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Last updated: 2021-11-29

Reasons for CEO Turnover and Effect on Stock Performance

CEO change - What leads to CEO change, and what is expected performance of a stock after changing CEO?

Reasons for CEO Turnover and Effect on Stock Performance
Introduction

In this blog post, I will go through selected literature on CEO turnover, and how this event relates to stock performance. Not all CEO changes are equal, and some conditions are more favourable for a turnaround and the big returns we are looking for.

Reasons for CEO Change

There are different reasons for change in the firm's top position [1].

  1. Succession - probably least important CEO change, typically chairman passing the CEO title, and staying with the company. Often CEOs reach retirement age. This event will probably not lead to drastic changes in direction for the company.
  2. Poor company performance - this could be driven both by CEO performance, or external factors like overall industry performance. However, a CEO is more likely to be fired when companies in peer group are doing well, and the underperformance is more apparent.
  3. Outsider brought in - could be by activist investors, in a merger, or when a company wants to expand to an unfamiliar area.

Literature [2] suggests that involuntary CEO change is most likely the result of significant underperformance of the stock, especially when compared to peers. In other words, an underperforming CEO is less likely to be forgiven by the board if the peers are doing well. When the whole industry is not doing well, a bad CEO can get the benefit of doubt. CEO change announcement is usually trying to hide that the departure was forced, citing retirement, new opportunities etc. If the age of "retiring" CEO is well below retirement age, and outsider comes in, is is often the tell that the departure was, in fact, not voluntary.

Short Term Effect of CEO Change on Stock Price

Immediately, CEO change announcement effect on stock has two components. First, the negative one, is the initial shock of the CEO leaving, and the realization of their bad performance. Second, positive, is that the change is in shareholders best interest and better times are coming. If we see stock go up or down on the news, it depends on which component dominates. For example if the poor performance of the CEO was well known, probably the reaction will be overall positive.

Longer Term Effect of CEO Change on Stock Price

In general, the long term effect on stock price is slightly positive, especially in case of forced departure. However, *volatility* increases significantly. According to [5] volatility increases 17% to 24% in the year following the event. I think that is because some CEO changes result in turnaround, while others were actually acknowledement that the company is failing.

Quote from [3]:

  forced resignations of top managers are preceded by large and significant declines in operating performance and followed by large improvements in performance.  

CEO change effect on operating income
CEO change effect on operating income. Forced resignations clearly show period of underperfomance leading to resignation, followed by greatly improved operating income. From [3]

It is often the case that short term shock and continuous downtrend keep the underperformance going for a while after CEO change annoucement. It also takes time for new CEO to implement changes in the firm. Research in [4] found that "The return begins to recover in the first 12 months following the departure and continues over the following 36 months".

CEO change effect on operating income
CEO change leads to positive abnormal return after 12 months. From [4]
Conclusion

There are different types of CEO change, and when it's forced change, ideally with an outsider coming in, it results in increased volatility, and, on average, outperformance. However, the outperformance usually begins in about 12 months.

One could make a checklist for promising CEO change:

  •  Company underperforms, peers perform well
  •  Departing CEO bellow retirement age
  •  Outsider coming in
  •  Investment time horizon > 12 months

References
  1. Warner, Jerold B., Ross L. Watts, and Karen H. Wruck. "Stock prices and top management changes." Journal of financial Economics 20 (1988): 461-492. https://www.sciencedirect.com/science/article/abs/pii/0304405X88900542(paywalled)
  2. Jenter, Dirk, and Fadi Kanaan. "CEO turnover and relative performance evaluation." the Journal of Finance 70.5 (2015): 2155-2184. https://onlinelibrary.wiley.com/doi/abs/10.1111/jofi.12282(paywalled)
  3. Denis, David J., and Diane K. Denis. “Performance Changes Following Top Management Dismissals.” The Journal of Finance, vol. 50, no. 4, [American Finance Association, Wiley], 1995, pp. 1029–57, https://doi.org/10.2307/2329343 (paywalled).
  4. GENERATING ALPHA FROM EVENT DRIVEN INVESTING, David S. Pope, CFA, Managing Director, Quantamental Research https://www.northinfo.com/documents/562.pdf
  5. Matthew J. Clayton & Jay C. Hartzell & Joshua V. Rosenberg, 2003. "The impact of CEO turnover on equity volatility," Staff Reports 166, Federal Reserve Bank of New York. https://ideas.repec.org/p/fip/fednsr/166.html

Tags: Research | Tickers: | Author: David Nohejl