Return Predictability Through Board Links ∗

We find that investors fail to immediately account for information in past prices among firms with interconnected boards: a long-short portfolio, formed based on these links, yields an annual alpha of 6.5%. This predictability is limited to the period of the board link and not driven by industry or previously identifed links. Investor inattention plays a key role: the predictability is concentrated among the largest firms, the long-end and in semi-private, hand-collected data on board links. Insider trading is a key mechanism: filtering on the trades of the linked director yields an annual alpha of 15%. ∗We are grateful to seminar participants at the University of Washington and the 2015 WFA meetings for helpful comments and suggestions. All errors are our own. †All authors are at the Michael G. Foster School of Business, University of Washington, PACCAR Hall, Box 353226, Seattle, WA 98195-3226, USA. Corresponding author: Christopher Hrdlicka, Phone: 206-6160332, Email: hrdlicka@u.washington. edu, Web: http://faculty.washington. edu/hrdlicka/ Boards of directors influence firms both by exercising control rights and providing valuable information and advice to managers. Directors often sit on multiple boards, creating links among firms. Shared directors provide a common influence and channel for information diffusion across firms. In efficient markets, investors should quickly incorporate this shared influence across firms into prices, eliminating predictability among board-linked firms. We find, however, that a firm’s returns can be predicted by the prior returns of those firms with which they share a director. Is it reasonable to expect sufficient commonality among board-linked firms to generate the comovement in returns necessary for return predictability? Extensive research has shown that board-linked firms tend to behave more similarly and experience similar events than non-linked firms behave and experience. Firms with linked boards are more likely to adopt similar governance structures such as poison pills (Davis, 1991; Davis and Greve, 1997). Board-linked firms are also more likely to adopt similar accounting techniques such as their choice of stock option expensing methods (Reppenhagen, 2010), willingness to backdate executive options (Bizjak, Lemmon, and Whitby, 2009) or use corporate life insurance tax shelters (Brown, 2011). Some of these more aggressive accounting techniques exemplify the general tendency of linked firms to engage in similar earnings management. This results in firms with shared directors to jointly be more likely to restate those earnings (Chiu, Teoh, and Tian, 2013). In the extreme case, a firm is more likely to be sued for fraud if one of its directors sits on the board of another firm that has been sued for fraud (Fich and Shivdasani, 2007). Outside of governance and accounting practices, firms with linked boards share other common behaviors. They are more likely to make the switch from the NYSE to NASDAQ together (Rao, Davis, and Ward, 2000), thereby increasing their visibility and access to capital. Firms sharing directors also have similar acquisition patterns with acquisitions by one firm making the other board-linked firm more likely to make an acquisition (Haunschild, For an overview of the influence of boards see the recent reviews by Hermalin and Weisbach (2003); Adams, Hermalin, and Weisbach (2010) and the references therein.