When governance issues impact performance
Plus: Hudson Labs timeline view is now LIVE (details below)
Small cap companies that disclose high risk governance issues do not significantly underperform companies without governance issues. Recent Hudson Labs research indicates that whether or not a small company has an independent board etc. is relatively unimportant. On the other hand, governance risks at larger companies dramatically increases the likelihood of price collapse and underperformance. The takeaway: Size matters. Certain types of red flags are only meaningful when assessed in context.
Last week in New York City, we presented new research on how specific types of qualitative disclosure impact stock price. Governance was one of the categories that we discussed.
At Hudson Labs, we use language models to find and extract meaningful qualitative disclosure. As part of this process we’re able to evaluate the severity or riskiness of qualitative information. For instance, the sentence “Our CFO resigned today.” is, on average, rated as higher risk than a sentence referring to the board member stepping down. We use these severity scores to assess company-specific risk within specific categories e.g. governance.
The chart below compares the likelihood of a price collapse in the 6 months after new higher-risk governance disclosure. We define price collapse as a month-over-month market adjusted return in the bottom 85th percentile of performance that does not subsequently rebound. As you can see, there is a strong relationship between the size of the company and the meaningfulness of governance risks. Large companies with high risk governance disclosure are more than twice as likely to see a price collapse. Small and micro cap companies with governance risks are only slightly more likely to experience price collapse. The chart shows average results from multiple measurement periods between March 2020 through the end of 2021.
An example of a company in the high-risk governance category was Applovin Corp ($APP) which scored high on governance risk in November, 2021 due to its status as a controlled company, its dual class share structure, a non-independent compensation committee etc. Applovin’s stock price decreased significantly following November, on a market adjusted basis, and did not recover.
There are more than ten different Hudson Labs risk categories that have a strong relationship with price collapse over the following 6 months.
Why is the Hudson Labs research on qualitative disclosure groundbreaking?
Hudson Labs software allows us to quantify and assess the relative severity or riskiness of qualitative disclosure at scale.This has never before been possible. Previous research was done at a much smaller scale because it required significant human annotation.
New on the Hudson Labs Platform: Introducing Timeline View & Better Filing Navigation
Easily explore red flags by categories like governance, management turnover, related party transactions, and more. You can filter red flags based on model confidence and severity scoring.
