect their
company's performance.
"There's no relationship whatsoever," said Dan R. Dalton, the dean of Indiana
University School of Business and one of the paper's four authors.
The conclusion is hardly intuitive, coming after years in which investors and
executives hailed stock ownership as a solution to the age-old problem of
how to ensure that people who run but do not own a business act in the best
interests of the owners. Adam Smith noted the problem in 1776, writing,
"negligence and profusion, therefore, must always prevail, more or less, in the
management of the affairs of such a company."
The recent stock market bubble has shown that negligence and profusion can
prevail, and investors can turn a blind eye to them, even when executives own
large stakes in their company. Now that some investors want to reform
executive pay, the new findings deserve a place in the debate.
When scientists talk about the relationship between two variables, they like to
use the numbers zero and one. Measuring the relationship between the height
from which a ball is dropped and its speed when it hits the ground, for
instance, will yield a number very close to one, showing a nearly perfect
correlation. The relationship between the latitude of an American city and its
average temperature will fall between zero and one — a significant correlation
but not close to perfect.
The relationship between executives' stock holdings and their companies'
performance is so close to zero that it is zero in statistical terms, the paper
says. This means that an alphabetical ranking of companies is as apt to predict
their performance as a ranking based on executives' holdings.
A number of explanations are possible. Other incentives, like cash pay and an
executive's reputation, may be as strong as stock in motivating executives.
Even if stock is a powerful incentive, the strength of the economy and the
long-term health of a company may determine its results more than a group of
executives can.
"It's possible that we attribute far too much control to executives relative to
what they actually possess," Mr. Dalton said.
The researchers looked at a long list of performance measures, and the only
one that seemed even slightly related to executives' equity was the easiest for
managers to manipulate: earnings per share. Executives can lift that figure by
directing the company to buy back shares or cut its dividend payments.
Buying back stock may not be ideal for the company, but it is likely to lift the
stock price at least temporarily.
"You have to step back and ask yourself who is attending to the long-term
interests of an organization?" said Kathryn M. Daily, a professor at Indiana
and one of the authors. "No one." The other authors are S. Travis Certo of
Texas A&M University and Rungpen Roengpitya of Indiana. The paper will
be presented at the annual meeting of the Academy of Management.
The paper's conclusions are not wholly original and are not likely to be the last
word on executives' stock holdings. Many economists believe that equity can
affect performance but only when it is part of a more complicated corporate
governance strategy, a possibility the authors do not dispute. Ira Kay, a
compensation consultant who has read the paper, said the fact that the studies
on which the paper is based dated to 1970 gave him hope that a new study
would produce different conclusions.
"A lot of the studies are old and were done before there was significant stock
ownership, which is what it took to have an effect on performance," Mr. Kay
said.
For now, however, skepticism is in order. When executives receive enormous
grants of stock or options, they like to say that they are acting in the interests
of their investors. The executives might be more credible if they simply said
they thought they deserved a lot of money.
nytimes.com
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