MarketPsych Report: Leadership Psychology and Investing - Buy the Accused, Sell the Acclaimed
December 07, 2014
They grumbled and complained of the long voyage, and I reproached them for their lack of spirit, telling them that, for better or worse, they had to complete the enterprise on which the Catholic Sovereigns had sent them. I cheered them on as best I could, telling them of all the honors and rewards they were about to receive. I also told the men that it was useless to complain, for I had started out to find the Indies and would continue until I had accomplished that mission, with the help of Our Lord.
~ Christopher Columbus, Wednesday, 10 October 1492
Christopher Columbus had set out 68 days earlier confident that he could reach Cathay (China), but a series of bad omens had spooked the crew, and by October 10th they were mutinous.
After setting out from Spain, they arrived in the Canary Islands to pick up supplies. There they received word that the Portuguese King had ordered the crew captured and imprisoned. Then after embarking from the Canaries, the rudder of the Pinta broke and they had to return to the islands for repairs. While on Tenerife, the island's volcano began to violently erupt - a new and frightening experience for the Spanish sailors.
They took to the seas again, and as the shores of the last of the Canary Islands faded out of sight, many sailors burst into tears, saying that "they were sailing off—off—off—upon the awful Sea of Darkness and would never see land any more" (Brooks, 1892).
The ships slowed in the Sargasso Sea - where there are few winds or currents - and drifted lazily through beds of seaweed and still waters for a week. The sailors became concerned that they would die, drift-less. Mirages of land raised hope and then dashed the crews' spirits.
Columbus soon realized that his calculations were incorrect - they had not found land where he thought they would. If Columbus returned to Spain without having reached land, he would face disgrace, imprisonment, or even death. He began to doctor the distances traveled in his logs, keeping one log of the true distance and one for his crewmen which showed less distance traveled. The sailors noticed that the magnetic compass no longer oriented itself properly to the North Star. To quiet their fears, Columbus lied and told the crew that the North Star had changed its position.
On October 10, 1492 the anxiety of the crew turned into mutinous fervor. To assuage his sailors' fears, Columbus took a gamble. He promised that if they did not sight land within three days, the ships would turn back to Spain.
Fortunately for Columbus and the sailors, landfall was made on the morning of Oct. 12, 1492. Columbus appealed to duty, cajoled, threatened, practiced deceit, and finally made a last ditch gamble, all to maintain his leadership in the pursuit of his vision.
Like Columbus, executives often face restive investors as they pursue their corporate goals. Sometimes they gamble their leadership on a specific outcome - Columbus' "just three more days" becomes their bet that they can turn around earnings "next quarter" or that a new product launch will be a hit. If they achieve their goal they are acclaimed, but if not their reputation may be destroyed.
The social psychology of how we perceive and respond to leaders has deep roots in the human psyche. Powerful positive social emotions about leadership - such as adoration and acclaim - are not far removed from blame and scapegoating. This month's newsletter examines human sacrifice, unfairly blamed leadership teams and their opposite - superstar CEOs, and predictive analytics of CEO comments and how those affect stock prices.
The Emotional Value of Human Sacrifice
Scapegoat - Process in which the mechanisms of projection or displacement are utilized in focusing feelings of aggression, hostility, frustration, etc., upon another individual or group; the amount of blame being unwarranted.
Blaming a scapegoat is a common social process in times of unexpected distress. In many societies and cultures, the physical chanelling of this process was human or animal sacrifice. These sacrifices established a sense of control over uncertain circumstances (weather, crop yields, war, and other events). In honor of the value of the scapegoating process to stabilizing the society, the chosen victim was often first elevated as a near-god and - in the Aztec society - given a year of luxurious living before being destroyed.
Modern references to workplace scapegoats acknowledge the social-emotional benefits of scapegoating. See this Dilbert comic strip for a humorous example. Other examples include this poster.
Of course most societies do not organize ritualistic sacrifices as part of their calendar of psychological stabilization activities, rather they experience episodic paroxysms of social violence. Witch hunts, pogroms, or ethnic cleansing are often driven by the politically powerful, to maintain their power, and evidence of their economic link is seen in the following correlation of cotton prices with anti-black violence (lynchings) in the U.S. South:
Studies of anti-black violence in the southern US between 1882 and 1930 show a correlation between poor economic conditions and outbreaks of violence (e.g., lynchings) against blacks. The correlation between the price of cotton (the principal product of the area at that time) and the number of lynchings of black men by whites ranged from -0.63 to -0.72, suggesting that a poor economy induced white people to take out their frustrations by attacking an outgroup. (Hovland, 1940).
In the business world a peanut gallery of analysts and investors is watching for strategic blunders by management teams. But the world is not so predictable. As a result, scapegoating of management teams is common and often inappropriately intense.
It's too easy to criticize a man when he's out of favour, and to make him shoulder the blame for everybody else's mistakes.
~ Leo Tolstoy, War and Peace
Reid Hastings' leadership was roundly criticized at Netflix (NFLX) after the DVD/streaming model was changed in 2011. The stock price plummeted from $300 to $70 per share over 6 months. Later Hastings' reputation (and stock price) recovered to new highs as his plan was vindicated.
Investor fear and anger drive accusations and innuendos about poor management quality. A chart depicting NFLX stock price, investor Fear, and frequently made comments about Netflix during 2011 is below: comments about ManagementChange, Misdeeds, and Litigation all occur with notable frequency.
Steve Jobs was famously ousted from Apple in 1985 under withering criticism of his leadership. And as we know, he was invited back to run the company he had founded in 1997, where he led the creation of the world's most valuable company.
Fortunately, we now have evidence for how leadership scapegoating affects asset prices.
Buy Mistrusted Leadership
In our last newsletter we commented on another famous cases of scapegoating corporate management at Groupon and we demonstrated how a form of scapegoating against governments (GovernmentInstability) creates excellent international buying opportunities. We saw such an opportunity in Pakistan's massive past 3-year stock index gain. We may be seeing such an event in the "SuperBull" 21% stock market return in China over the past 2 weeks. China had a high GovernmentInstability score in September's newsletter due to the Hong Kong protests. And closest to home for many readers, despite intense criticism and disdain for American political leaders, the U.S. stock markets are rising robustly.
In studying our individual company data, we've found that one of our new indexes - ManagementTrust - has strong correlations with future stock returns. Management Trust is calculated by quantifying all of the references to a company's corporate management team (Board, CEO, etc...). Trust associations (reliable, trustworthy, etc...) versus mistrustful associations (scoundrels, criminals, etc...) were converted into a time series index for thousands of global stocks. Our software uses a sophisticated text analytics process to ferret out and quantify these verbal associations. The end result is the Thomson Reuters MarketPsych Indices (TRMI). The TRMI are quantitative indexes of business news and social media content from 1998 to the present.
In order to study these indexes, our brilliant Head of Research CJ Liu creates simple rotational models. His software identifies the top 10 US companies with the highest Buzz in the news over the past 1 month. It then ranks those 10 companies by their average ManagementTrust value for the past month. To establish a broad effect, it simulates a portfolio that shorts the top 40% most-trusted-leadership-companies, and it goes long (buys) the bottom 40% least-trusted-leadership-companies. It then calculates the returns of this 4 long versus 4 short portfolio daily, and it re-ranks and re-enters positions monthly from 1998 to this summer. This model is performing emotional arbitrage.
In the US investors should buy stocks with low ManagementTrust - the equity curve of a simple monthly rotation strategy with 10x returns is below. When a company's management team is in the news incompetent behavior, we should be buying that stock, and when they are praised for excellent work, we should be selling.
When expanding the sample to 20 stocks and looking back at the past year's ManagementTrust and holding each position for 12-months, the returns drop somewhat (4-fold), but are still interesting.
ManagementTrust fluctuates closer to a monthly than to a yearly frequency. As Warren Buffett famously said, "It takes 20 years to build a reputation and five minutes to ruin it." Ironically, what most risks ruining a reputation - for people who have a modicum of self-control - is not 5-minutes of indiscreet tweeting, but rather resting on one's laurels.
The equity curves above are created by the excess returns of buying companies with mistrusted leadership and shorting companies with highly regarded leadership. This finding aligns with breakthrough research performed by Ulrike Malmendier of Stanford and Geoffrey Tate of UCLA, using data collected by Stefano DellaVigna.
In their 2009 paper "Superstar CEOs," the authors selected a sample of 283 companies whose CEOs had won prestigious nationwide awards from the business press. From 6 days following the award to three years later, they found that the stock of award winners underperformed those of predicted award winners (similar cohort in terms of business regard). In fact, the award-winners underperformed the predicted award winners by 20% over 3 years.
The business press has coined the term "CEO disease" to refer to the tendency of CEOs to underperform after achieving the top position in their organization. Hubris is one of the most dangerous emotional states that CEOs (and investors) can experience, as it often precedes the greatest losses.
What To Do When You Are the Scapegoat
Our advice to leaders who find themselves unfairly scapegoated? Delineate clearly and concisely where the company's stress originates - express a clear understanding of the dangerous situation. Explain what must be further investigated and how exactly that will occur and on what timeline (then meet the timeline). Outline a clear plan for tackling the fundamental causes of the stress. Solicit feedback that addresses the problem, but do not tolerate feedback that is personal or unconstructive.
A while back we consulted with a Fortune 500 company to help the CEO improve his communication to investors. The CEO had an unfortunate habit of saying the wrong thing at the wrong time, especially during earnings conference calls, and the investing public was doubting his leadership. Using the Thomson Reuters Street Events database of earnings conference call transcripts, we quantified his comments over 30 past quarterly conference calls. We identified exactly what content was impacting the stock price in the three months after each call.
Naturally, negative accounting news and uncertainties expressed by the CEO led to stock price declines. But as a subset of those negative calls, we found that if he announced a definitive plan to restore earnings, the stock was not negatively impacted in the long term. If he announced no plan or waffled, the stock fell and continued to fall. If he discussed new innovations at the company, the stock rose, if he did not, the stock underperformed. If he praised his team, the stock outperformed, if he did not, it declined. Expressing appreciation for his team members was one of the most powerful independent factors driving the stock price in the 3 months after a call.
The search for a scapegoat is the easiest of all hunting expeditions.
~ Dwight D. Eisenhower
On his third and fourth voyages to the New World, Columbus was evicted from the colony he founded on Santo Domingo by mutineers who despised him. He was later banned from landing at Santo Domingo to obtain badly needed supplies, and he was forced to weather a hurricane in a different harbor. He died with the Spanish crown having violated its commercial agreement with him (although it was later restored by his son).
Management of others is one of the most complex processes in business. As investors, it is crucial that we observe and use the cycles of blame and adoration of CEOs and management teams to our advantage.
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Remember: Mistrust Acclaim, and Don't Dismiss the Apparent Scoundrels Richard L. Peterson, M.D. and the MarketPsych Team
Elbridge S. Brooks. 1892. THE TRUE STORY OF CHRISTOPHER COLUMBUS: CALLED THE GREAT ADMIRAL. From: http://www.gutenberg.org/files/1488/1488-h/1488-h.htm#link2HCH0005
Hovland, C. I.; Sears, R. R. (1940). "Minor studies of aggression: VI. Correlation of lynchings with economic indices.". Journal of Psychology: Interdisciplinary and Applied 9: 301–310.
Malmendier, U. and G. Tate. 2009. “ Superstar CEOs. ” Quarterly Journal of Economics. 124, no. 4 (November 1, 2009): 1593 – 1638.
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