How much difference do chief executives really make to a business? “A lot,” say shareholders in Prudential. They raised the price of the company by £580 million yesterday when they learned that Jonathan Bloomer was to be replaced as CEO by Mark Tucker.
If this judgment is right, there's something very wrong about the market for chief executives; either Mr Bloomer was massively overpaid or Mr Tucker is grossly underpaid. But is it right? Of course, the Pru’s price fell sharply under Mr Bloomer’s watch. But how much of this is really his fault?
A proper answer to this question requires us to do two things. First, we must identify the Pru’s stock-specific returns. And then we must identify what proportion of these can be attributed to the chief executive.
Both steps are tricky.
Once, people thought step one was easy. The capital asset pricing model tells us that the only systematic effect on a share price is the market (or strictly speaking, a global portfolio). If this is right, stock-specific returns are simply those returns that cannot be explained by the share’s covariance with the global portfolio - they are the Jensen's alpha.
Sadly, though, we now know the CAPM is incomplete. The market is not the only systematic influence on a share’s price. The trouble is, though, that – as John Cochrane shows – we don’t yet know for sure what exactly the other systematic influences are. We don't even know whether they are mainly macroeconomic risk factors or mainly investors' cognitive biases.
If we don’t have a settled and agreed upon asset pricing equation, we can’t precisely identify stock-specific returns.
And even if we could identify stock-specific returns, we couldn’t pin down the proportion of these that are due to the CEO. CEOs don’t have unlimited power within a company. Even a good CEO can find himself frustrated by intransigent board members, a stubborn corporate culture or simply legal restrictions on his ability to sack bad employees. Equally, a bad CEO might preside over good stock-specific returns if he’s inherited a basically good company.
It is, then, impossible to say how much difference a CEO really makes.
If I were to say that CEOs made no difference to a company, and that the belief to the contrary were just an application of the fundamental attribution error or managerialist ideology, what hard evidence could you present to the contrary, except for pointing to a handful of extreme cases, such as Enron?
There’s one more problem here, though. Let’s say CEOs can make a difference. It doesn’t follow that investors can spot the bosses who are good enough to turn a company around.
Two cases will show my point. When Simon Wolfson took over at Next, many shareholders were sceptical. They thought he was too inexperienced for the job, and was the beneficiary of nepotism. Next’s price rose sharply in the following months. By contrast, when Rick Haythornthwaite took over at Invensys, shareholders welcomed his appointment. He’d done a good job, they thought, at Blue Circle. Invensys' share price has since collapsed.
As Warren Buffett once said: "when a chief executive with a good reputation takes over a company with a bad one, it is the company that keeps its reputation."
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