Policy Uncertainty and the Dual Role of Corporate Political Strategies

• Author: Chansog (Francis) Kim,Jung Chul Park,Christos Pantzalis,Incheol Kim
• Published date: 01 June 2019
• Date: 01 June 2019
• DOI: http://doi.org/10.1111/fima.12226

Policy Uncertainty and the Dual Role

of Corporate Political Strategies

Chansog (Francis) Kim, Incheol Kim, Christos Pantzalis,

and Jung Chul Park∗

Firms use active political strategies not only to mitigate uncertainty emanating from legislative

activity, but also to enhance their growthopportunities. We find that a firm’ssystematic risk (beta)

can be hedged away by employing various political strategies involving the presence of former

politicians on corporate boards of directors,contributions to political campaigns, and corporate

lobbying activities. The hedging effect is greater whenf irms operatein more uncertain industries.

In addition, active political strategies are associated with greater firm heterogeneity and make

real options more value relevant as potential drivers of competitive advantages in uncertain

environments.

“This country has come to feel the same when Congress is in session as when the baby gets hold

of a hammer.”

– Will Rogers, New York Times, July 5th, 1930.

In spite of ample prior empirical findings that support the notion that corporate political

strategies have value relevance, there is very little direct evidence with regard to the underlying

mechanism, which in the framework of a discounted cash flow valuation model could be a

numerator and/or a denominator effect. Essentially, corporate political strategies can reduce the

impact of political uncertainty on systematic risk, thereby reducing the cost of capital and/or

propel favorable changes in industry dynamics thus enhancing growth opportunities. The relative

importance of these two effects has not been explicitly addressed at the firm level in prior

studies. Boutchkova et al. (2012) in a cross-country study examine at the industry level how

local and global political risks affect the systematic and unsystematic components of industry

return volatility. We intend to fill this void in the literature by empirically investigating at the

firm level: 1) how corporate political strategies, political uncertainty, and their interactions affect

firms’ systematic risk, and 2) whether corporate political strategies enhance the value relevance

of firms’ real options and if this effect is more pronounced when political uncertainty is high.

Since political uncertainty can take many different forms, we choose to focus on the type

of uncertainty about future cash flows that emanates from legislative activity (i.e., policy

Weare especially grateful to Rajkamal Iyer (Editor) and an anonymousreviewer for their many insightful and constructive

suggestions. Wethank Tao Shen for sharing his data used in Frankand Shen (2016). We also appreciatehelpful comments

from participants at the 2013 Financial ManagementAssociation Meeting.

∗Chansog (Francis) Kim is an Associate Professor of Accounting in the College of Business at Stony Brook University

in Stony Brook, NY.Incheol Kim is an Assistant Professor of Finance in the Robert C. Vackar Collegeof Business and

Entrepreneurship at The University of Texas Rio Grande Valley in Edinburg, TX. Christos Pantzalis is a Professorin the

Finance Department in the Muma College of Business, at the University of South Florida in Tampa, FL. Jung Chul Park

is an Assistant Professor in the FinanceDepartment in the Muma College of Business, at the University of South Florida

in Tampa, FL.

Financial Management •Summer 2019 •pages 473 – 504

474 Financial Management rSummer 2019

uncertainty).1Policy uncertainty implies that there is a greater array of both threats and op-

portunities for affected firms (Kim, Pantzalis, and Park, 2012). We proxy policy uncertainty here

by the number of bills that have the potential to affect a firm’s future business landscape.

Weaccount for three distinct types of cor porate political strategies:1) appointing ex-politicians

on corporate boards, 2) making political action committee (PACs) contributions, and 3) lobbying.

For each of these types of strategies, weuse several measures that have been previously employed

in the literature. In addition, we devise a composite measure of corporate political strategies,

which we label the Political Strategy Index(PSI). Our investigation spans 15 years, from 1994 to

2008, utilizing over 66,000 firm-year observations. Consistent with the notion that exposure to

uncertainty emanating from legislative activity is a source of systematic risk, we find that beta

increases with the number of value relevant bills introduced over the past year. This result is

also in line with the industry-level findings of Boutchkova et al. (2012) who find that domestic

political uncertainty is positively correlated with the systematic component of industries’ return

volatility. More importantly, we find that corporate political strategies are associated with lower

betas, and that this relationship is more pronounced when political uncertainty is higher. Our beta

regressions’ results are in line with the view that stocks by firms that have access to political

intelligence co-vary less with the market.2

Contrary to the beta regressions findings, our political connection measures and their in-

teractions with policy uncertainty are shown to be significantly and positively correlated with

idiosyncratic risk. Given that idiosyncratic risk can arise from the way innovation affects the un-

certainty of expected future profits (Shiller, 2000; Campbell et al., 2001; Mazzucato and Tancioni,

2008), we interpret this result as suggesting that firms that have the means to mitigate political

uncertainty are better at innovation (Ovtchinnikov, Reza, and Wu, 2015). A potentiallyimpor tant

aspect of innovationcan be found in cor porate political participation. The extraordinary growth of

corporate lobbying and other forms of corporate political participation over the past few decades

can be viewed as the result of a path-dependent learning process (Drutman, 2015). Companies

may initially be reluctant to become politically active,but once they star t doing so, they can gain

more confidence in their ability to not only protect themselves from government actions, but also

to expand their growth opportunities in business environments increasingly affected by political

uncertainty. Through their political activism, firms can gather valuable political intelligence,

thereby lowering political uncertainty. As such, corporate political activism propels innovation

(Ovtchinnikov et al., 2015).

Alternatively, our idiosyncratic risk findings could be viewed as in line with the argument

made in Chun et al. (2008) that firm-specif ic performance heterogeneity (i.e., idiosyncratic risk)

may be a “finer and more nuanced metric” of the intensity of creative destruction that economic

growth theorists envision as the process wherein creative innovators dominate laggards. Thus, in

1Malkiel (1979) first argued that Congressional activity as a proxy for regulatory uncertainty can hamper economic

performance. He hypothesized that investors viewedg reater Congressional activity as increasing regulatory uncertainty

and that this greater uncertainty would be reflected in higher return volatility and lower returns. Ferguson and Witte

(2006) provide support for this hypothesisby demonstrating that stock returns are dramatically lower and volatility higher

when Congress is in session. Moreover, theyf ind that more than 90% of the capital gains overthe life of the DJIA have

come on days when Congress is out of session.

2This widely-held view that connected firms possess “inside” political information, while non-connected

firms do not, is also supported by anecdotal evidence, such as the one from an article that appeared

on Bloomberg Markets (http://www.bloomberg.com/news/articles/2011-11-29/how-henry-paulson-gave-hedge-funds-

advance-word-of-2008-fannie-mae-rescue). The article describes that Hank Paulson, in a private meeting with big

investors at Eton Park including several fellow Goldman Sachs alumni, revealed how he would nationalize Fannie

and Freddie and wipe out shareholders, while at the same time telling the public, via the NY Times and Congress, that

this was not going to happen.

Kim et al. rPolicy Uncertainty and the Dual Role of Corporate Political Strategies 475

a creative destruction framework (Chun et al., 2008; Chun, Kim, and Morck, 2011), it is possible

that political connections are accentuating firm heterogeneity within industries (consisting of a

mix of early adopters of political strategies and laggards) making firms’ portfolios of real options

more value relevant as potential drivers of competitive advantages in uncertain environments

(Trigeorgis, 1996; Trigeorgis and Lambertides, 2014).3

We demonstrate empirically that politically connected firms possess more value relevant real

options than non-connected firms. Specif ically, we find that the stock returns of connected firms

increase (decrease) more than those of non-connected firms when their stock return volatility

increases (decreases). This effect is significantly more pronounced among firms operating in

more uncertain policy environments, consistent with the notion that real options become more

valuable in such environments as the connected firm is in a better position to exploit the extra

managerial flexibility that comes with being connected.

We examine whether the aforementioned effects change as predicted after exogenous shocks

proxied here by cases of a politicallyconnected board member’s sudden death. Our results provide

confirmation of the notion that causality runs from cor porate strategiesto risk and/or retur ns. We

obtain similar results when we repeat our earlier tests using three different measures of corporate

political strategies and alternative measures of policy uncertainty. Furthermore, our results are

robust to the exclusion of low priced (less than $5 per share) stocks and the use of weeklyreturns.

Overall, our evidence supports the notion that corporate political strategies can both alleviate

the impact of political uncertainty on systematic risk and serve as facilitators of competitive

advantage in uncertain times.

Our paper contributes to the recent policy uncertainty and corporate political connection

literature. First, prior literature providesevidence that political or policy-related uncertainty affects

country- or industry-wide stock market volatility (Bialkowski, Gottschalk, and Wisniewski,2008;

Fuss and Bechtel, 2008; Boutchkova et al., 2012). Our investigation is done at the firm level

by exploiting each firm’s political activities. In addition, our findings contribute to our better

understanding of the mechanisms through which corporate political strategies create/destroy

value. Politically active firms, measured as f irms with PAC contributions, increase innovation

prior to industry deregulation (Ovtchinnikov et al. 2015) and delay investment in anticipation of

future lucrative tax incentives (Wellman, 2017) as connected firms are capable of timing industry

deregulation and tax regulation changes in advance. Our paper complements these papers that

identify the mechanisms through which political activism creates value. We formally provide

the underlying mechanism of corporate political strategies’ value relevance by investigating

systematic and idiosyncratic risks of connected firms and their real options in the valuation

framework. Moreover, most political connections studies suffer from endogeneity issues. We

use ex-politicians’ sudden deaths as an exogenous shock to establish a causal relationship. We

confirm that causality runs from cor porate political strategies to risk and growth opportunities.

Finally, we employ a comprehensive sample of corporate political activism, such as firms with

politically connected boards, lobbying, and political contributions, as opposed to relying on the

use of a single political connection measure that only represents one tactic among a menu of

choices available to politically active firms. In doing so, we mitigate the measurement errors of

corporate political connectedness.

3The results in Chun et al. (2008) support the notion that technological improvements can induce innovation across

many industries wherein some firms can end up as winners, while others as losers depending upon how well they exploit

opportunities. They view firm performance heterogeneity as a readily observable measure of ongoing creative destruction,

a process that Schumpeter (1934) argues sustains economic growth.