Put your money where your mouth is! Shareholders who put more skin in the game tend to get better returns

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Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. How do the suppliers of finance get managers to return some of the profits to them? How do they make sure that managers do not steal the capital they supply or invest it in bad projects? How do suppliers of finance control managers?

Extract from ‘A survey of corporate governance‘ – Andrei Shliefer, Robert W. Vishny. NBER working paper 5554.

Traditional corporate governance models acknowledge that the larger a shareholder’s stake is, as a fraction of a company’s outstanding stock, the keener the shareholder will be to ensure that the company pursues value increasing activities. While this makes perfect sense, any investment practitioner would point out that this is only one side of the story.

The shared interests of entrepreneurs and investors – ‘skin in the game

Venture capitalists and other private equity investors routinely require entrepreneurs to invest a significant portion of their own net wealth into their business. They do this because they want the entrepreneur to have ‘skin in the game’ and participate financially in the risk taking activity.

Hence, an investment constituting a significant portion of a shareholder’s wealth provides significant incentives to demand good governance. Together with Professor Benjamin Maury, we proposed and tested this way of measuring such shareholder incentives in the stock market: the size of the average shareholder’s investment in a company. Our paper was recently published in the Journal of Financial and Quantitative Analysis, which is a top-five finance journal.

We investigated the Finnish Central Securities Depository register that contains records of more than 120 million stock market transactions made by over 1.3 million shareholders active in the local equity market between 1995 and 2006. It enabled us to compile each shareholder’s portfolio holdings annually, and consequently to calculate the relative weight of each company in each portfolio. Finally, we calculated the average shareholder portfolio weight for each company.

Shareholder commitment and portfolio weight go hand in hand

We hypothesised that the average portfolio weight reflects how committed shareholders are to a company. For instance, if the average shareholder has invested 1% of total portfolio holdings in company A and 5% in company B, we would interpret it to mean that the shareholder’s commitment for company B is greater than for company A.

We found that for the period 1995-2006, there was a positive statistical relationship between the average shareholder’s portfolio weighting in a stock and that company’s operational performance and valuation. The effect is stronger for private investors than for institutional ownership concentration. Indeed, the relationship is even more apparent when we include smaller shareholders.

Thus, our results suggest that the size of a shareholder’s holding in a stock is even more important than shareholder activism. In other words, when investors ‘put their money where their mouths are’, it tends to pay off.

Knowing more and expecting more

Furthermore, for the time period under review, we found that past average shareholder portfolio weightings were positively related to future abnormal stock returns. In conclusion, our research suggests that shareholders who are more informed about individual companies, and consequently pick individual stocks into their portfolios, are rewarded with positive abnormal returns.

Anders Ekholm

Head of Investments at Alfred Berg Asset Management Finland

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