Business Week Board Rankings and Subsequent Stock Returns

ABSTRACT Recent corporate bankruptcies have placed renewed focus on the role of a firm's board of directors; therefore, I study rankings of the best and worst boards of directors as published by Business Week. Similar to prior studies examining survey data, I find that the portion of the rankings determined via investment manager survey is biased by the "halo effect." However, I also find that the rankings as a whole, and particularly the portion calculated via quantitative analysis, do provide information that can be used in a trading strategy capable of generating positive abnormal returns, thereby implying that board strength does matter. INTRODUCTION The fall of large firms such as Enron and WorldCom has led to renewed interest in the debate surrounding the importance of a firm's board of directors. In principle, the board exists to represent stockholder interests by reducing agency costs through oversight of management and dissemination of information to the investing public. However, recent accounting scandals, allegations of excessive compensation, apparent self-dealing, and outright business failures have highlighted the ineffectiveness of some boards, raising the question of whether a stronger board might have prevented, or at least constrained, certain ill-considered management actions. Prior studies have examined the importance of certain individual board characteristics; however, I am unaware of a single measure of board quality that has been extensively studied or proven to be informative for predicting long-run return. To address this issue, I investigate stock price performance for portfolios of companies with the best and worst boards of directors as published by Business Week. These rankings are determined through a process integrating investment manager survey results and Business Week?, quantitative analysis of board characteristics. Similar rankings, such as Fortune's Most Admired Companies and Institutional Investor's Investment Manager All-Stars, have previously been studied, with authors concluding that these rankings are primarily determined by prior stock return, an outcome of the "halo effect," and are, therefore, not unbiased representations of the primary variables of interest. If this is the case for Business Week rankings, then using the rankings for the purpose of investment decisions may be inappropriate. However, if the bias is not present, or if it can be eliminated, then firms with the best boards should outperform those with the worst boards, thereby providing information that can lead to profitable portfolio formation. In testing the rankings, I find that the halo effect has an influence on the survey portion of the rankings; however, I also find that the rankings as a whole are informative in creating profitable trading strategies. Specifically, I find that an average positive quarterly abnormal return of 3.72 (4.78) percent can be earned in the three-year (five-year) period subsequent to the rankings being published. These returns are achieved by going long in the firms classified as having a best board of directors and by shorting the firms classified as having a worst board of directors. As a further extension, I adjust the rankings by eliminating the portion of the rankings, i.e. the survey component, influenced by the halo effect. I find that this "re-ranking" increases the level and significance of the positive abnormal return. Given the results, I conclude that board strength does matter and that information on a firm's board of directors can be implemented into profitable trading strategies. AGENCY COSTS, INTERNAL CONTROL, AND THE BOARD OF DIRECTORS The seminal work by Jensen and Meckling (1976) provides the primary starting point for the majority of research focusing on internal control and agency costs. Jensen and Meckling (1976) identify agency costs as resulting from a separation of ownership and control; however, this separation would not create a conflict if all actions of the manager were known and controllable by the owners. …