Ever noticed how some of the most bullish, confident and charismatic chief executives have later been discovered to have perpetrated frauds on their stockholders or have ruined their companies via their own bad management? For example, Lehman Brothers Chairman and Chief Executive Dick Fuld rejected an offer from Korea Development Bank to purchase Lehman Brothers because he felt the bid undervalued Lehman, despite the fact that Lehman Brothers was heading towards bankruptcy; and while Jeffrey Skilling and Kenneth Lay of Enron were selling down their stakes in Enron as the company descended into insolvency, they continued to trumpet the success of the business and encouraged their employees to hold as much Enron stock as possible in their 401(k) pension plans. Well, according to a working paper published by Chao-Rung Ho and Yuanchen Chang of National Chengchi University in Taiwan entitled “CEO Overconfidence and Corporate Financial Distress”, there exists an empirical link between overconfident CEOs and the probability of a firm entering financial distress. They postulate that:
“Overconfident CEOs overestimate their abilities and believe they can maximize firm value. Thus, they overvalue investment projects, invest lots of negative NPV projects and then waste firms’ capital. As a result, firms may have less free cash flow to deal with sudden incidents generating financial distress.”
To model CEO confidence, they utilise data on the CEOs stock and option holdings in the company, as well testing for the appearance of certain words in the business press (eg. “optimistic” or “optimism”, “confident” or “confidence”, “reliable”) to estimate CEO beliefs. Once the data-crunching is complete, they conclude:
“our analysis confirms that overconfident CEOs increase the probability of corporate financial distress”.
Therefore, Cautious Bull would advise investors to beware relying upon presentations from and interviews with the Chief Executive, and to pay more attention to the disclosures in and accompanying the financial statements.