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Company execs and stock analysts too close, studies suggest

September 1, 2004

For more information, contact: Benjamin Haimowitz,

The people who are at the tops of major firms today are quite different from their predecessors of 25 years ago in terms of their values, their ethos, their outlooks. The predecessors of 25 years ago would have been Steady Eddies...Contemporary CEOs ...are surrounded by the language of wealth maximization...and they in turn adopt this as their own mantle, expecting their cut.

The intense focus today on raising stock prices leads investors to identify the company with the CEO and makes the CEO?s relationship with the Street an increasingly important determinant of company valuation. I think this state of affairs has led to a different kind of CEO, who may be inclined to different types of behavior than we've encountered before.

How far is the world of company management from the world of Wall Street? Closer than the two have been in quite a while, one would gather from the above comments of professors who took part in an Academy of Management panel discussion last year on the subject of CEO pay.**

Is that closeness a good thing? Several studies presented at the 2004 annual meeting of the Academy of Management (New Orleans, August 8-11) suggest not -- notwithstanding the fact that management gurus have been working assiduously over the past few decades to bring it about.

Among several thousand studies on a host of subjects to be presented at the Academy of Management meeting, four in particular addressed this issue.

-- One study found that, to a surprising extent, stock analysts are influenced by the image CEOs project in the letter to shareholders in companies' annual reports, and are unduly swayed by hints of charisma they find there.

-- A second study found that, the longer analysts report on a company, the more uncritically optimistic they tend to be. When it comes to predicting firm performance, objectivity trumps familiarity.

-- A third study focused on the recovery of airlines after 9/11 and finds that those that made the best recovery were able to do so because of financial policies for which they were strongly criticized by Wall Street. Meanwhile, the major airlines that adopted the policies Wall Street favored have been struggling ever since.

-- A fourth study compared the way corporate executives and stock analysts evaluate the performance of major companies and finds good reason for a wary, arm's-length relationship between the two groups.

Hints of charisma in CEO letter to shareholders have undue impact on stock analysts

Considerable evidence in recent years suggests that corporate America has come to attach great importance to charisma in CEOs. Now research presented at the Academy of Management annual meeting suggests that stock analysts are equally sold on charismatic company chiefs -- so much so that they are all too receptive to hints of charisma in annual-report messages of new CEOs.

Such is the conclusion of Angelo Fanelli of HEC School of Management, Vilmos F. Misangyi of the University of Delaware, and Henry Tosi of the University of Florida. As they put it, "The social contagion effects of CEO charisma can be triggered by the careful use of words and text as a symbolic management tactic hinging upon the projection of a charismatic persona and vision...[P]revious firm performance lapses may be overlooked and mistakes forgiven, at least for a period of time."

In earlier studies, these same researchers had gathered evidence of CEO charisma through anonymous surveys of managers who worked for the chiefs in question. In this study, they seek evidence in something more remote from the source -- namely, the CEO letter to shareholders that is a staple of corporate annual reports.

Even at that remove, they find, evidence of CEO charisma proves enticing enough to have a significant effect on ratings issued by stock analysts.

"The letter to the shareholders is the most widely read section of the annual report," the authors write, "and presents several characteristics that make it suitable to study symbolic management: it is relatively free from legal restrictions about its form or content, communicates both facts and beliefs in a form that is directly approved by the CEO, reflects managerial attributions, locus of attention and framing strategies."

The study draws on the text of CEO letters to shareholders in the annual reports of 367 companies selected from among the largest corporations in 30 industries. So that CEO charisma would not be mixed up with company performance, the sample was restricted to new CEOs, whose message to the shareholders would represent the chief's first direct communication with that constituency.

To measure the amount of charisma in the letters, the professors assigned individual sentences in each letter to one of three themes -- 1) assessment of the past, 2) vision for the future, and 3) shareholders, employees, and organizational capabilities. Then for each sentence related to one or another of the themes, they made a count of particular words that conveyed the theme in strong, decisive, or emphatic ways and thereby conveyed an impression of charisma. In doing so, they were able to draw on thematic lists of words compiled in earlier linguistic research by other management scholars.

-- In sentences relating to the past, the words that project a charismatic image would be clearly negative or suggestive of crisis.

-- In sentences relating to vision for the future, the words would be moral, ideological, or emotional.

-- In sentences referring to employees, shareholders, and organizational potential, the words would convey outreach, approbation, optimism.

By this process, the professors obtained a measure of the frequency of charisma-projecting words for each of the 367 CEO messages to shareholders. They were then able to assay the relationship between this measure and the ratings that stock analysts assigned to the individual companies on a scale ranging from 1=strong buy to 5=sell. To get a true picture of that relationship, the professors controlled for an array of factors that affect such ratings, including prior firm performance, CEO reputation, and analysts' previous records of stock recommendations.

Other things being equal, the study concludes, the more charisma the CEO's letter projects, the more favorable a company's ratings from stock analysts are likely to be -- and the more uniformity there is likely to be in those ratings.

The professors find no evidence, though, that picking up on charisma makes for better stock-picking. Analysts turn out to be no more accurate in their assessment of companies with dynamic-sounding CEO letters than of companies with dull ones.

But what is that the analysts are responding to -- real charisma or simply the skills of company wordsmiths adept at making an impression on investors? Prof. Misangyi considers the latter alternative unlikely, since the letter is the CEO's first communication with shareholders and is likely to reflect the new chief's true vision. But he adds: "Whether the analysts are responding to real charisma or just a skillful simulation, the point is that the impression of charisma influences the way they rate the companies. The CEO charismatic image, as we call it, accounts for six percent of the variance in analyst ratings, and that's a sizable amount."

He continues: "Two years ago, my colleagues and I reported to the Academy of Management annual meeting findings to the effect that charismatic CEOs do little or nothing to enhance company performance that low-key CEOs don't do and yet make far more money. Our conclusion was that their high pay reflects the excessive valuation people in the corporate world assign to CEO charisma.

"The findings in this study suggest that stock analysts are buying the same bill of goods."

When it comes to predicting company performance, objectivity trumps familiarity

A perennial question about stock analysts is whether long experience in monitoring the performance of a company and issuing forecasts about it enhances forecast accuracy or diminishes it.

A study presented at the Academy of Management 2004 annual meeting, based on close to a million forecasts of thousands of stock analysts, suggests the latter to be the case.

The authors, Paul Healy, Amanda Cowen, and Boris Groysberg, all from Harvard Business School, pose the issue in these terms:

"Experience could reflect superior private information that analysts develop about a company's economics the longer they follow it, leading to more accurate forecasts. Alternatively, it could reflect selection bias -- better-performing analysts with more accurate and less optimistic forecasts are more likely to be retained.

"However, company experience could also be associated with forecast optimism in a different way. Analysts who follow a company for long periods develop a close relationship with management, making it difficult to challenge or question management's performance. This reduced objectivity is likely to be reflected in relatively more optimistic and less accurate forecasts."

In probing these alternatives, the authors reviewed the forecast records of thousands of stock analysts with respect to near-term earnings, long-term earnings growth, and target prices. They measured forecast optimism through a formula that compared each analyst's forecasts with those of all other analysts covering the same companies. The near-term earnings sample consisted of about 6,500 analysts, while the other two samples consisted of about 4,000 analysts. All told, close to one million forecasts from 1996 through 2002 made up the final sample.

To assess how analysts' length of company experience affects their forecast optimism, the authors calculated for each analyst the number of quarters elapsing between the analyst's first forecast (going back to 1983) regarding a particular company and his or her forecasts from the current period.

They found that for earnings predictions of greater than 90 days and for stock-price forecasts, which are typically for 12 months ahead, longer company experience was associated with significantly greater forecast optimism, which in turn was generally associated with less accuracy.

"This suggests," the authors write, "that analysts who cover a company for longer periods find it more difficult to take a negative longer-term view on the company relative to their peers, either because their relation with management boosts their confidence about management's ability to deliver strong performance or because they rely more heavily on management's input."

In sum, they add, the results suggest that "over time analysts develop relations with management that make it difficult to be independent."

In the aftermath of 9/11, the airlines that recovered best broke with Wall St.'s conventional wisdom on finance

The devastating decline in air passengers caused by the terrorist attacks of 9/11 posed a huge challenge to the country's airlines, one that led an industry observer to comment that, "if there was ever a stress test for a good business, this is it."

What enabled some airlines to recover a lot better than others? A study presented at the 2004 annual meeting of the Academy of Management identifies two critical factors that made the difference -- 1) the ability to maintain good employee relationships by avoiding major layoffs; and 2) the existence of company financial reserves, engendered by low debt and high levels of cash on hand, without which major layoffs would have, if not necessary, exceedingly difficult to forego.

Yet, those very financial reserves, so basic to companies' resilience, were a consistent sore point with Wall St. analysts, according to the study's authors, Jody Hoffer Gittell of Brandeis University and Kim Cameron and Sandy G. P. Lim of the University of Michigan.

For example, analysts had earlier criticized Southwest Airlines' "conservative" approach to finance and argued that the airline should use its extra cash to make acquisitions or buy stock." One analyst called the balance sheet "too strong," even while conceding "that when times are tough, they have a lot more flexibility." In fact, Southwest did make the strongest recovery from 9/11 of any of the country's nine major airlines.

Why should something as ostensibly desirable as a strong balance sheet be viewed with disfavor? An investment summary from Goldman Sachs explained: "When an airline with a strong balance sheet suffers, the shareholder absorbs the risk, but when an airline with a weak balance sheet suffers, other stakeholders (creditors, employees, local government and suppliers) share the risk."

"In other words," the study's authors add with something akin to disbelief, "high debt levels are argued to be beneficial not in spite of the fact that they force organizations to break their commitments in times of crisis, but rather because they allow organizations to break their commitments in times of crisis."

In their analysis of the response of the country's nine major airlines to 9/11, the professors find a strong inverse relationship between the percentage of employees laid off following the terrorist attacks and the recovery of companies' stock price in the post-attack period. In other words, the greater the percentage of layoffs, the smaller the likelihood of the stock's recovery to the level of Sept. 10, 2001. They also find a strong association between high company debt and high layoffs.

The findings, the authors conclude, suggest the weakness of the Wall St. conventional wisdom whereby "corporate leaders were encouraged to rid their organizations of financial reserves, with the promise that this would make them efficient, lean, and more accountable to shareholders. The fact that there would be few reserves in place to preserve relationships and commitments in the face of crises, and that a decline in organizational resilience was the risk, is the often-neglected aspect of that [strategy]."

Study probing the way execs and analysts rate firm performance suggests ample reason for arm's-length relationships between the 2 groups

Finally, a fourth study analyzed the responses of executives and stock analysts to Fortune magazine's annual "Most Admired Companies" survey and found their perspectives dissimilar enough to justify mutual wariness, if not so different as to warrant mutual enmity.

Even in the pressure-free setting of a survey, in the absence of incentives that might bring the two groups into conflict, "the results provide evidence that analysts and executives have internalized different cognitive perspectives on what constitutes high-quality firm performance," writes the study's author, E. Geoffrey Love of the University of Illinois at Urbana-Champaign.

True, he adds, there is considerable overall similarity in the way the two groups rate company performance. But there are also significant differences. And, "given that competitive and strategic decisions are by nature made on the margins rather than the averages, these differences are important."

Prof. Love gathered the reputation rankings assigned to the country's 100 largest industrial firms over a 10-year period by participants in the annual survey -- executives and outside directors who rate companies in their industry plus security analysts who rate firms in industries they follow. Participants assess firm quality on a 1-to-10 scale on eight attributes, which are then combined into a single composite score.

Separate data being available for executives and analysts, Love was able to analyze the relationship between the average rankings assigned companies by members of each group and a number of factors that may be expected to affect rankings. These factors included such basic performance measures as changes in market capitalization, changes in earnings expectations, return on sales, asset changes, three-year average return on assets, three-year average sales growth, and market-to-book value.

Of 11 factors that might predict reputation rankings, the two groups differed significantly on five. Stock analysts attached more importance to company size and gave twice as much weight to market-to-book value, while executives gave 50% more weight to three-year average sales growth.

Most striking was the difference between the groups regarding changes in earnings expectations, a measure derived by subtracting the number of analysts' downward earnings revisions in the course of a year from the number of upward earnings revisions. The analysts attached considerably more importance to that measure for both the year previous to the survey and the year before that.

"Essentially, it appears that executives almost view such changes as noise, as far as reputations go, whereas the changes are among the most important dimensions for analysts," Love observes, taking note of "executives' complaints about the importance placed on the last penny of earnings during a short period in uncertain and turbulent competitive environments."

These results notwithstanding, Love was surprised to find no significant difference in the time horizons of the two groups -- a measure reflecting the relative importance assigned to performance measures of the rated year and the year before that.

**(The panel discussion cited at the beginning of this press release, "What Should Be Done About CEO Pay?" can be accessed in its entirety at > Professional Development)

Media Coverage:
The Wilmington News Journal. Charisma of top CEOs just hype. (Tuesday, September 07, 2004).

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