It Pays To Be Connected: CEOs With High Social Capital Earn Greater Stock Returns

It Pays To Be Connected: CEOs With High Social Capital Earn Greater Stock Returns
October 8 , 2021  |  By Dobrina Jandik, Tomas Jandik, Lucas Cuni-Mertz

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There are many ways we connect with others in our social networks. We may work at the same job, go to the same university, or be involved in the same sports and clubs. But while our social networks may overlap with others, our positions in these networks often differ. For instance, a long-time employee at a company likely knows more people, and is more knowledgeable about how the company operates, than a new intern. In this example, we could say the long-time employee has a more advantageous, or central, position in the company’s network. 

Academic research has shown that individuals in these central positions, that is, those with more connections to their peers, have greater social capital, defined as the “information, trust and norms of reciprocity in one’s social network.” This social capital provides an individual with many benefits. With greater social capital, individuals have a superior position in the social hierarchy and are considered more influential and powerful. Furthermore, those with high social capital have superior access to the information in their network, can process this information more efficiently, and “command a greater reputation or trust, causing their activities to have more powerful effects.” 

While the benefits of social capital are well documented, how exactly does this capital benefit individuals with a centralized position in their network? A study done by Rwan El-Khatib, Dobrina Jandik and Tomas Jandik explores this question, examining the insider trading gains of S&P 500 CEOs as they relate to their connectedness within their network. The authors found that highly connected CEOs earned greater returns following the purchase or sale of their firms’ shares compared to less connected CEOs. Additionally, they found that a CEO’s stock gains are greatest in firms where social capital advantages are more substantial. This includes companies that are riskier, have weaker governance, and have a CEO without a financial background.

CEO Centrality and Stock Gains 

The authors measured CEO centrality with Boardex, a database that tracks the network connections of more than 1.4 million executives and board members around the world. This includes records on the CEO’s bilateral links, such as work, education, and social clubs. The authors then analyzed the insider trades initiated by these CEOs between 2001 and 2014, finding that “highly central CEOs earn significantly higher abnormal returns (about 10 percentage points) after purchases of shares of their own firm” than their less connected counterparts. Additionally, the authors found that the frequency of trades between high and low-centrality CEOs was not significantly different, meaning that the higher returns weren’t the result of a few, extremely profitable trades. Instead, well-connected CEOs consistently outperformed less-connected CEOs in these purchases.

One might guess that the cause of such large stock gains for high-centrality CEOs is their ability to consult with the many people in their network. However, there is more to it than that. “The authors argue that centrally positioned CEOs have superior access to—as well as better ability to receive and process—the high-quality, noise-free information that flows through their social network.” With direct access to accurate market information, well-connected CEOs can “become more knowledgeable about their firm, competitors, industry and economic trends, and they use this knowledge to out-perform low-centrality CEOs in earning higher insider stock returns.”

CEO Centrality and Corporate Governance

While the authors found that CEO centrality leads to higher stock returns, these gains can be even greater in companies where social capital is more valuable. For example, prior research has found that executives in weakly governed firms profit more from these insider trades than other executives. In their own test of corporate governance, the authors found that weak governance amplifies the effect of CEO centrality: “More central CEOs working in weakly governed firms may either have additional social capital advantages (information, influence, power, trust) and/or additional opportunities to take advantage of their superior network position through their insider trades.” 

CEO Centrality and Firm Risk

Previous research has also shown that executives in riskier firms generate greater gains from insider trading. In comparing the effect of centrality on these gains between risky and less risky companies, the authors found that impact of being well-connected is also amplified in companies with greater risk. This is because at risky companies, “influence, power, reputation and the flow of information” matter more, and in turn, the superior position of these executives is especially important.

CEO Centrality and Financial Expertise

While weak governance and firm risk amplify the benefits of CEO centrality, its effects are less pronounced in companies with a CEO that has financial expertise. “CEOs with a career background in finance are able to raise capital more advantageously, understand their firm’s investment policies better, and manage financial policies more actively.” As a result, the authors found the effect of CEO centrality on insider trading gains to be less significant for these financially expert CEOs, as they have less need to rely on their network to receive and transmit financial information. On the other hand, they found that the insider trading gains are especially great in companies without a financial expert CEO, where social capital advantages are more substantial.

CEO Centrality and Timing of Sale Trades 

A CEO’s centrality and social capital can also influence when they decide to sell shares at the sign of trouble for the company. This trouble is described by the authors as “bad news,” or days when a firm suffers a price drop of more than 5% after adjusting for market-wide movements. The authors theorize that if a high-centrality CEO has greater social capital advantages, they are better able to predict the subsequent stock drop and have greater returns on the sales they make before bad news. After analyzing such sale trades, the authors found that highly connected CEOs “not only avoid more substantial losses due to their trades but also place significantly greater sale orders” ahead of these days. Well-connected CEOs also trade more frequently and at greater volumes as compared to their low-centrality counterparts ahead of bad news.  

CEO Centrality and Opportunism 

While these findings are evidence that CEO centrality leads to greater stock returns, it’s also possible these gains are more the result of CEOs that are especially opportunistic in their trades and more successful at networking. Prior research has shown that “opportunistic managers—that is, those initiating profitable insider trades right before quarterly earnings announcements (QEAs) are associated with (a) higher insider trade profits during post-QEA periods and (b) a higher chance of managerial misconduct.” However, after controlling for these opportunistic trades, the authors found that CEO centrality remains a strong predictor of insider trading gains. They also found a negative relationship between CEO centrality and opportunity, which may suggest that an opportunistic CEO may not be as successful at building a strong network.

Conclusion and Implications 

This study demonstrates the value of social capital associated with high-centrality positions. In short, it pays to be connected. Well-connected CEOs earn greater returns on purchases of their firm’s shares compared to less-connected CEOs, and that their personal returns on insider trades preceding “bad news” events are also greater. Additionally, these gains are greatest in companies where social capital is more important, including companies that are riskier, have weaker corporate governance, and CEOs without a financial background.

The key implication of the study, the authors state, is that the social network capital of top managers at a company can have important consequences, good or bad. Well-connected CEOs can earn greater profits from the buying and selling of their company’s shares and personally benefit through the sale of stock ahead of “bad news”—even at the expense of the firms’ investors. But on the other hand, the social capital advantages (being more informed, influential, and reputable) that come through greater network connections “can shape CEOs’ decision making, improve firm innovation, bring advantages when contracting with firm’s counterparts, and ultimately positively influence firm value.”

Dobrina JandikDobrina Jandik is a Clinical Associate Professor of finance at the Sam M. Walton College of Business. Her research work is focused on social networks in finance, the role of formal and informal country institutions around the world and the impact of gender inequality on financial transactions and markets. Her work has been presented at international conferences such as Financial Management Association, Midwest Finance Association, Eastern Finance Association and published in journals such as The Financial Review. Dr. Jandik’s teaching interests are corporate and international finance.  

Tomas JandikTomas Jandik is a professor in the Department of Finance at the Walton College of Business and holder of the Dillard’s Chair in Corporate Finance. His research has been published in top finance and business journals such as the Journal of Financial Economics, the Journal of Financial and Quantitative Analysis, the Financial Management, the Journal of Corporate Finance, and the Journal of International Business Studies. His work has been featured in Financial Times, on National Public Radio, as well as in popular business and industry journals such as Dow Jones MarketWatch, Chief Executive Magazine, Risk Management Magazine, and EnergyBiz. His research has also been presented at the U.S. Securities and Exchange Commission. He served as an Associate Editor for The Financial Review (2015-2021).