People like losses lower than gains. This phenomenon, also often known as loss aversion, is a cornerstone of Daniel Kahneman and Amos Tversky’s Prospect theory.
A upcoming paperwhich I co-authored with Didem Kurt, Koen Pauwels and Shuba Srinivasan for, applies this theory to product and financial markets and analyzes how investors react to negative and positive changes in firms’ product warranty payments.
If investors interpret rising guarantee payments as a signal of “quality losses” and falling guarantee payments as a signal of “quality gains,” an asymmetric stock return response is prone to occur.
To put our research into context, we consider a number of the proposed implications of Loss aversion in real lifeFor example, sellers often ask for more for an item than buyers are willing to pay. Why? It is believed that the worth of an item is higher whenever you own it. This is often known as the endowment effectThat is, sellers perceive giving up the item as a loss, while buyers view the exchange as a gain. Because losses hurt people greater than gains make them feel good, there is usually a big gap between a seller’s original asking price and the customer’s asking price.
But what concerning the financial markets? There is evidence that investors react more strongly to Dividend cuts versus dividend increaseswhich is consistent with the concept losses are greater than gains. Another example is the so-called Disposition effect Investors are likely to hold loss-making stocks longer than winning stocks. However, this effect is less pronounced in experienced and wealthy investorsIn this context, there may be debate about whether loss aversion is admittedly necessary for investors.
Our study doesn’t address individual stock trading decisions. Rather, we concentrate on how the stock market as an entire reacts to quality losses or quality gains signaled by changes in firms’ product warranty payments. To validate warranty payments as a signal of product quality information, we conducted an experiment with potential investors recruited from an internet survey panel.
For the experiment, we used information from the published financial reports of a publicly traded company, which we presented under a fictitious company name. We randomly assigned participants to 2 conditions: high guaranteed payments (i.e., 6% of sales) and low guaranteed payments (i.e., 1% of sales). There was no other difference between the 2 conditions within the financial information presented.
Participants with high guarantee payments perceived the firm’s product as inferior and invested less within the firm’s stock than participants with low guarantee payments. This result supports our argument that guarantee payments provide stock market participants with relevant details about product quality.
Our examination of analyst reports provides additional evidence. We theorized that when warranty payments capture details about product quality, higher warranty payments in the present period predict the intensity of debate of quality-related issues in analyst reports, but they don’t. For this validation test, we analyzed over 66,000 analyst reports and searched for various word mixtures similar to “quality issues,” “quality problems,” and “product problems.”
As expected, we found that the upper the guarantee payments for the present period, the more intense the discussion of quality-related topics in future analyst reports.
For our most important analyses, we examined 666 guarantee providers listed on U.S. exchanges, with the sample period covering fiscal years 2010 to 2016. Because investors reply to unexpected information, we estimated a first-order autoregressive model for guarantee payments and used the residuals of this model as a proxy for unexpected changes in guarantee payments.
The results support the assumed asymmetric response of investors to increasing guarantee payments (“quality losses”) in comparison with decreasing guarantee payments (“quality gains”). While stock returns decline when there may be an unexpected increase in guarantee payments, there is no such thing as a positive stock market response when a firm experiences an unexpected decrease in guarantee payments. The economic significance of the documented result is just not insignificant. A one standard deviation increase in unexpected guarantee payments is related to a 2.5 percentage point lower annual stock return for the typical firm within the sample.
Are there other product market signals that may alter investors’ interpretation of quality signals communicated by changes in firms’ warranty payments? We considered three possible candidates: promoting spending, research and development (R&D) spending, and industry concentration. Each of those aspects can increase or decrease the informational value of changes in warranty payments.
Our results show that increased promoting spending, but not R&D spending, reduces investors’ sensitivity to bad news through increasing guarantee payments. One possible explanation for this result’s that while increased promoting efforts may help strengthen a firm’s brand image within the short term, R&D investments are related to significant uncertainty and will not play a positive moderating role in investors’ evaluation of realized guarantee outcomes in the present period.
Regarding industry concentration, we discover that when an industry has recently change into less concentrated (i.e., more competitive), there may be a positive relationship between stock returns and declining guarantee payments. This result suggests that, within the face of increased competition, investors reward firms with improved product quality.
One final note: offering product warranties doesn’t necessarily guarantee high shareholder value. In fact, corporations that provide warranties and whose warranty claims increase have lower shareholder value than corporations that don’t offer warranties.
So, unless managers have made the vital investments in product quality, short-sightedly offering warranties within the hope of boosting current sales could prove very costly in the long term. And before investors get enthusiastic about an organization’s declining warranty claims, they should be sure that this information translates into higher stock returns by closely monitoring changes within the industry’s competitive landscape.
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