The Risks and Rewards That Go With Investing In Turnaround Stories:
Verifone (PAY) and Groupon (GRPN) both recently ousted their respective CEOs, and are currently looking for new leaders, most likely from outside the firms. Both firms are in need of significant changes going forward, so in both cases, after the old CEO was fired, the markets responded positively. But what happens over the medium term? What are the average returns to stocks that experience a forced CEO turnover in the ensuing 12 months?
In other words, when CEOs are forced out, do the new CEOs improve operations and generate better returns for shareholders going forward, or are the fired CEOs merely scapegoats with shareholders aboard a sinking ship?
To answer this question, it's important to start out by distinguishing between forced and unforced CEO turnover. Forced CEO turnover comes in the wake of a problem or series of problems at a company that leads the firm's board to fire the CEO. In these cases, the board is not happy with the way things are going, and they want to shake up the company and senior management. Overwhelmingly, these forced CEO turnovers occur when a company has done badly and needs to be turned around in the next few years. An unforced CEO turnover occurs when a CEO quits or dies unexpectedly. Past research has shown that forced CEO turnovers are greeted by the market with an average event date return of +5.6%. In contrast, unforced CEO turnovers result in an average decline in share prices of -4.7%.
In cases of forced CEO turnover, historically, new CEOs hired from outside the firm have on average improved operating return on assets (OROA) at the firm by an average of 14% in the ensuing 24 months. (For the stats wonks out there, this is a statistically significant result with a t-stat of 3.5.) In contrast, new CEOs hired from within the firm (e.g. the CFO is promoted) on average improved OROA by just under 3% (insignificant with a t-stat of 0.72).
So new CEOs improve ROA... but what about stock returns?
The average annual returns over each of the three years following a forced CEOs turnover and the hiring of an outside CEO are 4% annual excess returns above the market return based on a 4 factor model. (See my article on using stock characteristics to predict returns for details.) This is a statistically and economically significant outperformance that is based on 141 forced CEO turnovers over the last 15 years. Basically, whatever that firm would be normally expected to return given its size, valuation, beta, and the performance of the overall market, add 4% annually. So since the average firm has returns of about 8% annually, firms that forced out their previous CEOs and hired an outsider have an average return of around 12%. In contrast, when an insider is hired as the new CEO, the average excess return is only 0.5% which is statistically insignificant.
This mean outperformance is only one factor to consider. The other factor of note is the risk involved in these firms. While there is a 47% chance of the average firm declining in value in any given year (see my blog for more on this), firms that experience forced CEO turnovers actually have a 62% chance of seeing a decline in their stock price. What this implies is that the overall average outperformance among these firms is driven by the 38% of stocks that have successful turnaround and the huge price appreciation they see (56% return on average). Those 62% of stocks that do fall, decline by an average of about 15%. Thus the key point here is that investing in turnaround stocks that have forced out their CEOs is an activity that is high risk (62% chance of failure on average) and high reward (56% returns if the firm succeeds in turning around). Again, these figures only hold when an outsider is hired. When an insider is promoted, the turnaround chances and returns are much more dismal.
So what will happen with Groupon and Verifone? What will happen with firms that have already chosen a new CEO like (NOK) and (HPQ)? Well, for any given firm it is impossible to predict the future, but if the firms choose competent outsiders, the markets are likely to react positively on average, and on average, the firms will outperform the markets going forward. However, these are just averages, and investing in any of these stocks is a high risk-high reward proposition.
Return Calculation Check: (0.38 up probability)*(56% up return) + (0.62 down probability)*(-15% down return) = (4% excess return + 8% market return)*1.00