A new working paper from Stanford University Rock Center for Corporate Governance, by David Larcker, Eric So, and Charles Wang, is worth a read. The paper, titled Boardroom Centrality and Firm Performance, finds that “Firms with central or well-connected boards of directors earn superior risk-adjusted stock returns.” According the paper, this is just one of several benefits that centralized boards accrue to their companies.
The crux of the paper lies in the concept of “well-connectedness”. Larcker, et al. build on social network theory, and outline the following definitions of a well-connected board:
- DEGREE Centrality: The board has “relatively many channels of communication or resource exchange, yielding such a board more opportunities or alternatives than otherwise comparable firms”.
- CLOSENESS Centrality: the board has “relatively closer ties to outside boards (i.e., there are fewer steps between boards), making information or resource exchange quicker and more readily available”.
- BETWEENNESS Centrality: the board “lies on relatively more paths between pairs of outside boards, making such a company a key broker of information or resource exchange”.
- EIGENVECTOR Centrality: a variation on Degree Centrality, the board has members that are personally connected to well-connected people.
The paper covered a sample of 115,411 directors of the period of 2000 – 2007 and found that “boards with relatively better-connected boards earn significantly higher future returns than those with less-connected boards”. Another interesting conclusion was that companies with better-connected board also “experience significantly higher innovations in profitability”.
And perhaps most interestingly, the authors write, “The combination of these results suggests that the analysts fail to incorporate the economic implications of boardroom networks into their forecasts in a timely fashion. To the extent that the consensus analyst forecast is a proxy for market expectations, the positive relation between board centrality and future stock returns appears to stem from expectation errors of firm operating profitability.”
Will analysts begin to consider connectedness in evaluating stocks? Will nominating committees consider connectedness? While it is too early to reach such conclusions, this report provides food for thought for analysts, investors, and boards.