Corporate Strategy, Conformism, and the Stock Market

Transcription

1 Corporate Strategy, Conformism, and the Stock Market Thierry Foucault HEC Paris Laurent Frésard University of Maryland April 2015 Abstract In choosing their business strategy, managers must account for the e ect of their choice on the value of the real options associated with each strategy. When managers rely on stock market information to exercise or not these options, their value is higher when stock prices are more informative. We show theoretically that this induces conformity in strategic choices because the stock market is more informative about the value of common strategies. This conformity e ect is stronger for private rms because investors have no incentive to produce information about their strategies. Consistent with this prediction, we show empirically that rms choose more di erentiated products after going public and more so when their managers are better privately informed or when their peers stock prices are less informative. We are grateful to Maria Cecilia Bustamante, Julien Cujean, Claudia Custodio, Miguel Ferreira, and seminar participants at the Nova School of Business for useful comments. We thank Jerry Hoberg and Gordon Phillips for sharing their TNIC data, and Jay Ritter for sharing its IPO data. All errors are ours. 1

2 1 Introduction A central tenet of strategic management is that rms should choose corporate strategies the business in which they operate that give them the strongest competitive advantage (e.g. Porter (1985)). This competitive advantage can be obtained by unique combinations of resources (e.g. through acquisition of new assets or restructuring), di erentiation of product o ering, or lower costs (e.g. through innovations or the adoption of new technologies). According to this view, managers create value by choosing unique strategies, i.e., strategies that are di erent from those of other rms, and that others cannot easily replicate (e.g. Barney (1986) or Hoberg and Phillips (2014)). In choosing their strategy, managers often face considerable uncertainty about their payo s, however. One way for managers to reduce this uncertainty is to rely on stock market prices as a source of information. In this paper, we show theoretically that the reliance on the stock market can signi cantly reduce managers incentives to choose unique strategies and we provide evidence thereof. That is, the possibility of learning information from stock prices is a source of conformism in strategic choices, even when managers choose strategies that maximize the value of their rm. We formally derive this result in a model in which stock price informativeness and managers strategic decisions are jointly determined. In our model, a manager can choose to follow either a common strategy, already followed by several established public rms, or a unique strategy. The net present value of each strategy is uncertain. Their payo depends on a future state speci c to each strategy that is unknown when the manager chooses his strategy (e.g., the strength of consumers demand). Ex post, once the state is known, the type of the chosen strategy can be either good (if it yields a payo higher than expected) or bad (if it yields a smaller payo than expected). The net present value of a good unique strategy is higher than that of a good common strategy because uniqueness generates a higher payo. However, a bad unique or common strategy has a negative net present value. After announcing his strategy, the manager receives additional information about the type of his strategy and has 2

3 the option to abandon it. Thus, when the manager chooses his strategy, he must incorporate the impact of his choice on the information he will obtain about its type since this information in uences the value of his abandonment option. As a benchmark, we rst consider the case in which the manager only relies on his own private information in exercising the option to pursue or to abandon his chosen strategy. In this case, he always chooses the unique strategy because the expected net present value of this strategy (including the value of the option to abandon the strategy) is higher. The reason is simply that di erentiation yields a higher payo on average, in particular when the unique strategy is good. Then, we consider the possibility for the manager to learn information from its own stock price (if his rm is publicly listed) and established rms stock prices, in addition to his own private information. In this case, the manager sometimes nds optimal to choose the common strategy. The reason is that the value of the abandonment option is higher for the common strategy because the stock market is more informative. This superior informativeness stems from two complementary economic forces. First, speculators who are informed about the type of the common strategy can exploit this information by trading the stocks of all rms following this strategy. For instance they buy the stocks of all these rms if they learn that the common strategy is good. As a result, intermediaries setting prices (i.e., market makers) are more likely to discover the type of the common strategy than that of the unique strategy. Therefore, prices contain more information about whether the strategy is good or bad. Second, there are economies of scale in trading on information about the common strategy: The xed cost of obtaining information about the common strategy can be amortized by trading all stocks of rms following it. Thus, the information cost per stock is naturally lower for the common strategy. So, when the demand for information about a strategy is endogenous, speculators trading the common strategy must obtain a smaller expected pro t per stock in equilibrium. This implies that stock prices are more information about the type of the common strategy. 3

4 When the manager relies in part on stock market prices as a source of information, he faces a trade-o when choosing his strategy. Ignoring the abandonment option, the unique strategy has a higher expected net present value. The value of the abandonment option is however smaller for the unique strategy because the stock market is (endogenously) less informative about its payo. Given this trade-o, there is a range of values for the parameters such that the manager is better o choosing the common strategy while he would not in the absence of stock market information. The reliance on the stock market can thus push the manager s decision toward strategic conformity. This conformity e ect becomes stronger when the bene t of obtaining information from the stock market is higher for the manager. This happens when (a) his private information is less precise, (a) the number of investors producing information about the common strategy increases, or (c) the number of investors who produce information about the unique strategy decreases. While the model o ers several new insights, one unique testable implication of our theory is that the conformity e ect is stronger for a private rm than for a public rm, other things equal. By construction, a private rm cannot rely on its own stock price as a source of information. This lowers the value of the abandonment option associated with the unique strategy compared to the case where the rm is public. Thus, the model predicts that rms that go public should be relatively more di erentiated after their Initial Public O ering (IPO) compared to prior their IPO. 1 We test this novel prediction using a sample of 1,231 U.S. rms that go public between 1996 and We measure the uniqueness of the strategy chosen by a rm by the degree of di erentiation of its product o ering relative to that of related (peer) rms. We identify the set of peers for each newly public rm at the time of its 1 Some papers (e.g., Maksimovic and Pichler (2001), Spiegel and Tookes (2009), or Chod and Lyandres (2011)) analyze the e ects of IPOs on competitive interactions in the product market. However, this literature has not considered a possible direct e ect of the going-public decision on di erentiation choices, as we propose in this paper. For instance, Chod and Lyandres (2011) shows that newly-public rms compete more aggressively with their rivals after going public because their owners can better diversify idiosyncratic risks in capital markets. However, their analysis and tests assume that industry de nition and the extent of di erentiation among rms is xed before and after the IPOs. 4

5 IPO using Hoberg and Philipps (2015) s Text-Based network Classi cation (TNIC). This classi cation is based on textual analysis of the product description sections in rms 10-Ks. For every pair of rms, Hoberg and Phillips (2015) de ne an index of product similarity based on the relative number of words that rm-pairs share in their product description. We use (one minus) this index to measure the extent of product di erentiation between each rm-pairs. 2 For each going-public rm, we then measure the change in its di erentiation vis-àvis each of its established peers, measured at the time of the IPO and de ned as rms that have been listed for more than ve years. We track the change in di erentiation within each pair over the ve years following the IPO. To better isolate e ects that are due to the IPO and not re ecting general trend in di erentiation or peers decisions to di erentiate, we construct counterfactual rm-pairs that are made of established peers of peers of the IPO rm i that are not peers of rm i. Consistent with the model s prediction, we nd that going-public rms become signi cantly more di erentiated in the years that follow their initial public listing. In particular, the average degree of product di erentiation between a newly-public rm and an established peer increases signi cantly more over time compared to that observed for counterfactual pairs. Notably, this result is obtained using regressions that include rm-pair xed-e ects that capture any time-invariant di erences within pairs (e.g. age di erences or geographical location) and time-varying control variables that could a ect the evolution of rms di erentiation choices over time (e.g. size, growth opportunities, or access to capital). In a similar vein, we nd a signi cant decrease in the return co-movement between IPO rms and their established peers throughout the post-ipo period, which con rms that the fundamentals of IPO rms become less similar than that of their peers after they become publicly traded. Our model further suggests that the weakening of the conformity e ect following an IPO should be larger for newly-public rms for which the informational cost of 2 For instance the peers of rm i at a given point in time are rms for which the index of product similarity exceeds a pre-de ned threshold. A decrease in this index of similarity for a rm i relative to one of its peers j indicates that the degree of di erentiation increases between these two rms. 5

6 di erentiation is smaller, that is, when the managers of going public rms are better informed, or when the stock prices of established peers are less informative. Our empirical analysis con rms these predictions. We nd that the increase in product di erentiation of IPO rms is larger for rms whose managers are better informed, as measured by proxies for the intensity and pro tability of insider trading. In addition, IPO rms for which established peers stock prices are less informative (as proxied by the PIN measure or the size of price reactions to earnings surprises) appear to increase their degree of di erentiation signi cantly more over time. In addition, the increase in di erentiation is larger for rms whose peers receive less coverage by professional nancial analysts. There is a vast theoretical and empirical literature on conformism in managerial decisions (see Lieberman and Asaba (2006) for a review). The economic literature on this topic emphasizes that conformism in strategic choices can originate in reputation concerns (e.g. Scharfstein and Stein (1990)), information cascades and herding (e.g. Bikhchandani, Hirshleifer, and Welch (1998), or simply as a response to correlated signals among related rms. The mechanism and the consequences analyzed in our paper are distinct. In our theory, conformism arises in equilibrium because it allows managers to receive more precise information from the stock market. In addition, imitation is perfectly rational and value enhancing. To our knowledge, our paper is the rst to analyze the connections between conformism and informational feedbacks from the stock market. Our paper builds upon the growing literature that studies corporate decision making when managers learn information from the stock market (see Bond, Edmans, and Goldstein (2012) for a recent survey). In general, this literature has focused, both empirically or theoretically, on the e ects of stock price information on real investment decisions by rms (see, for instance, empirical analyses in Chen, Goldstein, and Jiang (2007), Bakke and Whited (2010), Edmans, Goldstein, and Jiang (2012), or Foucault and Frésard (2012)). This literature has however not considered how the prospect of learning information from stock prices a ects strategic decisions by rms, 6

7 such has product di erentiation and product market positioning. 3 Our paper also adds to the literature that examines the connections between nancial and product market decisions. Models analyzing the interplay between product market competition and rms nancing choises do not consider the information produced by the stock market, nor its e ect on rms product market strategies (e.g., Titman (1984), Brander and Lewis (1986), Maksimovic (1988), or Bolton and Scharfstein (1990)). Similary, existing research that links product market characteristics to stock prices typically take the intensity of competition in product markets as given and analyze how (various dimension of) competition in uences stock returns (e.g. Hou and Robinson (2006) or Bustamante (2015)) or informed investors trading decisions (e.g. Peress (2010) or Tookes (2008)). Our paper focuses on the reverse e ect: How information produced in the stock market can in uence rms di erentiation decisions, and ultimately shapes product market structures. The rest of the paper is organized as follows. In the next section, we describe the model and show how the reliance on stock market information can lead to conformism in strategic choices. We also show that the going public decision should weaken this bias, which leads to our main prediction: going public rms should, on average, increase product di erentiation after IPOs. We present the data used to test this prediction in Section 3. Section 4 reports the empirical ndings and Section 5 concludes. 2 Model Choosing a strategy. At date 1, rm A chooses a strategy, denoted S A. At date 2, the stock market opens, investors observe rms strategy, and trade (see below). At date 3, the manager of rm A decides to implement or not the strategy chosen 3 In our model, a rm manager learns information from his own stock price. In equilibrium, when the rm chooses the common strategy, its stock price is a su cient statistic for the information in its peer stock price. Thus, implications of the model are identical if rms learn only from their own stock price or more generally from the stock price of all rms following the same strategy. Foucault and Frésard (2014) provide evidence that rms rely on their peers stock prices for their investment decisions. 7

8 at date 1, after observing stock prices at date 2 and receiving private information on the payo of his strategy (see below). At date 4, the payo s of all rms are realized. Figure 1 describes the timing of the model. 4 [Insert Figure 1 about here] Firm A can choose one of two possible strategies, denoted S u or S c. Strategy S u is a unique strategy whereas strategy S c is a common strategy, already chosen by n other public rms. We interpret a strategy as a di erentiation choice. The unique strategy allows rm A to signi cantly di erentiate its strategy from its competitors strategy while the common strategy, S c, does not. We denote by n(s) the number of rms following strategy S at the end of date 3. As strategy S u is unique, we have n(s u ) = 1 if A chooses it and implements it. Otherwise n(s u ) = 0. Similarly, n(s c ) = n + 1 if the manager of rm A chooses strategy S c and implements it. Otherwise n(s c ) = n. If the manager of rm A abandons his strategy at date 3, he bears no cost but he cannot switch to a new strategy. Firm A s payo is then zero. If instead the manager of rm A chooses to implement his strategy, rm A must invest an indivisible amount, normalized to one. For public rms following strategy S c, the implementation cost is sunk. These rms represent established rms who have already decided to follow strategy S c and incurred corresponding investments. We denote by r(s; n(s)) the expected return of strategy S per dollar invested. The actual return of the strategy is uncertain, however. For instance, a rm with a di erentiated product might nd no consumers with a taste for his product. To capture this uncertainty, we assume that both the common and the unique strategy can be Good (G) or Bad (B) with equal probabilities and we denote by t S 2 fg; Bg, the type of strategy S 2 fs u ; S c g. This type becomes known at date 4 and determines the realized return on a strategy at this date. The realized return on a good strategy is r(s; n(s); G) = r(s; n(s)) + S while the realized return on a bad strategy is 4 While we focus on product di erentiation strategies, the timing of the model resemble the evidence provided by Luo (2005) who document that rms annouce an acquisition strategy, and then decide to implement or not the strategy (i.e. pursue the acquisition) based on the stock market reaction. 8

9 r(s; n(s); B) = r(s; n(s)) S. Thus, the expected net present value (NPV) of implementing strategy S for rm A is E(NPV(S; n(s))) = r(s; n(s)) 1 for S 2 fs u ; S c g. (1) We assume that the payo of a good (bad) unique strategy is higher than the payo of a good (bad) common strategy: A.1: (n) r(s u; 1; t S ) 1 r(s c ; n + 1; t S ) 1 > 1, (2) This assumption captures the notion that di erentiation is a way to increase revenues, provided the common and the di erentiated strategy have the same type. 5 It is natural (but not critical for our ndings) to assume that (n) increases with n: as more rms follow the common strategy, competition among these rms intensi es and the return of the common strategy decreases. 6 For the problem to be interesting, arrival of information about the type of a strategy must a ect the manager s decision to pursue or not his strategy. Thus, we assume that the net present value of a good strategy is positive (r(s; n(s); G) > 1) but that the net present value of a bad strategy is negative (r(s; n(s); B) < 1) for rm A. Thus, rm A will implement his strategy at date 3 if its manager learns that the strategy is good and abandons it otherwise. We also assume that the expected net present value of both strategies for rm A is negative: A.2 : r(s; n(s)) 1 for S 2 fs u ; S c g. (3) Thus, absent new information at date 3, the manager of rm A always abandons his strategy, whether he chose the unique or the common strategy at date 1. This assumption can be relaxed without a ecting qualitatively the main ndings of the 5 In line with this assumption, Hoberg and Phillips (2015) show empiricall that unique rms (de ned as rms whose product o ering is di cult to replicate using a combination of other rms) display higher valuation compared to less unique rms. 6 The alternative assumption is that (n) < 1 and (n) decreases with n. In this case, rms strategies are complements rather than substitutes in the sense that a rm s payo is higher when more rms choose the same strategy. In this situation, rms would choose not to be di erentiated even when they do not learn information from the stock market. We focus on the other, more natural case, precisely to highlight the fact learning from the stock market can induce conformity. 9

10 paper. Finally, we assume that : A.3: r(s c ; n + 1; G) > r(s c ; n; B); which is equivalent to r(s c ; n) r(s c ; n + 1) < 2 c. This means that the payo of a good common strategy chosen by n + 1 rms is higher than the payo of a bad strategy chosen by n rms. This assumption implies that observing that the strategy of a rm is good is a more positive news than observing that it is bad even if, in the former case, one extra rm ( rm A) decides to adop the strategy. It guarantees that, in equilibrium, informed investors prefer to buy stocks of established rms than selling them when they learn that the common strategy is good. In the baseline version of the model, we assume that rm A is public. Hence, the manager of rm A has three sources of information when he decides or not to implement his strategy at date 3. First, he privately observes a signal s m 2 fg; B;?g about the type of his strategy. Speci cally, s m = t S with probability or s m =? with probability (1 ), where? is the null signal corresponding to no signal. Thus, measures the likelihood that the manager has full information about the type of his strategy. We refer to s m as direct managerial information and to as the quality of this information. Second, the manager of rm A observes the stock prices of established rms, denoted by p j2 for j 2 f1; :::; ng. Finally, the manager of rm A observes his own rm s stock price. Let I be the manager s decision at date 3, with I = 1 if the manager of rm A implements his strategy and zero otherwise. At date 3, for a given decision, I, the expected value of rm A is V A3 (I; S A ) = I E(NPV(S A ; n(s A )) j 3 ); (4) where 3 = fp 12 ; ::; p n2 ; p A2 ; s m g is the information set of the manager when he makes his decision at date 3. Firm A faces no nancing constraints and, at date 3, its manager makes the decision I that maximizes V A3 (I; S A ). We denote by I ( 3 ; S A ) the optimal decision of the manager at date 3 given his information at this date. 10

11 At date 1, the manager has no information and the value of rm A is V A1 (S A ) = E(I ( 3 ; S A ) NPV(S A ; n(s A ))): (5) The manager chooses the strategy, S A, at date 1 that maximizes V A1(S A ). The Stock Market. There are three types of investors in the stock market: (i) a continuum of risk-neutral speculators, (ii) liquidity traders with an aggregate demand z j, uniformly and independently distributed over [ 1; 1], for rm j, and (iii) risk neutral dealers. Each speculator assesses strategies chosen by publicly listed rms and obtains a signal bs i (S) 2 fg; B;?g about the type of strategy S. We assume that a fraction S of speculators receives a perfect signal (i.e., bs i (S) = G) about strategy S. Remaining speculators observe no signal about this strategy (bs i (S) =? for these speculators). After receiving her signal on strategy S, a speculator can choose to buy or sell one share in all stocks of rms following this strategy or he can decide not to trade at all. We denote by x i (bs i (S(j))) 2 f 1; 0; +1g the demand of speculator i for shares of rm j following strategy S(j) given her signal about this strategy. Let f j (S(j)) be the order ow the sum of speculators and liquidity traders net demand for the stock of rm j when it follows strategy S(j): f j = z j + x j (S(j)); (6) where x j = R 1 0 x i(bs i (S(j)))di is speculators aggregate demand of stock j. As in Kyle (1985), order ow in each stock is absorbed by dealers at a price such that they just break even given the information contained in the order ow. We assume that market makers observe the realizations of order ows in each market when they set their prices. 7 Thus, p A2 (f A (S A )) = E(V A3 (I ( 3 ; S A ); S A ) j 2 ), (7) 7 Thus, the stock price for each stock re ects all available information at the end of date 1, not just the information contained in the order ow of the stock. It is natural to focus on this case since managers make their decisions at low frequency relative to the frequency at which market makers can observe order ows in all stocks and adjust their prices accordingly. Thus, by the time at which managers make their decisions, stock prices are likely to re ect all order ow information. In any case, the main implications of the model are identical if market makers can condition their prices on the order ow in their stock only. 11

12 and, p j2 (f j (S c )) = E(r(S c ; n(s c ); t Sc ) j 2 ) for j 2 f1; ::; ng, (8) where 2 = ff 1 ; :::; f n ; f A g. Hence, using the Law of Iterated Expectations, the stock prices of rms A and j 2 f1; ::; ng at date 1 are p A1 (I ) = V A1 (S A ) and p j1 (f j (S c )) =E(r(S j ; n(s c ); t Sc )), respectively. Equilibrium. The stock price of rm A clearly depends on the manager s optimal decision, I ( 3 ; S A ). The stock prices of established rms also depend on this decision when rm A chooses the common strategy. Indeed, the manager s decision to pursue the strategy at date 3 determines the number of rms following the established strategy, which in turn determines established rms payo s. In turn, the manager s optimal decision at date 3 itself depends on stock prices. Thus, in equilibrium, the manager s optimal decision, I ( 3 ; S A ), and the stock prices of all rms are jointly determined. Formally, a stock market equilibrium for is a set of trading decisions x i (bs i (S j )), stock prices p j2( 2 ) and a decision rule I ( 3 ; S A ) such that (i) the trading strategy x i () maximizes the expected pro t for speculator i given other traders actions and rm A s decision rule, (ii) the decision rule I () maximizes the expected value of rm A, V A3 (I; S), at date 3, and (iii) p j2() solves (7) given that agents behave according to x i (), and I (). 2.1 The stock market and strategic conformity As a benchmark, we rst consider the case in which the manager does not have access to stock market information (or ignores it). In this case, the manager only relies on his private information. Therefore, he implements his strategy at date 2 if he learns that the strategy is good and does nothing otherwise. Thus, in this case, the expected value of rm A at date 1 is: We deduce that V benchmark A1 V benchmark A1 (S A ) = 2 (r(s A; n(s A ); G)) 1): (S u )=VA1 benchmark (S c ) = (n) > 1. Hence, the manager optimally chooses the unique strategy in the benchmark case. 12

13 Proposition 1 (benchmark) The manager of rm A optimally chooses the unique strategy when he does not use information from the stock market. We now analyze how stock market information a ects the choices of the manager of rm A. For this we must rst derive the equilibrium of the stock market when rm A chooses the common strategy. Let de ne p H A (S A) = r(s A ; n(s A ); G) 1, p L A (S A) = 0, and p M A (S A) = VA1 benchmark (S A ). Observe that p H A (S A) > p M A (S A) > p L A (S c). Lemma 1 When rm A chooses the common strategy, the equilibrium of the stock market at date 2 is as follows: 1. Speculator i buys one share of rm j if bs i (S c ) = G, sells one share of rm j if bs i (S c ) = B, and does not trade otherwise. 2. The stock price of an established rm is (i) p j = if the order ow of one stock (including stock A) is larger than (1 c ), (ii) p j = (1 =2)r(S c ; n)+r(s c ; n+ 1)=2 if the order ow of all stocks (including stock A) belongs to [ (1 c ); (1 c )], (iii) p j = r(s c ; n; B) if the order ow of one stock (including stock A) is less than (1 c ): 3. The stock price of rm A is (i) p H A (S c) if the order ow of one stock (including stock A) is larger than (1 c ), (ii) p M A (S c) if the order ow of all stocks (including stock A) belongs to [ (1 c ); (1 c )], and (iii) p L A (S c) if the order ow of one stock (including stock A) is less than (1 c ): 4. If the manager receives a private signal then he implements the strategy is his signal indicates that the strategy is good and abandons it if his signal indicates that the strategy is bad. Else, the manager follows his stock price: he implements his strategy at date t = 2 if his stock price is p H A (S c) and abandons it otherwise. If the manager receives a private signal about the type of his strategy, he only relies on this signal for his decision at date 2 since this signal is perfect (Part 4 of 13

14 Lemma 1). Otherwise, the manager relies on the information conveyed by his own stock price to make his decision. The information obtained from the stock market depends on the realization of the total demand (f j ) for each stock. If speculators have negative information, they optimally sell stocks and, therefore, the largest possible realization of the order ow in this case is less than (1 than (1 c ). Thus, when the demand for one stock is higher c ), market makers infer that speculators know that the common strategy is good. Thus, the stock price of all rms, including rm A, adjusts to its highest possible level (Part 3 of Lemma 1), which signals to the manager of rm A that the common strategy is good. 8 Hence, in this case, the manager of rm A decides to go on with the common strategy and he implements it (Part 4 of Lemma 1), even if he has no private information. Symmetrically, market makers infer from a relatively weak demand in one stock (i.e., a realization of the order ow less than (1 c )) that speculators have negative information about the type of the common strategy. Thus, the stock price of all rms, including rm A, adjusts to its lowest possible level, which signals to the manager of rm A that the common strategy should not be pursued further. Last, market makers cannot infer whether speculators have received a positive or a negative signal when the demand for each stock is neither relatively strong or relatively weak, that is, when f j belongs to [ (1 c ); (1 c )] for each stock. Indeed, realizations of the order ow in this range are equally likely when the strategy is good or when the strategy is bad. Thus, in this case, stock prices do not contain information and the manager of rm A optimally chooses not to pursue the strategy since its unconditional net present value is negative (Assumption A.1). 8 The stock price of established rm is higher when market makers learn from order ow that the strategy is good than when they learn no information because r(s c ; n + 1; G) > (1 =2)r(S c ; n) + r(s c ; n+1)=2; under Assumption A.3. When Assumption A.3 is not satis ed, this is not necessarily the case. Intuitively, discovery by the stock market that the common strategy is good has an ambiguous e ect on the value of established rms. On the one hand, it raises their value because, other things equal, a good strategy yields a larger cash- ow than a bad strategy. On the other hand, it lowers the value of established rm because it implies that rm A will implement his strategy (which means that established rms willl face one additional competitor). The former e ect always dominates i A.3 is satis ed. 14

15 Using eq.(5), the value of rm A at date 1 is: V A1 (S c ) = (Pr(I = 1 jt Sc = G) (r(s c ; n+1; G) 1)+Pr(I = 1 jt Sc = B) (r(s c ; n+1; B) 1))=2: From the last part of Lemma 1, we deduce that: Pr(I = 1 jt Sc = G) = + (1 ) Pr(p A1 = p H A (S c ) jt Sc = G). (10) Thus, stock market information increases the likelihood that the manager of rm A will implement the strategy chosen at date 1 when it is good. Indeed, conditional on the strategy being good, the manager will implement the strategy either when (i) he receives managerial information (as in the benchmark case) or (ii) if its stock price at date 1 is high (i.e., equal to p H A (S c)) when his private signal is uninformative. Using the fact that the demand from liquidity traders is uniformly and independently distributed across stocks, we deduce that 9 Pr(p A1 = p H A (S c ) jt Sc = G) = (n; c ) def = 1 (1 c ) n+1 As the number of rms following the common strategy increases, the likelihood that stock prices reveal the type of the common strategy increases. This explains why (n; c ) increases with n. When the common strategy is bad, speculators sell all stocks. Accordingly, the order ow in each stock is at most (1 (9) c ) and therefore the stock price of rm A has a zero probability of being high. Moreover, if the manager receives private information, this information indicates that the strategy is bad and, therefore, the manager does not implement the strategy. Thus, the likelihood that the manager of rm A implements a bad strategy is zero: Pr(I = 1 js c = B) = 0. We deduce from eq.(9) that the expected value of rm A at date 1 is: V A1 (S c ) = ( + (1 )(n; c)) (r(s c ; n + 1; G) 1): (11) 2 9 To see this, observe that, Pr(p A1 = p H A (S c) jt Sc = G) = Pr([ j=n+1 j=1 (f j ) (1 c ) js c = G) = 1 Pr(\ j=n j=1 (f j) < (1 c ) js c = G) according to Lemma 1. As f j = z j + c when t Sc = G, we deduce that Pr(p A1 = p H A (S c) jt Sc = G) = 1 Pr(\ j=n+1 j=1 fz j g < (1 2 c )) = 1 (1 c ) n+1, where the last equality from the fact that the z j s are uniformly and independently distributed over [ 1; 1]. 15

16 The next lemma describes the equilibrium of the stock market when rm A chooses the unique strategy. Lemma 2 :When rm A chooses the unique strategy, the equilibrium of the stock market at date 2 is as follows: 1. Speculator i buys one share of rm j if bs i (S j ) = G, sells one share of rm j if bs i (S j ) = B, and does not trade otherwise. 2. The stock price of an established rm is (i) p j = r(s c ; n; G) if the order ow in the stock of one established rm is larger than (1 c ), (ii) p j = r(s c ; n) if the order ow of all stocks of established rms belongs to [ (1 c ); (1 c )], (iii) p j = r(s c ; n; B) if the order ow in the stock of one established rm is less than (1 c ): 3. The stock price of rm A is (i) p H A (S u) if the order ow in stock A is larger than (1 u ), (ii) p M A (S u) if the order ow in stock A belongs to [ (1 u ); (1 u )], and (iii) p L A (S u) if the order ow in stock A is less than (1 u ): 4. If the manager receives a prive signal then he implements the strategy is his signal indicates that the strategy is good and abandons it if his signal indicates that the strategy is bad. Else, the manager follows his stock price: he implements his strategy at date t = 2 if his stock price is p H A (S u) and abandons it otherwise. The equilibrium is very similar to that obtained when rm A chooses the common strategy. The only important di erence is that when rm A chooses the unique strategy, market makers in rm A cannot learn information from trades in stocks of established rms. Thus, the stock price of rm A only depends on the order ow in its stock. Accordingly the probability that the manager of rm A will implement its strategy when it is good depends only on the fraction of speculators informed about the unique strategy, u. This probability is Pr(I = 1 jt Su = G) = + (1 ) Pr(p A1 = p H A (S u ) jt Su = G) = + (1 ) u : 16

17 Then proceeding as in the case in which rm A chooses the common strategy, we deduce that the expected value of the rm at date 1 when it chooses the unique strategy is V A1 (S u ) = ( + (1 ) u) (r(s u ; 1; G) 1): (12) 2 For a given strategy, the expected value of rm A when it uses stock market information is higher than when it ignores it: V A1 (S A ) V benchmark A1 (S A ) for S A 2 fs c ; S u g, with a strict inequality if < 1. The reason is that stock market information complements managerial information and therefore enhances the manager s ability to make value enhancing decisions. Moreover, as explained previously, the stock price of rm A at date 1 is p 1A = V A1 (S A ). Hence, whether the manager of rm A announces the common or the unique strategy, we have p L A2 < pm A2 < p A1 < p H A2. Thus, Lemma 1 and 2 imply that the manager of rm A goes on with the strategy announced at date 1 if, in reaction to this announcement, his stock price goes up (p A = p A2 p A1 > 0) and abandons it if his stock price goes down. This explains why the stock price of rm A drops even if market makers cannot infer from demands of various stocks whether speculators have a good or a bad signal about rm A s strategy (i.e., why p M A2 < p A1). Indeed, in this case, market makers factor in their price the fact that the rm is less likely to pursue his strategy, which tends to lower its value. In either case, the value of rm A is higher when the fraction of speculators who are informed about the payo of its strategy ( u or c ) is higher. The reason is that the informativeness of the stock market about a strategy increases with the fraction of speculators informed about this strategy. For instance, consider the case in which rm A chooses the common strategy. It follows from the third part of Lemma 1 that the stock price of rm A reveals the type of its strategy with probability (n; c ), which increases with c. Thus, we refer to (n; c ) (or u depending on the strategic choice of rm A) as the informativeness of the stock market for the manager of rm A. The next proposition states our main result. 17

18 Proposition 2 (Conformity e ect): If u < (n; c ) then, at date 1, rm A optimally chooses the common strategy if (n) < (; b u ; c ; n) and it chooses the unique strategy if (n) > (; b u ; c ; n), where (; b u ; c ; n) = (+(1 )(n;c) (+(1 ) u) > 1. If u > (n; c ) then rm A always chooses the unique strategy. Hence, there is a set of values for the parameters ( u < (n; c ) and (n) < b(; u ; c ; n)) such that the manager of rm A chooses the common strategy while he always chooses the unique strategy when he ignores stock market information (see Proposition 1). This shows that when managers rely on the stock market as a source of information, their incentive to di erentiate is weakened. We label this the conformity e ect. The intuition for this nding is as follows. When rm A chooses the unique strategy, its stock price reveals the type of its strategy with probability u while when rm A chooses the common strategy, its stock price reveals its type with probability (n; c ). Thus, if u < (n; c ), the stock market is more informative about the value of rm A s strategy if it does not di erentiate. In this case, the manager of rm A faces a trade-o in choosing his strategy: di erentiation yields a larger payo if the unique strategy is good but the manager receives a less informative signal from the stock market about whether the strategy is good or bad. He is therefore less likely to implement a good (unique) strategy when it should indeed be implemented. If (n) < (; b u ; c ; n)), the latter e ect dominates the former and the manager is better o not di erentiating. If u > (n; c ), there is no trade-o since di erentiation brings both a larger payo if the manager s strategy is good and is associated with a more informative stock market. The case in which u < (n; c ) is more likely to occur in reality for two reasons. First, (n; c ) quickly increases with the number of established rms. Thus, even if c is smaller than u, (n; c ) can be larger if n is large enough (e.g., for n = 5, we have (n; c ) = 40% if c = 10%). The reason is that intermediaries (market makers) can extract more information from speculators trades since trades in one 18

19 stock are informative about the payo s of other stocks. 10 Second, speculators can use information about the common strategy to speculate in all stocks of rms following this strategy. Thus, for a xed cost of producing information, they bene t from economies of scale when producing information about the common strategy. If information acquisition is costly and endogenous, this scale e ect should tend to make the informativeness of the stock market about the common strategy ((n; c )) larger than its informativeness ( u ) about unique strategies in equilibrium, as the next corollary shows. 11 Corollary 1 Suppose that speculators must pay a cost C to become informed about a strategy. In equilibrium, the informativeness of the stock market about the common strategy when n + 1 rms follow this strategy is higher than the informativeness of the stock market about the unique strategy when one rm follows this strategy, i.e., (n; c) > u if n (r(s u;1)+ u c) (2 c (r(s c;n) r(s c;n+1)) : To understand the corollary, observe that the standard deviation of possible payo s for an established rm is c follows the unique strategy. 12 while it is (r(s u ; 1) + u )=2 for rm A when it Thus, one attractive feature of the unique strategy for speculators is that its speculative value is higher if 2 c < (r(s u ; 1) + u ). If n (r(s u;1)+ u c) (2 c (r(s c;n) r(s c;n+1)), this e ect however is not strong enough to o set the economy of scale e ect and, in equilibrium, the fraction of informed speculators about each type of strategy is such that (n; c) > u. 13 Importantly, one can obtain 10 See Pasquariello and Vega (2014) and Boulatov et al.(2011) for evidence of such cross asset learning by market makers. 11 In unreported tests, we con rm this intuition using the proxies for uniqueness and price informativeness de ned in the empirical section below. 12 Indeed, if rm A follows the unique strategy, it will keep the strategy if it learns that it is good and abandons it if it is bad or if the manager learns no information about the type of the strategy. Thus, in equilibrium (i.e., accounting for the optimal exercise policy of the abandonment option), the payo s for a rm adopting the unique strategy are r(s u ; 1) + u or zero. 13 The corollary compares the informativeness of the stock market about the common strategy when rm A chooses this strategy (so that n+1 rms choose this strategy) with the informativeness of the stock market about the unique strategy when rm A chooses this strategy. Of course, if rm A chooses the common strategy, the informativeness of the stock market about the unique strategy is then nil since no rms choose this strategy. 19

20 (n; c) > u even if the equilibrium demand of information about the common strategy c is less than that about the unique strategy, u. It is easily seen that (; b u ; c ; n) decreases with and goes to one when goes to one. Indeed, when the manager has more precise private information, he needs to rely less on stock market information. Hence, the informational gain of adopting the common strategy the conformity e ect is smaller. This informational gain is also smaller (larger) when u ((n; c )) is higher so that (; b u ; c ; n) decreases with u and increases with (n; c ). Moreover when goes to zero and u goes to zero, b(; u ; c ; n) become in nitely large. In these cases, rm A chooses the common strategy even if the increase in payo with a successful unique strategy is very large. 2.2 A unique testable implication Strategic choices of public status One way to test whether the conformity e ect plays a role in di erentiation decisions of rms is to analyze empirically whether and how a variation in u a ects the choice of its strategy by a rm. For instance, an exogenous increase of u increases the likelihood that a given rm shifts to a more unique strategy (since it lowers b(; u ; (n; c ))). One immediate problem with this approach is that u is not observed unless the rm decides to di erentiate and choose the unique strategy in the rst place. When a rm is private, however, u is by de nition zero since the rm is not publicly traded such that it cannot attract information gathering by any speculator. In contrast, c is di erent from zero irrespective of whether rm A is private or public as long as established rms are public. Now suppose that rm A goes public. If it shifts to the unique strategy then u > 0 as its stock will attract some trading from informed investors (maybe a small fraction but at least a strictly positive fraction). Hence, going public is a positive shock on u. All else equal, going-publci should therefore increase rm A s incentive to di erentiate its strategy. To formalize this intuition, suppose rst that rm A is private. In this case, if rm A chooses the unique strategy then it cannot obtain information from the stock 20

21 market. Thus, its expected value at date 1 is identical to that in the benchmark case (or to the case in which u = 0): V private A1 (S u ) = VA1 benchmark (S u ): (13) If instead, rm A chooses the common strategy then its manager can learn information about his strategy from the stock price of the n established public rms. In particular, if the stock price of these rms is high then the manager of rm A can infer that the common strategy is good and therefore he will choose to implement the common strategy in this case, even if he does not receive managerial information. Thus, proceeding as in the case in which rm A is public, we deduce that the expected value of rm A when it is private and when it chooses the common strategy is 14 V private A1 (S c ) = V A1 (S c ) = ( + (1 ) c(n 1)) (r(s c ; n + 1; G) 1): (14) 2 The only di erence with the expression obtained when rm A is public (eq.(7)) is that (n 1; c ) replaces (n; c ). The reason is that the manager of rm A learns that the common strategy is good if the stock price of the n established public rms is high but it cannot learn information from its own stock price. For reasons explained in the previous section, this event happens with probability (n 1; c ) = 1 (1 c ) n. Proposition 3 When rm A is private, it optimally chooses the common strategy at date 1 if (n) < b private (; c ; n) and it chooses the unique strategy if b private (; c ; n), where b private (; c ; n) = (+(1 )c(n 1). In choosing its strategy, rm A faces the same trade-o when it is private and when it is public. Thus, its behavior is identical in each case: it chooses to di erentiate only if the gain from di erentiation o sets losses due to less informed decision, that is if (n) exceeds a threshold ( b private (; (n; c ))) that is stricly larger than one. However, this threshold is di erent than that obtained when the rm is public ( b private (; c ; n) 6= b (; u ; c ; n))). In particular, if u > ((n;c) (n 1;c)) +(1 )(n 1; c) then 14 For brevity, we formally derive eq.(14) in the on-line appendix for the paper. When rm A is private and chooses the common strategy, its decision to implement or not its strategy is determined by established rms stock prices rather than its own stock price, as in Lemma 1). 21

22 b private (; c ; n) > (; b u ; c ; n). That is, the manager of rm A chooses the common strategy for a larger set of parameters when it is private than when it is public. In this sense, the conformity e ect is stronger when a rm is private than when it is public. The reason is as follows. When rm A is public, the informativeness of the stock market about the strategy chosen by rm A is enhanced but for two di erent reasons depending on whether rm A chooses the unique strategy or the common strategy. If it chooses the common strategy, stock price informativeness is larger by (n; c ) (n 1; c ) because market makers can now learn from trades in the market of stock A as well. This increases the likelihood that speculators trades reveal their information about the common strategy. If instead rm A chooses the unique strategy, the stock market is more informative for rm A simply because rm A can learn from its own stock price when public while it cannot if private. This second e ect dominates the former when u > following implication. ((n;c) (n 1;c)) +(1 )(n 1; c). We therefore obtain the Corollary 2 (the conformity e ect is weaker for public rms). Suppose that u > ((n; c) (n 1; c)) +(1 )(n 1; c). If (n) 2 [ b (; u ; c ; n); b private (; c ; n)] then rm A chooses the common strategy if it is private and the unique strategy if it is public. Otherwise rm A chooses the same strategy whether public or private. Thus, other things equal, a public rm is more likely to choose a di erentiated strategy than a private rm. Figure 2 illustrates Corollary 2. It shows the optimal strategic choice of rm A when it is public or private for speci c parameter values. When u < ((n;c) c(n 1)) +(1 ) c(n 1) then b private (; c ; n) < b (; u ; c ; n). In this case, if (n) 2 [ b private (; c ; n); b (; u ; c ; n)] then rm A chooses the unique strategy when private and the common strategy when public. 15 Thus, the previous result is reversed: the conformity e ect is now stronger for public rms. The reason is that stock price informativeness about the common strategy increases by (n; c ) (n 1; c ) = n c (1 c ) when rm A is public rather than private while the informativeness of price about the unique strategy increases by u if rm A chooses this strategy when public. If u is small relative to 15 For other values of (n), rm A chooses the same strategy whether public or private. 22

23 (n; c ) c (n 1) then the common strategy is relatively more attractive when rm A is public. This case however is unlikely because (n; c ) (n 1; c ) = n c (1 c ) decreases quickly with n and in fact the condition u < ((n;c) (n 1;c)) +(1 )(n 1; c) can never be satis ed if u > 1. Thus, Corollary 2 describes the most plausible scenario and is 4 our main testable implication. 2.3 Methodological issues A natural way to test Corollary 2 is to study empirically whether a given rm chooses to be more di erentiated when it is public than when it is private. In principle, our model applies to any strategic choices. In our tests, we measure strategic di erentiation with an index of product di erentiation for each rm relative to a set of publicly listed peers, J ( "established rms" in the model). Let B be a rm from the set J A of peers for rm A and let A;B (k A ; A ) be the degree of product di erentiation of rm A vis-à-vis B when rm A has ownership status k A 2 fprivate; publicg and type A represents the gain of being di erentiated for A (i.e., (n) in the model). Finally, let A( A ) be the average di erence in the degree of product di erentiation of rm A and is peers when A is private and when A is public: A( A ) = 1 X ( A;B (public; A ) A;B (private; A )); (15) n B2J A Corollary 2 implies that A( A ) is either zero or positive depending on A. One di culty is that we can empirically measure the degree of di erentiation of a rm and its peers only when a rm is public as we do not have proxies for di erention before a rm goes public (see Section 3). To overcome this problem, we look at the evolution of A;B (public; A ) over time, starting from the year in which a rm goes public. 16 Speci cally, let de ne the event time variable = 0; 1; :::; T as the public age of rm A since its IPO, with = 0 being the year of its IPO. We assume that A;B (private; A ) can be proxied using the degree of product di erentiation between A and B measured at the time of rm A s IPO, or A;B;=0 (public; A ). We then 16 This is similar to the approach in Spiegel and Tookes (2014) or Chod and Lyandres (2011). 23