Conglomerate Investment, Skewness, and the CEO Long-Shot Bias

Oliver Spalt is Professor of Behavioral Finance at Tilburg University. This post is based on an article authored by Professor Spalt and Christoph Schneider, Assistant Professor of Finance at the University of Mannheim.

Making investment decisions that maximize shareholder value is the central task of corporate managers, and every MBA curriculum features state-of-the-art valuation tools prominently. Nevertheless, making investment decisions in the real world is difficult because even the best valuation tools rely to a considerable extent on assumptions that are subjective. Consistent with substantial residual uncertainty around true project value, about half of the CEOs mention in surveys “gut feel” as an important or very important factor in their investment and capital allocation decisions. As there is by now overwhelming evidence suggesting that intuitive reasoning in financial matters frequently leads to biased and therefore suboptimal decisions, a natural—and potentially very important—question is whether biases distort optimal capital allocation in firms.

A central difficulty in addressing this question is that researchers do not usually observe the characteristics of individual projects considered by corporate decision makers. In our article, Conglomerate Investment, Skewness, and the CEO Long-Shot Bias, recently published in the Journal of Finance, we propose looking at segment-level capital allocation in multisegment firms (“conglomerates”) as an identification strategy. Since firms are required to disclose segment-level information, we can “look inside” conglomerates and study how biases affect capital allocation across segments.

A particular advantage of this approach is that prior research suggests that there may be a link between capital budgeting and executive biases. CEOs are central to the capital allocation decision as they have “total and unconditional control rights” and can “unilaterally decide” what to do with a segment’s physical assets. Further, almost 40% of U.S. CEOs say in surveys that they make capital allocation decisions with very little or no input from others. Hence, looking at capital allocation in conglomerates allows us to obtain a large sample of economically important investment decisions made by individuals who self-report a tendency to rely on gut feel.

Our article provides new evidence indicating that managerial biases can lead to distorted capital budgets that do not maximize shareholder wealth. We focus on the implications of a powerful behavioral phenomenon that we label the “CEO long-shot bias,” which is the tendency of CEOs to systematically overvalue projects with high perceived upside potential (as proxied by expected skewness in our empirical tests). One prominent potential source of this phenomenon is prospect theory’s probability weighting feature, but there may also be other drivers. We posit that the special authority of conglomerate CEOs in capital allocation decisions, together with the fact that assumptions in valuation models are partly subjective, allow the CEO long-shot bias to affect capital budgeting. CEOs subject to such bias destroy shareholder wealth by investing too much in segments with high perceived upside potential.

We analyze investment patterns in the Compustat universe of U.S. conglomerates from 1990 to 2009 and find that capital expenditure is indeed significantly higher for segments with projects that have higher expected skewness (“long shots”). This effect is particularly pronounced for smaller segments, as predicted by the CEO long-shot hypothesis. When we match conglomerate segments to comparable stand-alone firms, we find that investment in conglomerates is significantly higher when skewness is high, even though we control for potentially greater debt capacity and other factors known to affect investment. We also find that conglomerate firms with skewed segments are valued at a significant discount by the market. Combined, this suggests that conglomerates overinvest in segments with high expected skewness and that this investment behavior is detrimental to shareholder wealth.

We provide a direct test of the CEO long-shot bias hypothesis by exploiting exogenous variation in the CEO’s propensity to gamble. Specifically, we use the gambling propensity of decision makers based on local religious beliefs and associated gambling norms, so it is plausibly exogenous with respect to capital allocation decisions. We find that the skewness effects concentrate in areas where gambling propensity is high. We argue that this test is particularly informative because it raises the bar for any alternative explanation of our results: any candidate variable must not only be positively correlated with the propensity to invest in a skewed project, but also must be positively correlated with our measure of gambling propensity, that is, the fraction of Catholics in the county of the company’s headquarters. As an example, misaligned risk taking incentives resulting from inefficient contracting does not easily explain our results as it is not obvious why inefficient contracting should be more of a problem in Catholic regions.

Additional evidence supports the hypothesis that the skewness-investment relation is induced by CEOs who are attracted to long shots. Using data on regional lottery ticket sales, we find that investment in skewed segments is particularly high when people around a firm’s headquarters buy more lottery tickets, that is, when the local gambling propensity increases. The skewness investment relation is stronger for younger CEOs and for CEOs who are more powerful in their organization.

In sum, we conclude that our evidence on the skewness-investment relation is consistent with a theory of distorted capital budgets due to the CEO long-shot bias.

To the best of our knowledge, our article is the first to document that skewness is related to inefficiencies in capital budgeting, and also the first to suggest that the CEO long-shot bias can contribute to seriously distorted corporate investment decisions.

The full article is available for download here.

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