Incentives Work. - btbirkett@gmail.com - Gmail

Two Cheers for a Stronger Yuan and a Decisive U.K. - btbirkett@gmail.com - Gmail



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Incentives Work...

It is established investment lore that hubristic behavior by CEOs can tell you a lot. Avoid companies that have just spent a lot on flagship new headquarters. And steer clear of those where insiders are selling.

It is also established lore that incentives work. Give someone an incentive to do something, and they will do it.
 

Putting these beliefs together, new research suggests, might be a good way to spot some good stocks to own, and some to avoid.

Looked at more rigorously, fast asset growth in a company can often be a red flag, as it suggests empire-building may be taking priority over shareholder value. Meanwhile, buying back shares is a sign that managers believe they are undervalued.

How far can either signal be trusted? A lot, it turns out, provided we combine them with information on how exposed a company’s executives are to its share price. An ambitious study for Financial Analysts Journal by Shu Yan of the Spears School of Business at Oklahoma State University and a group of colleagues tried constructing a portfolio in the following way:

• For companies with low managerial incentives (meaning top management didn’t gain much from incremental improvements in the share price), it sold short those with high asset growth, and bought those with low asset growth;
• For companies with high managerial incentives, it shorted those that were issuing shares (showing management considered them overvalued), and bought those that were shrinking the float (showing that management thought the stock was cheap). 

To cut a lot of mathematics short, the strategy worked beautifully. It delivered returns comfortably above the market, even after taking into account transaction costs and established investment factors such as value and momentum. You can trust the market-timing decisions of heavily incentivized managers, and you can thoroughly distrust the empire-building of managers who aren’t incentivized. As of Monday, the paper should be available here.