Why Are Successive Cohorts of Listed Firms Persistently Riskier?

• Author: Senyo Y. Tse,Anup Srivastava
• DOI: http://doi.org/10.1111/eufm.12087
• Date: 01 November 2016
• Published date: 01 November 2016

Why Are Successive Cohorts of Listed

Firms Persistently Riskier?

Anup Srivastava

Tuck School of Business, Dartmouth College, 100 Tuck Mall, Hanover, NH 03755, USA

E-mail: anup.srivastava@tuck.dartmouth.edu

Senyo Y. Tse

Mays Business School, Texas A&M University, 4113 TAMU, College Station, TX 77843, USA

E-mail: stse@mays.tamu.edu

ABSTRACT

Prior studies show that the risk level of each new cohort of listed firms is higher

than its predecessor’s. We find that these risk differences are persistent and

investigate two potential explanations: (1) Each cohort adopts and retains

operating innovations that are associated with higher risks, and (2) increasing

numbers of younger and less-experienced firms are represented in each new

cohort. Our results support the first explanation. Each new cohort uses riskier

production technologies and operates in more competitive product markets than its

predecessor.

Keywords: idiosyncratic risk, earnings volatility, intangible investments, product

market uncertainty

JEL classification: G11, G32, M41

1. Introduction

Prior studies conclude that successive cohorts of initial public offering (IPO) firms

exhibit increasing risks. Fama and French (2004) find that firms listed after 1970

(new-list firms) display lower profitability and survival rates, higher growth and more

We thank two anonymous referees, Ken French, Pino Audia, Richard D’Aveni, John

Doukas (Editor), Lale Guler, Jairaj Gupta (discussant), Sebastian Lobe, Bob Magee, Steve

Penman, Thierry Post, Tavy Ronen, Richard Sansing, Logan Steele (discussant), and the

seminar participants at the 2015 annual meeting of the American Accounting Association,

the 2015 annual meeting of the European Financial Management Association (Holland),

Baruch College (City University of New York), Koc¸University (Turkey), University of

Padua (Italy), and University of International Business and Economics in Beijing (China)

for their useful comments.

European Financial Management, Vol. 22, No. 5, 2016, 957–1000

doi: 10.1111/eufm.12087

© 2016 John Wiley & Sons, Ltd.

volatile profits than firms listed before 1970 (pre-1970 firms). Similarly, Brown and

Kapadia (2007) find that the stock returns for each new 10-year cohort of IPO firms are

more volatile than can be explained by multifactor models. Their evidence indicates that

risk differences across cohorts persist, although they do not formally test for this (Brown

and Kapadia, 2007, Figure 2, p. 366). Both studies attribute their findings to increases

over time in IPO investors’risk appetite and, thus, to changes outside the firm. We reason

that risk differences across cohorts should be related to their distinctive business

practices, which could be caused by shifts in investors’risk appetite or other factors. To

date, however, researchers have not systematically examined differences in successive

cohorts’operating characteristics and strategic choices.

In this study, we confirm persistent risk differences between successive cohorts, which

we refer to as the cohort risk phenomenon. We show that the survival rate of each

new-list cohort over successive 5-year periods remains relatively constant and

significantly lower than the survival rate of pre-1970 firms. In addition, there are

statistically significant differences in the idiosyncratic and earnings volatility of

successive cohorts that persist over long periods. More importantly, we provide a

business strategy explanation of the cohort risk phenomenon. We show that successive

cohorts adopt and retain innovations in their production functions, reflected in the

monotonically increasing use of intangible assets and the declining use of material

inputs, and operate in increasingly fragmented and competitive product markets that are

associated with higher risk. Thus, we contribute to the literature by systematically

documenting the nature of the changes within firms that lead Brown and Kapadia (2007,

p. 359) to conclude that there is ‘a fundamental change in the character of a typical

publicly traded firm’and Fama and French (2004, p. 231) to conclude that there is

increasing right-skewness in growth and left-skewness in the profits of listed firms. Our

findings should interest researchers who examine changes in the economic conditions in

which public firms are born, live and die.

We derive our business strateg y explanation from an extensive pr ior literature.

Porter (1980) and Prahalad and Hamel (1990) argue that new firms must differentiate

their products or achieve cost leadership t o earn economic rents. Since th e 1970s,

physical assets have becom e less distinct and a smaller sour ce of competitive

advantage (Zingales, 2000 ), which is evident from a grad ual shift in manufacturing

operations from the US to low -cost economies (Apte et al., 2008). T hus, several

economists argue that new-list U S firms are more likely to offer innov ative products

and customer-centric ser vices and are less likely to com pete by manufacturing

commodity products more inex pensively than their predec essors (Baumol and

Schramm, 2010; Brickley an d Zimmerman, 2010; Payne and Frow, 2005; Shapiro and

Varian, 1998). These changes ar e likely to increase firm risk, becau se they increase

intangible inputs –such as r esearch and development (R &D), information technolo gy

(IT), databases and exper t human capital –with futu re benefits that are less certai n

than those from tangible assets (Apte et al., 2008; Comin and Philippon, 2005; De mers

and Joos, 2007; Kothari et al., 2002).

Economic developments ar e also likely to increase risk because they increase the

rivalry in product market s and the pace at which firms launch new products. The US

consumer population has shi fted toward those who rely mor e on digitised versions of

physical products (such as news papers), have lower brand loyalty and more frequently

demand new products and serv ices (Cudaback, 2013; Gier e, 2008; Howe and Strauss,

2008; Zeller, 2006). Firms that rely on human cap ital, intangible inputs an d online

© 2016 John Wiley & Sons, Ltd.

958 Anup Srivastava and Senyo Y. Tse

delivery mechanisms can mor e quickly offer innovative pr oducts and services than

firms that rely on factories, war ehouses and physical dist ribution networks which tak e

a long time to build (Shapiro and Var ian, 1998). A new firm whose princi pal resource

is knowledge residing wit h employees can quickly imit ate its rival’s products by

hiring its employees (Cockbur n and Griliches, 1988). Thus, new cohorts, characterised

by more intangible productio n functions, are likely to face mo re competitive and

rapidly changing market con ditions than old cohorts are (D’Av eni, 1994; Thomas

and D’Aveni, 2009).

We focus our empirical analysis on three conditions for the production and marketing

differences outlined in prior research to plausibly explain the cohort risk phenomenon.

First, the differences must be present on the IPO date. We find that, on the production

side, successive cohorts are characterised by increasing R&D expenditures and rising

market-to-book ratios, consistent with an increasing reliance on intangible inputs.

Successive cohorts also use declining materials inputs in their production functions, as

indicated by the declining percentage of the cost of goods sold (COGS) in their total

costs.

1

On the marketing side, new cohorts sell their products and services in more

fragmented markets than their predecessors, as measured by the Herfindahl index.

Fragmented markets are characterised by intense rivalry and vulnerability to

competitors’unexpected actions (Chen et al., 2010). Successive cohorts offer

increasingly similar products and services that are likely to lower their pricing power

(Hoberg et al., 2014). We create a measure of product launch based on firms’financial

information.

2

We find that product launches increase with each successive cohort. In

addition, each new cohort reports a higher frequency of one-time items such as

restructuring charges, asset impairments and gains or losses on asset sales, consistent

with an increasing trend of unexpected and sudden developments in its product markets

(Donelson et al., 2011).

Second, the differences in operating characteristics on the IPO date must persist.

Studies show that firms choose their business strategy relatively early in their lifecycles

to reflect the technological advances and economic conditions prevalent when they are

formed. Firms subsequently retain these business strategies to avoid costly disruptions

and technological transitions (Chen et al., 2010; Hambrick, 1983; Yip, 2004). Stated

differently, legacy firms have difficulty changing their business models, even when they

face strong competition from players with newer technologies.

3

Other streams of

1

Firms report the costs of purchasing or manufacturing products (raw materials, labour and

overheads) in the COGS accounts. In contrast, intangible inputs, such as R&D, advertising,

brand building, IT expenses and customer relationships, are reported in the selling, general

and administrative (SG&A) accounts. Srivastava (2014) argues that COGS and SG&A

expenses, measured as percentages of total cost, represent material and intangible intensities,

respectively (Eisfeldt and Papanikolaou, 2013). These outlays constitute approximately 90%

of total costs.

2

We classify a year in which a firm shows seasonally adjusted quarterly growth in revenues in

the top decile of its industry as a successful product launch.

3

Legacy firms may or may not be able to compete with new firms if they continue with old

business models. For example, Borders could not survive the competition from Amazon.com

but Barnes & Noble did.

© 2016 John Wiley & Sons, Ltd.

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