Politically Connected Companies, Handle With Care

The earnings forecast error (which is the difference between the forecasted and the actual earnings) is larger if the company is politically connected

Published: Jul 1, 2010

What impact do politically connected companies – with top management that has the ear of high-level government officials – have on the predictions of financial analysts? What is the link between political connection and corruption?

China Europe International Business School Professors Charles Chen and Yuan Ding are two of the authors of a recent research paper that explores these issues. They use five years of data from 114 politically connected companies in 17 locations across the globe: Australia, Canada, France, Germany, Hong Kong, Indonesia, Italy, Japan, Korea, Malaysia, Singapore, Spain, Sweden, Switzerland, Taiwan, UK and USA.

They outline their findings:
“Financial analysts are a group of professionals who make a living by forecasting companies’ future earnings, future cash flows and revenues. They’re almost a group of fortune tellers. They’re very influential because securities firms make recommendations to the general financial community – on whether to buy, sell or hold financial instruments – based on these analysts’ reports. What we found is that – after controlling all the other variables – the earnings forecast error (which is the difference between the forecasted and the actual earnings) is larger if the company is politically connected. However, the forecast error is smaller if this company is in a low-corruption level jurisdiction.  Put another way, the forecast error is larger for politically connected firms in jurisdictions where there is corruption.

So if you want to make an investment in a specific firm, in a specific country, it’s very important for you to figure out if the firm is politically connected. You also need to deal with the corruption factor at the country level. Investors need to be aware that if they go to a country with a high corruption level, there is even less transparency at the firm level. And political connection has an even higher impact on future uncertainty.

We use the accepted definition of political connection to refer to a company where a board member or top management is connected to high-level political leaders such as a prime minister, congressman, senator – at that level. Our reported results are conservative, because of this restrictive definition. If we expand our definition, our results would be even more pronounced.

This is the first study, to our knowledge, which clearly makes the distinction between political connection and corruption. Political connection is more or less common across countries; it exists not only in developing countries but also in developed countries. But we show that by developing a low-corruption-level environment we can lessen the negative effects of political connection on the information environment and transparency. This means curbing corruption is the more important factor (as opposed to stopping political connections) in building a better information environment for investors.

This also means that for governments or politicians, if they want to attract more investment from overseas they should curb the level of corruption. By reducing corruption levels within their jurisdictions, they can improve financial transparency at firm level and the cost of capital should be lower. So their locations become more attractive to investors. 

From an investor’s point of view, when choosing a local partner, multi-national enterprises (MNEs) need to be more careful when they are assessing their finances because if these firms are politically connected, the quality of financial information is less reliable. And when they go solo, corruption is also an issue they have to consider. They also have to be just as diligent when choosing other business partners such as long-term suppliers or prospective clients. They have to ask themselves: What about their political connections, and how has this affected the way financial analysts report on their financial strength?

After the recent global financial crisis, more and more emerging economies will play a more important role in the world economy. And many of these emerging economies are faced with the corruption issue; so our findings will have some direct impact or implications not only for businesses but also for researchers and policymakers as well.” 

Charles Chen is Professor of Accounting, Associate Dean and Director of the EMBA Programme at CEIBS
Yuan Ding is Professor of Accounting at CEIBS

[Reprinted with permission from The China Europe International Business School.]

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