Why Are Successive Cohorts of Listed Firms Persistently Riskier?

DOIhttp://doi.org/10.1111/eufm.12087
Date01 November 2016
Published date01 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 rms is higher
than its predecessors. We nd 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 rms are represented in each new
cohort. Our results support the rst 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) rms
exhibit increasing risks. Fama and French (2004) nd that rms listed after 1970
(new-list rms) display lower protability and survival rates, higher growth and more
We thank two anonymous referees, Ken French, Pino Audia, Richard DAveni, 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, 9571000
doi: 10.1111/eufm.12087
© 2016 John Wiley & Sons, Ltd.
volatile prots than rms listed before 1970 (pre-1970 rms). Similarly, Brown and
Kapadia (2007) nd that the stock returns for each new 10-year cohort of IPO rms 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 ndings to increases
over time in IPO investorsrisk appetite and, thus, to changes outside the rm. We reason
that risk differences across cohorts should be related to their distinctive business
practices, which could be caused by shifts in investorsrisk appetite or other factors. To
date, however, researchers have not systematically examined differences in successive
cohortsoperating characteristics and strategic choices.
In this study, we conrm 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
signicantly lower than the survival rate of pre-1970 rms. In addition, there are
statistically signicant 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, reected 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 rms that lead Brown and Kapadia (2007,
p. 359) to conclude that there is a fundamental change in the character of a typical
publicly traded rmand Fama and French (2004, p. 231) to conclude that there is
increasing right-skewness in growth and left-skewness in the prots of listed rms. Our
ndings should interest researchers who examine changes in the economic conditions in
which public rms 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 rms 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 rms 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 rm 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 benets 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 rms 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
rms 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 rm whose princi pal resource
is knowledge residing wit h employees can quickly imit ate its rivals 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 (DAv eni, 1994; Thomas
and DAveni, 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 nd 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 Herndahl index.
Fragmented markets are characterised by intense rivalry and vulnerability to
competitorsunexpected 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 rmsnancial
information.
2
We nd 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 rms choose their business strategy relatively early in their lifecycles
to reect 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 rms have difculty 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 rm shows seasonally adjusted quarterly growth in revenues in
the top decile of its industry as a successful product launch.
3
Legacy rms may or may not be able to compete with new rms 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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