Governance and Market Governance and Market EfficiencyEfficiency

René M. StulzRené M. Stulz

The Ohio State University, The Ohio State University, ECGI, and NBERECGI, and NBER

Stock-price focused Stock-price focused governancegovernance• Key principles:Key principles:

– Management should maximize firm’s stock priceManagement should maximize firm’s stock price– Compensate management according to wealth Compensate management according to wealth

created as measured by change in firm’s stock created as measured by change in firm’s stock priceprice

– Management should be given incentives to Management should be given incentives to maximize firm’s stock pricemaximize firm’s stock price

• Problem: Relies critically on market efficiencyProblem: Relies critically on market efficiency

• Why? Otherwise, management can make the Why? Otherwise, management can make the right decision but the stock price can fallright decision but the stock price can fall

AgendaAgenda

• Forms of market efficiencyForms of market efficiency

• Market efficiency and stock-price Market efficiency and stock-price reactions to corporate decisions: reactions to corporate decisions: Using acquisitions as an exampleUsing acquisitions as an example

• Managerial incentives when markets Managerial incentives when markets are not strong-form efficientare not strong-form efficient

• What should be done?What should be done?

1. Forms of efficiency1. Forms of efficiency

• Strong formStrong form– All information is in stock priceAll information is in stock price– Does not exist when information Does not exist when information

asymmetries are importantasymmetries are important

• Semi-strong formSemi-strong form– All public information is in stock priceAll public information is in stock price– Focus of behavioral finance critiqueFocus of behavioral finance critique

• Weak formWeak form

2. Stock price reactions2. Stock price reactionsAggregate dollar return to acquiring-firm shareholders

-160

-140

-120

-100

-80

-60

-40

-20

0

20

40

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Bil

lion

dol

lars

Some resultsSome results

• 4,136 acquisitions from 1998 to 20014,136 acquisitions from 1998 to 2001• Typical acquisition is associated with stock-price Typical acquisition is associated with stock-price

gain but…gain but…• 87 acquisitions from 1998 to 2001 have dollar loss 87 acquisitions from 1998 to 2001 have dollar loss

exceeding $1 billion eachexceeding $1 billion each• The 87 represent 43.4% of amount spent on The 87 represent 43.4% of amount spent on

acquisitionsacquisitions• Total loss of $397 billion Total loss of $397 billion • Abnormal return of -10.6%.Abnormal return of -10.6%.• From 1998 to 2001: Total loss from acquisitions is From 1998 to 2001: Total loss from acquisitions is

$240 billion$240 billion• Abnormal return of the 87 is -10.6%. What does it Abnormal return of the 87 is -10.6%. What does it

mean? mean?

What does the stock-price What does the stock-price reactions mean?reactions mean?

• Depends on form of market efficiencyDepends on form of market efficiency

• Strong-form: NPV of acquisition; Strong-form: NPV of acquisition; shareholders are necessarily worse offshareholders are necessarily worse off

• Semi-strong form: not NPV; long-term Semi-strong form: not NPV; long-term shareholders may be better offshareholders may be better off

• Weak-form: not NPV; long-term Weak-form: not NPV; long-term shareholders may be better offshareholders may be better off

Bottom lineBottom line

• Actions that are associated with Actions that are associated with negative stock-price reactions may negative stock-price reactions may be good for long-term shareholdersbe good for long-term shareholders

• But, they are necessarily bad for But, they are necessarily bad for short-term shareholdersshort-term shareholders

• With strong-form market efficiency, With strong-form market efficiency, there is no distinction between short- there is no distinction between short- and long-term shareholdersand long-term shareholders

Managerial incentives and Managerial incentives and efficiencyefficiency

• Strong-form efficiency: maximizing Strong-form efficiency: maximizing stock price is the right objective.stock price is the right objective.

• Not strong-form efficiency: Not strong-form efficiency: – Management may not do the right thing Management may not do the right thing

from the perspective of long-term from the perspective of long-term shareholdersshareholders

– Management may manipulate stock Management may manipulate stock price through accountingprice through accounting

Fastow, March 8, 2006Fastow, March 8, 2006

• "At Enron, the culture was, the "At Enron, the culture was, the business practice seemed to business practice seemed to consistently be, to do transactions consistently be, to do transactions that maximized the financial that maximized the financial reporting as opposed to maximized reporting as opposed to maximized the true economic value," he said.the true economic value," he said.

Are departures from strong-Are departures from strong-form efficiency important? form efficiency important? EvidenceEvidence• Enron, Worldcom, ParmalatEnron, Worldcom, Parmalat• Insider trading evidence?Insider trading evidence?• Accounting fraud and taxesAccounting fraud and taxes• Long-term returnsLong-term returns• What about departures from semi-strong What about departures from semi-strong

form of efficiency?form of efficiency?• Long-term returnsLong-term returns• BubbleBubble• Back to the merger caseBack to the merger case

Mergers againMergers again

• Moeller, Schlingemann and Stulz (2006) Moeller, Schlingemann and Stulz (2006) examine the impact of departures from examine the impact of departures from strong-form market efficiency on strong-form market efficiency on merger announcement returnsmerger announcement returns

• Evidence shows that proxies for Evidence shows that proxies for information asymmetries are importantinformation asymmetries are important

• Can’t exclude a role for departures from Can’t exclude a role for departures from semi-strong formsemi-strong form

What should be done?What should be done?

• Governance should be robust to departures from Governance should be robust to departures from strong-form efficiencystrong-form efficiency

• Deadweight costs of focusing on short-term Deadweight costs of focusing on short-term shareholdersshareholders

• Social welfare case is strongest for focusing on Social welfare case is strongest for focusing on long-term shareholderslong-term shareholders

• Make market more efficient through greater Make market more efficient through greater disclosuredisclosure

• Make managers bear the consequences of their Make managers bear the consequences of their actions even after they have leftactions even after they have left

• Combine accounting and stock price performance Combine accounting and stock price performance measuresmeasures