When a new CEO’s at the helm, investors pay attention.

Like anyone taking on a new job, there’s a learning curve that person must go through. But when that person is the leader of a publicly traded corporation, the consequences can be immediate and large.

Yihui Pan, assistant professor of finance, explores the effects a new CEO can have on a company’s stock in the paper she co-authored, “Learning about CEO Ability and Stock Return Volatility.” The paper, which was co-authored with Tracy Yue Wang and Michael S. Weisbach, has been accepted in the Review of Financial Studies.

“Any manager’s ability to do a new job is, to some extent, unknown. The uncertainty about ability could be related to innate talent or the quality of the match between the job and the manager’s personality, skills, or strategic vision,” Pan said. “Over time, especially when the manager is highly visible, like a CEO, his or her ability to create value at a particular firm will be revealed to the market.”

Listen to a podcast of Pan detailing her research. A full transcript is below.


Eccles School: Yihui Pan is an assistant professor of finance at the David Eccles School of Business at the University of Utah. She co-authored the paper “Learning about CEO Ability and Stock Return Volatility,” which has been accepted for publication in the Review of Financial Studies. Yihui, thanks for joining us.

Yihui Pan: Thanks for having me here.

Eccles School: Tell me about your findings in your paper “Learning about CEO Ability and Stock Return Volatility.”

Yihui Pan: As the title reveals, we study how the market’s learning about new CEO’s ability affects stock price movement. Any manager’s ability to do a new job is, to some extent, unknown. The uncertainty about his ability could be related to his innate talent or the quality of the match between the job and his personality, skills, or strategic vision. Over time, especially when the manager is a highly visible one like a CEO, his ability to create value at a particular firm will be revealed to the market.

For example, in 2011, JC Penney hired Ron Johnson, a former Apple executive, to be its CEO. When Johnson’s strategy of adopting policies similar to those used by Apple turned out to decrease rather than increase profits, Johnson was fired; his style did not work well at an old-fashioned retailing company like JC Penney as at a technology company like Apple. This uncertainty about management ability could stir up stock return volatility, which could be reduced as investors learn about management ability.

In particular, we present a stylized Bayesian learning model formalizing this idea. We evaluate the model’s implications on a large sample of CEOs in publicly traded U.S. firms to understand the market’s learning process, for example, the factors that affect the speed of learning and the shape of the learning curve. The model also allows us to quantify the extent to which CEO ability affects firm value. Consistent with this model, we find that return volatility is indeed unusually high around the time of CEO turnover, but it declines with CEO tenure in a convex manner due to market’s learning about his ability.

Eccles School: Tell me about the motivation behind your research.

Yihui Pan: Sure. Much of what we study in business schools concerns the role of the CEO and his/her management team. Yet, we are still not sure about the right economic model for understanding the role of the CEO. While the popular press typically ascribes many important actions firms take to CEOs, it is difficult to verify systematically the extent to which top management actually matters. Our paper takes a novel angle to back out the importance of management: to what extent the investors on the stock market care about management ability will be reflected in how much the uncertainty about this ability contributes to the stock price movement.

Eccles School: Tell me more about how a new CEO taking the helm of a company can initially affect stock return volatility.

Yihui Pan: When a new CEO takes office, uncertainty about the quality of the new leadership is likely to be high, so any news about the firm will contain information about the CEO’s unknown ability, magnifying stock return movements and increasing stock return volatility. In fact, the estimates of the learning model suggest that uncertainty about CEO ability contributes substantially to return volatility, accounting for approximately 25% of total stock return volatility at the time of CEO turnover.

Eccles School: It sounds like time plays a big factor in that volatility though, right?

Yihui Pan: Absolutely. Over time, as the CEO’s ability becomes more of a “known quantity”, the market’s update from a particular signal of his quality through say corporate news, becomes smaller, leading volatility to decline with CEO tenure. Interestingly, our results suggest that the decline is faster when there is higher uncertainty about the CEO’s ability, for example if the CEO is young or inexperienced.

The decline in volatility is also faster when there is more transparency about the firm’s prospects, for example if the company is followed by more stock analysts; and it’s faster when CEO ability is more important, for example in human-capital intensive industries.

Eccles School: So how does this research impact our understanding of the role of management?

Yihui Pan: First, our study contributes to the literature on the role of management by estimating the fraction of stock price movements that occur because of uncertainty about management ability. CEOs of public firms have become well-known public figures, who are generally believed to be important sources of value in firms. Yet, the common occurrence of high expectations surrounding new appointments, combined with disappointment when they do not deliver indicates that there is often substantial uncertainty about a CEO’s ability to add to his firm’s profits. The empirical evidence we provide indicates substantial variation in management quality, which leads to meaningful differences in firm profitability and valuations. Finally, our results suggest that the process by which the market learns about the manager’s ability can be well characterized by a Bayesian learning model.

Eccles School: Excellent. Well, thanks so much for joining us today and for sharing your research.

Yihui Pan: Thank you.

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