Do Director Networks Improve Managerial Learning from Stock Prices?

Musa Subasi is Assistant Professor of Accounting and Information Assurance at the University of Maryland, College Park. This post is based on a recent paper by Professor Subasi; Ferhat Akbas, Associate Professor of Finance at the University of Illinois at Chicago; Rebecca N. Hann, Associate Professor & KPMG Faculty Fellow at the Robert H. Smith School of Business, University of Maryland; and M. Fikret Polat, a PhD Student in Accounting & Information Assurance at the Robert H. Smith School of Business, University of Maryland.

Like financial markets, director networks serve as a conduit of information exchange and managers may access a wealth of information from the network through their boards’ connections. In this paper, we address several questions. Do director networks improve managerial learning from financial markets? Does corporate governance affect the extent to which managers utilize the information advantage from their boards’ connections in their investment decisions? And, what types of director connections are more instrumental in preventing managers from basing their investment decisions on faulty price signals?

We explore these questions by studying the effect of director networks on the sensitivity of investment to noise in stock prices, which has been documented to be positive in prior research. We use the number of director connections to capture board connectedness. To capture the extent of managerial (mis)learning from stock prices, we use a Q-theory of investment framework and decompose stock prices into a non-fundamental component (noise) and its orthogonal component using mutual fund redemptions as an exogenous shock to stock prices.

Consistent with prior research, we document that firm investment responds significantly to the non-fundamental component of its own stock prices. More importantly, we find that the sensitivity of investment to the noise in prices is significantly lower for well-connected firms, while the sensitivity to the orthogonal component does not vary with board connectedness. For a one standard deviation drop in the non-fundamental component of the firm’s stock price, the investment cut goes from 4.6% for firms in the lowest decile of board connectedness to 0.05% for firms in the highest decile of board connectedness, representing an economically significant difference. These results are consistent with our main hypothesis—connected boards help managers filter out the noise in stock prices and reduce the extent to which financial markets act as a faulty informant.

Negative non-fundamental shocks may increase firms’ cost of capital and lead to investment cuts, which could be an alternative explanation for our results since board connections have been shown to facilitate easier access to external capital. To rule out this alternative explanation, we repeat our main analysis controlling for measures of cost of capital and find similar results. Further, we examine the effect of director networks on the sensitivity of investment to peer firms’ stock prices, because non-fundamental shocks to peers’ stock prices are less likely to have a direct effect on the focal firm’s cost of financing. We continue to find that director networks moderate the effect on investment of noise in peer firms’ stock prices. These results help alleviate concerns that our results are driven by the financing cost channel.

Next, we explore how the effect of board connections on the investment-to-noise sensitivity varies with the strength of firms’ corporate governance. Using two conventional measures of the strength of corporate governance, the G-index and E-index, we demonstrate that the negative relation between board connectedness and investment-to-noise sensitivity is more pronounced for firms with stronger corporate governance and lower managerial entrenchment. These results suggest that the information channel from director networks is most beneficial when firms have a governance structure that is conducive to learning and when managers are more likely to listen to their board of directors, lending additional support to our hypothesis.

Finally, we perform several cross-sectional analyses to shed light on the types of board connections that would matter more in preventing mislearning from prices. First, we find that the negative relation between board connectedness and investment-to-noise sensitivity is stronger in firms with a larger proportion of board connections to directors who serve at industry peers’ boards. Moreover, boards are more effective in curbing managerial mislearning from stock prices when executive directors, who ultimately make the investment decisions, are more connected compared to non-executive directors. These findings suggest that while director networks serve as an important channel through which managers can better learn from financial markets, connections are not homogenous—selecting directors with certain types of connections can have significant real effects.

Taken together, our results complement the growing body of research on the feedback effects of financial markets by identifying director networks as a mechanism through which managers can improve their learning from stock prices. Our evidence suggests that director networks fulfill an information discovery function that increases the quality of managers’ private information, which complements the market information and is crucial for managers in understanding whether changes in prices are due to fundamentals. Moreover, we add to the corporate governance literature by highlighting the information production role of corporate boards through director connections. Lastly, our findings suggest that director connections may enhance firm value by providing managers with the information required to filter out the noise from fundamentals in prices, thereby preventing faulty price signals from affecting investment decisions.

The full paper is available for download here.

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