Net Share Issuance and Asset Growth Effects: The Role of Managerial Incentives

Abstract

By considering executives’ stock holdings (incentives) alongside their decisions over equity buybacks/issuance and asset growth, investors can discern companies likely to outperform.

In the presence of asymmetric information, managerial equity incentives mitigate company managers’ empire-building motives while increasing their market-timing motives. If the market underreacts to these motives, the negative return predictability by net share issuance (NSI) and asset growth (AG) should be more pronounced among stocks with, respectively, larger managerial equity incentives and smaller managerial equity incentives. Our evidence supports this prediction. A hybrid strategy that exploited the NSI and AG effects in different groups of stocks screened by managerial equity incentives attained significant alphas after transaction costs, even after we controlled for the investment and profitability factors known to attenuate the two effects.

Disclosure: The authors report no conflicts of interest.

Editor’s Notes

Submitted 4 June 2019

Accepted 17 September 2019 by Stephen J. Brown.

Acknowledgment

We would like to thank executive editor Stephen Brown, co-editor Luis Garcia-Feijoo, and two anonymous reviewers. We would also like to thank James Hasbrouck; Vitali Kalesnik; Engin Kose; Corey Lang; Bing-Xuan Lin; James Opaluch; Xinyuan Tao; Konari Uchida; Masahiro Watanabe; Xiaowei Xu; Toru Yamada; Fang Yu; Fei Su; conference participants at FMA 2019 (New Orleans), CIRF 2019 (Tianjin), and Nippon Finance Association 2019 (Tokyo); and seminar participants at Hitotsubashi University, Kyushu University, and the University of Rhode Island for helpful comments and suggestions.

Correction Statement

This article has been corrected with minor changes. These changes do not impact the academic content of the article.

Notes

¹ For the NSI effect, see Fama and French (2008) and Pontiff and Woodgate (2008). For the AG effect, see Cooper, Gulen, and Schill (2008). Unlike many other effects, the NSI and AG effects are not driven by small-capitalization stocks that are difficult to trade (Hou, Xue, and Zhang forthcoming). Moreover, transaction costs do not wash away the effects completely (Novy-Marx and Velikov 2016). Both effects are present not only in the US market but also in many other developed markets (McLean, Pontiff, and Watanabe 2009; Watanabe, Xu, Yao, and Yu 2013).

² To our knowledge, this study is one of the first to investigate the effects of managerial incentives on the cross-sectional predictability of stock returns. Several earlier event studies examined the effects of managerial equity incentives (i.e., sensitivities of the top managers’ wealth to stock price changes) on the stock market’s reactions to seasoned equity offerings. They include Datta, Iskandar-Datta, and Raman (2005); Brisker, Autore, Colak, and Peterson (2014); and Kim and Purnanandam (2014). In particular, Brisker et al. (2014) showed that the long-run underperformance of seasoned equity offerings is more pronounced for the companies with large managerial equity incentives than for those with small managerial equity incentives. We are not aware of other studies that have provided similar results for share repurchases or capital investments (asset growth). Few papers, to our knowledge, have examined the effects of managerial equity incentives on cross-sectional return predictability in the factor-investing framework.

³ Here, large (small) managerial equity incentives mean high (low) sensitivities of the top managers’ wealth to stock price changes. According to Edmans, Gabaix, and Jenter (2017), in the period between 2000 and 2015, stock grants and options on company shares accounted for 50%–60% of CEOs’ and other top executives’ compensation at US public companies.

⁴ Goto, Kalesnik, de Kok, and Kose (2019) observed a significant NSI effect only among the companies that timed their equity financing activities successfully in the previous year; that is, successful market-timing activities tend to persist.

⁵ Some earlier influential studies that examined the long-run underperformance of seasoned equity offerings include Loughran and Ritter (1995, 1997) and Spiess and Affleck-Graves (1995). Pontiff and Woodgate (2008) proposed NSI as a cross-sectional return predictor to get around econometric concerns associated with long-run event studies (Brav, Geczy, and Gompers 2000; Mitchell and Stafford 2000; Schultz 2003). Our analysis of the NSI effect thus focuses on the cross-sectional return predictability of the NSI signal along the lines of Pontiff and Woodgate (2008) and Fama and French (2008).

⁶ Both AG and NSI effects are stronger among companies with high idiosyncratic volatility than among those with low idiosyncratic volatility. See Lipson, Mortal, and Schill (2011) for the AG effect and Larrain and Varas (2013) for the NSI effect.

⁷ We found that the hedge portfolio for exploiting the NSI effect among the companies with large managerial equity incentives was only moderately correlated with the hedge portfolio for exploiting the AG effect among companies with small managerial equity incentives, which suggests potential diversification benefits.

⁸ We provide a detailed description of Delta5 in the next section.

⁹ In this study, the information ratio is the annualized ratio of alpha to residual return volatility, as in Grinold and Kahn (1999). Some readers may prefer the term “appraisal ratio” for this definition of IR. A rule of thumb would be that only the top 25% of active equity portfolio management strategies will attain an IR of 0.5 or above against a simple market model (e.g., Grinold and Kahn, p. 114).

¹⁰ More precisely, ExecuComp started covering the S&P 1500 universe in 1994. The coverage in 1992–1993 was mostly for S&P 500 companies. Excluding the first two years of the sample had virtually no effect, however, on the findings we report.

¹¹ Alternatives to NSI include the net external financing signal proposed by Bradshaw, Richardson, and Sloan (2006) and the composite equity issuance signal of Daniel and Titman (2006).

¹² We greatly benefited from the SAS program (previously known as “Statistical Analysis System”) provided by Lalitha Naveen on her website: https://sites.temple.edu/lnaveen/data/.

¹³ The ExecuComp database provides compensation data for the five highest compensated officers for each company. An alternative would be to use the CEO delta. Our results were almost identical when we used the CEO delta instead of Delta5. Armstrong, Larcker, Ormazabal, and Taylor (2013) argued, however, that focusing on the delta of the management team is more sensible than focusing on CEO incentives, which may be confounded by the CEO’s individual-specific characteristics.

¹⁴ Following Fama and French (2008), we defined micro-cap stocks as those with market capitalizations below the 20th NYSE percentile.

¹⁵ We greatly benefited from the SAS code provided by Joel Hasbrouck on his website: http://people.stern.nyu.edu/jhasbrou/. He also kindly answered our questions regarding the implementation of his transaction cost measures.

¹⁶ That is, we subtracted transaction costs from the long leg and added transaction costs to the short leg.

¹⁷ The large downside risk of the momentum factor, called the “momentum crash,” was documented by Barroso and Santa-Clara (2015) and Daniel and Moskowitz (2016).