Governance Through Shame and Aspiration: Index Creation and Corporate Behavior

Akash  Chattopadhyay; Matthew D.  Shaffer; Charles C.Y. Wang

Article | Journal of Financial Economics | Forthcoming

Governance Through Shame and Aspiration: Index Creation and Corporate Behavior

by Akash Chattopadhyay, Matthew D. Shaffer and Charles C.Y. Wang

Abstract

After decades of deprioritizing shareholders' economic interests and low corporate profitability, Japan introduced the JPX-Nikkei400 in 2014. The index highlighted the country's "best-run" companies by annually selecting the 400 most profitable of its large and liquid firms. We find that managers competed for inclusion in the index by significantly increasing ROE, and they did so at least in part due to their reputational or status concerns. The ROE increase was predominantly driven by improvements in margins, which were in turn partially driven by cutting R&D intensity. Our findings suggest that indexes can affect managerial behavior through reputational or status incentives.

Keywords: JPX-Nikkei 400 index; Status incentives; return on equity; capital efficiency; Social Norms; Index inclusion; Reputation incentives; Motivation and Incentives; Corporate Governance; Behavior; Investment Return; Status and Position; Japan;

Format: Print

58 pages

SSRN Read Now

Citation:

Chattopadhyay, Akash, Matthew D. Shaffer, and Charles C.Y. Wang. "Governance Through Shame and Aspiration: Index Creation and Corporate Behavior." Journal of Financial Economics (forthcoming).

The case describes the investment of hedge fund, Totem Point Management in Analog Semiconductors (ADI) as a way to discuss forecasting and valuation in growth companies. In June 2016, hedge fund Totem Point invested in ADI at around $55 a share. In general, Totem Point aimed for their investments to yield 50% returns over a two-year time horizon. It was now 2018, and Totem Point was evaluating whether to maintain its position in ADI, expand it, or close it and walk away with its (substantial) winnings from the investment. Though the stock had done well in the prior two years, it had recently seen numerous downgrades by sell-side analysts, as its price slid 15% from a historic high. The question facing Totem Point, was whether it would grow by a further 50% over the next two years. To answer this question, Totem Point considered growth trends in each of ADI’s main end-markets: industrial applications, consumer applications, automotive applications, and telecommunications applications. If these end-markets expanded over the coming two years, ADI would do very well, but if they failed to expand, the stock would stagnate. Totem Point’s task was to figure out which scenario was most likely and what that scenario would mean for the stock’s price.

Relative total shareholder returns (rTSR) has become the predominant metric to isolate managers' idiosyncratic performance. Among firms that explicitly use rTSR in relative performance contracts, 60%—those that choose specific peers as benchmarks—select rTSR metrics that do a remarkable job of filtering out the systematic component of returns in adherence to the informativeness principle. However, firms that choose index-based benchmarks retain substantial systematic noise in their rTSR metrics. We document that the selection of noisy benchmarks is associated with compensation consultants' preferences, which are uncorrelated with observable firm attributes. Firms with weak governance are more likely to choose indexes, not because of opportunism, but because they do not adequately scrutinize outside experts' advice. Collectively, our findings provide a new explanation for why some executives are evaluated based on systematic noise and novel evidence on how compensation consultants can impact firms.

Faculty & Research

Governance Through Shame and Aspiration: Index Creation and Corporate Behavior

Abstract

Citation:

About the Author

More from the Author