A forthcoming articlewhich I co-wrote with Didem Kurt, Koen Pauwels and Shuba Srinivasan for the International Journal of Marketing Researchapplies this theory to product and financial markets and analyzes how investors respond to negative and positive changes in companies’ product warranty payments.
If investors interpret increasing collateral payments as a signal of “quality losses” and decreasing collateral payments as a signal of “quality gains”, an asymmetric response in equity returns is likely to occur. produce.
To put our research into context, let’s consider some of the proposed implications of loss aversion in real life. For example, sellers tend to charge more for an item than buyers are willing to pay. For what? We believe that the value of an object is higher once we own it. This is known as the endowment effect. In other words, sellers perceive the abandonment of the item as a loss, while buyers perceive the exchange as a gain. Because losses hurt people more than gains make them feel good, there is often a large gap between the seller’s original asking price and the buyer’s bid price.
But what about financial markets? Evidence shows that investors react more strongly to dividend cuts versus dividend increases, which is consistent with the idea that the losses are greater than the gains. Another example is the so-called layout effect where investors tend to hold onto losing stocks longer than they hold onto winning stocks. However, this effect is less marked in sophisticated and wealthy investors. Along the same lines, there is a discussion of whether loss aversion really matters to investors.
Our study does not focus on individual stock trading decisions. Rather, we focus on how the stock market collectively reacts to quality losses versus quality gains signaled by changes in companies’ product warranty payments. Nevertheless, to validate collateral payments as an informational signal about product quality, we conducted an experiment with potential investors recruited from an online survey panel.
The experiment used information from the published financial statements of a public company that we presented under a fictitious company name. We randomly assigned participants to two conditions: high guarantee payments (ie, 6% of earnings) and low guarantee payments (ie, 1% of earnings). There were no other differences in the financial information presented between the two conditions.
Participants in the high guarantee payment condition perceived the company’s product to be of lower quality and were less likely to invest in company stock than those in the low guarantee payment condition. This finding lends credence to our argument that collateral payments communicate relevant product quality information to stock market participants.
Our review of analyst reports offers additional supporting evidence. We hypothesized that if warranty payments capture information about product quality, higher warranty payments in the current period will predict the intensity of discussions of quality-related issues in product reports. ‘analysts published in the coming period. For this validation test, we analyzed more than 66,000 analyst reports and looked for different combinations of words, such as “quality issues”, “quality issues” and “product issues”.
As expected, we found that the higher the warranty payments in the current period, the greater the discussion of quality-related issues in future analyst reports.
For our main analyses, we looked at 666 collateral-offering companies listed on US stock exchanges, with the sample period spanning fiscal years 2010 to 2016. Because investors react to unanticipated news, we estimated a first-order autoregressive model guarantee payments and used the residuals of this model as a proxy for unforeseen changes in guarantee payments.
The results support the proposed asymmetric reaction of investors to increasing collateral payments (“quality losses”) relative to decreasing collateral payments (“quality gains”). While stock returns decline with an unexpected increase in collateral payments, there is no favorable stock market response when a company experiences an unexpected drop in collateral payments. The economic importance of the documented result is not negligible. A one standard deviation increase in the unexpected increase in guarantee payments is associated with a 2.5 percentage point decline in annual equity returns for the average firm in the sample.
Are there other commodity market signals that might change investors’ interpretation of the quality signals communicated by changes in corporate guarantee payments? We considered three potential candidates: advertising spend, research and development (R&D) spend, and industry concentration. Each factor has the potential to amplify or dampen the informational value of changes in warranty payments.
Our results show that increasing advertising spending, but not R&D spending, reduces investors’ sensitivity to bad news conveyed by increased collateral payments. A possible explanation for this finding is that while greater advertising efforts may help boost a company’s brand image in the short term, R&D investments involve significant uncertainty and may not play a positive moderating role in branding. assessment by investors of the guarantee results achieved during the current period.
With respect to industry concentration, we have found that when an industry has recently become less concentrated (i.e., more competitive), a positive relationship exists between stock returns and lower payouts. of guarantee. This result suggests that in the face of increased competition, investors reward firms with improved product quality.
One final note: Offering product warranties does not necessarily guarantee high firm value. In fact, companies offering guarantees with increasing guarantee demands have a lower enterprise value than companies not offering guarantees.
So unless managers have made the necessary investments in product quality, offering warranties lightly in the hope of boosting current sales could prove very costly in the long run. As for investors, before rejoicing in a company’s decline in warranty claims, they should ensure that this information will translate into higher stock market returns by paying close attention to changes in the competitive landscape of the industry.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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