Empirical Analysis Of Relationship Between Managerial Overconfidence

Published Date: 02 Nov 2017

Abstract

Researches of psychology and behavioral economics show that people's judgment and decision-making are often subject to state of mind and the emotional situation. Business managers show beyond the emotional state of the general level of self-confidence in the business activities, which is called managerial overconfidence. Whether this "irrational" managerial overconfidence is correlated with corporate performance? Using operating performance forecast bias as a measure of overconfidence as well as samples from listed companies in real estate industry in Shanghai and Shenzhen stock exchange from 2007 to 2011, this paper conducts an analysis focusing on the relationship between managerial overconfidence and corporate performance. The findings show that business performance and "irrational" managerial overconfidence are positively correlated. The companies with overconfident managers can get 0.34% performance improvement relative to other companies.

Keywords

Managerial overconfidence, corporate performance, empirical analysis

Introduction and Motivation

This paper is aiming at conducting an analysis focusing on the relationship between managerial overconfidence and corporate performance. In this paper, overconfidence is not a derogatory term. We just follow the previous scholars and use managerial overconfidence to describe the self-confidence of business managers above average. Past studies suggested that all decision-making behaviors of business managers cannot be rational, and overconfidence is one of the manifestations of the irrational behaviors. As decision makers of the organizations, managers are prone to show cognitive biases and their expectations of company are not practical. Currently, researches of managerial overconfidence mainly focus on excessive corporate investment and financing, excessive mergers and acquisitions, excessive debt and other negative operating results. In contrast, there are limited researches concerning positive relationship between managerial overconfidence and operating performance, especially for empirical researches in China. Basing on the modern butler theory, this paper attempts to analyze the positive relationship between the "irrational" managerial overconfidence and corporate performance, which serves as a new perspective and innovation of this paper.

Literature Review

Some previous studies believes that managerial overconfidence will improve corporate operating performance while others holds that managerial overconfident will damage corporate operating performance.

On one hand, some previous studies held that managerial overconfidence can improve business performance: modern housekeeper theory believes that the pursuit of dignity, beliefs, and intrinsic job satisfaction will lead CEO efforts to run the company and become a good steward of company's assets. This will help enterprises adapt to the changing market environment and also help to improve business performance. Adams (Adams 2007) pointed out that the friendly relations between the Board of Directors and the CEO are conducive to the enhancement of the value of the company. Tian (Tian 2001) found that China's listed companies are more in line with the theory of modern housekeeper. Rao Yulei and Wang Jianxin (Rao Yulei and Wang Jianxin 2010) used managers’ shareholder changes as a measure of CEO overconfidence, Tobin’s Q to measure corporate performance, and did a regression analysis basing on Chinese A-share listed companies from 2007 to 2008. The results showed that under the premise of managerial overconfidence, the separation of the two roles of chairman and CEO can help improve the company's operating performance. Instead, there was no such relationship between non overconfident CEO and corresponding company’s performance.

On the other hand, other researches of managerial overconfidence mainly focus on excessive corporate investment and financing, excessive mergers and acquisitions, excessive debt and other negative operating results.

Foreign research began to focus on the impact of managerial overconfidence on the company's investment decisions from the 1980s. Roll (1986) introduced the concept of "managerial overconfidence" to the field of corporate merger and acquisition, and he thought a lot of M&A activities undermined the enterprise value. Heaton (2002) constructed a two decision-making model, and made a research about managerial overconfidence and corporate investment issues. The overconfident managers tend to overestimate return of target projects. Under the premise that the company's cash flow is sufficient, the overconfident managers will make excessive investment in negative NPV projects. Doukas and Petmezas (2007) conducted a survey of mergers and acquisitions implemented by overconfident managers and found that these M & A activities cannot produce high-yield return. On the contrary, these M & A activities showed lower declared income, therefore the overall performance of the company subjected to the impact.

In China, many scholars are also keeping up with the pace of foreign scholars, combining with China's national conditions and characteristics of the executives of listed companies in China, to conduct a large amount of researches concerning the impact of investment by overconfident managers. Because of China’s unique regular background and traditional culture, current listed companies are in the transaction period of continuous improvement, which makes it more difficult for domestic scholars to make researches on managerial overconfidence. Lin Zhaonan, Hao Ying and Liu Xing (2005) proposed that more than 25% of the executives of China's listed companies were overconfident. Due to the unique governance structure and corporate system in China, over-investment behavior is more likely to appear among Chinese executives.

As we can see from the research results at home and abroad, on the one hand, overconfident managers affect enterprise’s overall level of investment through merger and acquisition activities. Overconfident managers, on the other hand, affect the company’s investment through investment opportunities and the use of free cash flow, which will not only result in the company's non-efficient capital expenditure, and also lead to a reduction in company's operating performance.

Foreign studies have shown that the impact of managerial overconfidence on corporate financing decisions mainly reflected in three aspects. The first is the impact of the financing order. Heaton (2002) pointed out that even if the market is effective pricing, overconfident managers believe that the market underestimated the value of corporate equity securities, and then the manager will try to avoid the use of external financing. This is consistent with the interpretation of the pecking order hypothesis. The second is about the cause of the high level of indebtedness of enterprises. Hackbarth (2009) constructed t enterprise value model basing on a random cash flow to illustrate that overconfident managers tend to use more debt. The third is the impact of the debt maturity structure. Yu Minggui, Xia Xinping and Zou Zhensong (2006) used data of listed companies in Shanghai Exchange and Shenzhen Exchange from 2001 to 2004, to conduct a business empirical analysis. They used climate index as proxy variable of managerial overconfidence, proving that managerial overconfidence had significant positive relationship with short-term liabilities.

Research Hypothesis

From the literature review of managerial overconfidence, we can see that some previous studies believes that managerial overconfidence will improve corporate operating performance while others holds that managerial overconfident will damage corporate operating performance. This paper argues that the former is more reasonable.

Since 1990s, modern housekeeper theory has experienced rapid development. It reveals another kind of relationship existing between managers and shareholders. From the opposite perspective of agency theory, modern housekeeper theory provides a new way of thinking in order to solve the problem of corporate governance. Modern housekeeper theory holds that, there is consistency between the interests of self-regulated managers and the interests of stakeholders. Based on organizational psychology and sociology of organizations, modern housekeeper theory believes that managers are motivated by the need for achievement. They get inner satisfaction by completing challenging work, taking responsibility, establishing authority and obtaining recognition from colleagues, which serves as non-material incentives. Managers know that, even if he is a stakeholder, his own future is closely linked with the company. Therefore, managers are in the pursuit of their own dignity, beliefs and intrinsic job satisfaction, resulting in their devotion to the company and becoming housekeepers of the company.

As Adams (2007) [1] mentioned, the friendly relations between the Board and CEO was conducive to the enhancement of the value of company. Research by Tian (2001) [2] concerning outside directors found that China's listed companies were more in line with modern housekeeper theory. This paper argues that even though managerial overconfidence is the emotional state of "non-rational", it also serves as an optimistic estimate of future profitability. Managers provide a better "vision" for all employees of the enterprise as well as outside investors. Basing on the pursuit of their own dignity, beliefs and intrinsic job satisfaction, this will lead managers to strive to run the company. Thereby, it has driven employees and external investors more confidence in the future of the enterprise. So the quality of the overall operation of the enterprise as well as liquidity efficiency has improved and overall corporate performance will be improved accordingly.

This paper attempts to analyze the role of overconfident managers in improving operating performance of the company, and we propose the following to be tested assumptions:

H1: Overconfident managers can improve the level of corporate operating performance.

Data and Methodology

This research focuses on real estate industry in China. From 2002, Shanghai Stock Exchange and Shenzhen Stock Exchange require listed companies to disclose company's forecast for full year operating results in the third quarter report. However, at the beginning of a few years, there are quite limited companies disclosing corporate performance forecast. Therefore, this paper selected samples among listed companies in real estate industry from 2007. The data set covers all the listed real estate companies in Shanghai Stock Exchange and Shenzhen Stock Exchange from 2007 to 2011. First, we kick out all the ST companies. Second, we only select real estate companied that having corporate performance forecast over these five years. Finally, we get 172 observations: 33observations for 2007; 33 observations for 2008; 37 observations for 2009; 35 observations for 2010; 34 observations for 2011. All the data involved in this paper are from WIND.

Variable Definitions

One of the most important topics for this paper is how to measure managerial overconfidence. Based on previous studies as well as in the consideration of adaptability and data availability, in this paper, we use company’s performance forecast bias as a proxy for managerial overconfidence. We call it as "Forecast Bias". Yu Minggui, Xia Xinping and Zou Zhensong [3] (2006) regarded whether the notice of annual results of listed companies changed as the indicators for managerial overconfidence. If the actual performance was below the expected performance, then the managers were considered overconfident. We applied the similar measurement method in this paper. In detail, we use the value differences between forecast net profit margin growth rate (disclosed by the management teams for the company) and actual net profit margin growth rate in the same year, to measure the degree of managerial overconfidence. If forecast net profit margin growth rate is larger than the actual net profit margin growth rate, we regard it as managerial overconfident sample. Otherwise, it is considered as non-overconfident sample. Moreover, the larger the value difference between these two data, the more overconfident the company’s manager presented.

This paper selects return of asset (ROA) as a measure of operating performance indicators. Xu Liping and Xin Yu (2006) [4] believed that when selecting operating performance evaluation indicators for China's listed companies, it was inappropriate to use Tobin Q, which was frequently used in Western literature. The reason for this is that compared with the United States, as the representative of the mature Western markets, the degree of effectiveness of China's stock market is still lower; high stock price volatility and high turnover will lead to a potential deviation in Tobin's Q. Therefore, in order to address the above problem, it is more reasonable to use ROA as operating performance indicator in this paper. Based on former researches concerning company’s operating performance, corporate governance and managerial overconfidence, we select some explanatory variables and the variables described as shown in Table 1. In addition, we add four dummy variables: year2008, year2009, year2010, year2011, to control the year effect.

Table Variable Definitions

Variable Type

Name

Signal

Measurement Method

Dependent Variable

Return on Asset

ROA

Net Income/ Total Asset

Independent Variable

Managerial Overconfidence

OVERC

Forecast Net Profit Margin Growth Rate - Actual Net Profit Margin Growth Rate

Main Business Profit Growth Rate

MBPG

[Main Business Profit(t) – Main Business Profit(t-1)]/ Main Business Profit(t-1)

Enterprise Value

EV

Ln(Market value of Stock + Net Debt)

Controlled Variable

Year 2008

Year2008

Dummy

Year 2009

Year2009

Dummy

Year 2010

Year2010

Dummy

Year 2011

Year2011

Dummy

Empirical Model

ROA= α0 + α1OVERC + α2MBPG + α3 EV + α4YEAR2008+ α5YEAR2009+ α6YEAR2010+ α7YEAR2011 + ε

First of all, we conduct a correlation test. The following table is the correlation coefficient matrix of the variables of the above model. It can be found that proxy variable for company operating performance, ROA, is significantly positive correlated with managerial overconfidence OC at 0.01 significant level, which to some extent verify the assumptions of this article. The model of this paper does not exist the problem of multi-collinearity since the correlation coefficients between the independent variables do not exceed 0.2. The results from correlation test can ensure the accuracy of the following model results.

Table 2 Correlation Coefficient Matrix

Regression Results

The regression results are shown as follows. For the overall model significance, F statistics is significant under 1% significant level, which guarantee that our model is fitted and meaningful. The coefficient of managerial overconfidence (OVERC) is significant at the 1% level. That is to say, real estate companies with overconfident managers will have positive improvement on companies’ operating results, which verify hypothesis 1. Moreover, Main Business Profit Growth Rate and Enterprise Value both have significantly positively impact on ROA, which in line with our intuition. In addition, there has been significant year effect in line with the whole economic trend from 2007 to 2011. As we all know, the financial crisis of 2008 have made the whole economy experience a distress in 2008. As presented in the following results, average level of ROA in 2008 was just a little larger than that of 2007. And the following years of 2009, 2010, 2011 have enjoyed a significant and steady increase.

Table 3 Regression Result from STATA

Researches of psychology and behavioral economics show that people's judgment and decision-making are often subject to state of mind and the emotional situation. In this paper, we use operating performance forecast bias as a measure of overconfidence, along with samples from listed companies in real estate industry in Shanghai and Shenzhen stock exchange from 2007 to 2011, this paper conducts an analysis focusing on the relationship between managerial overconfidence and corporate performance. Basing on the modern butler theory, this paper attempts to analyze the positive relationship between the "irrational" managerial overconfidence and corporate performance. The findings show that business performance and "irrational" managerial overconfidence are positively correlated, which verify the hypothesis. The companies with overconfident managers can get 0.34% improvement in return on asset ratio relative to companies without overconfident managers.

Managerial overconfidence is a "non-rational" emotional state, but as an optimistic forecast of future profitability, managers provide a better "vision" for all employees of the enterprise as well as outside investors. When employees and outside investors are more confidence in the future of the enterprise, the enterprise's overall quality of operation and cash flow efficiency will be improved, so that the performance of enterprises will increase accordingly. According to our study, there is significant optimistic relationship between the quality of business performance and managerial overconfidence. When managers have an optimistic forecast of enterprise operating performance, the business performance of the company will be significantly improved. The conclusion of this study is creative, and it offers investing strategies for ordinary investors when making buying and selling decision. In reference to forecast for corporate performance, we can pay more attention to the companies who publish better performance forecast, since these companies generally will have better operating results.

Directions for Future Researches

However, managerial overconfidence’ positive impact on corporate performance cannot be unlimited. In what scope and to what extent managerial overconfidence can bring beneficial effects to enterprise performance are the directions of future researches. The last thing I want to figure out is that, there may be some limitations of this research. One of these limitations includes the self-selection problem for the real estate companies which decide whether disclosure the operating performance forecast or not. If the companies have confidence in future operation, they tend to be more willing to disclose operating performance forecast. That is to say, overconfidence of managers expanded optimistic bias of the company's voluntary disclosure of earnings forecast, and there existed significant upward bias. Otherwise, it may be the opposite case. This issue also offers the directions for future researches.