Wisdom of Crowds and Corporate Strategy

Product Differentiation

From Stock markets, wisdom of crowds, and corporate strategy,

We consider the particular case of product differentiation choices by firms. By differentiating their products from rivals, firms can gain market shares and increase their value (see, for instance, Tirole 1988). We show, however, that differentiation can bear an informational cost, as it makes the information that a firm’ manager can extract from its stock price less informative. The reason is that while stock prices aggregate investors’ private information they also typically contain noise, which limit their how informative they are. We show that it is easier for investors to filter out the noise from stock prices when they observe the prices of several firms whose cash flows load on the same fundamentals (e.g. they are exposed to the same demand shocks). As a result, the stock prices of firms following similar product market strategies are collectively more informative (i.e. contain less noise). One direct consequence is that a firm constrains its ability to learn from the stock market if it differentiates too much from its rivals. Overall, the equilibrium levels of product differentiation and stock price informativeness in the economy are jointly determined.

One implication of our theory is that firms’ incentive to differentiate from rivals should increase when they publicly list their share on stock markets. In this case, managers switch from an environment in which they cannot learn from their own stock price to an environment in which they can. Thus, at the margin, an initial public offering mitigates the informational cost of differentiation, and therefore increases firms’ incentive to differentiate and opt for more unique product market strategies.

Earnings Differentiation

From Earnings Increases as a Type-Revealing Signal,

We argue managers use earnings increase as a signal to distinguish themselves from
their counterparts when sales are decreasing. Managers increase earnings by making changes to the firm’s business and through real and accruals earnings management all costly actions suitable for the production of a credible signal. That is, prior work has shown that when faced with increased demand uncertainty and demand shocks, managers adjust the firm’s cost structure or manage earnings. Thus, when managers want to attain earnings targets (avoid losses, reach analyst forecasts), they decrease cost stickiness; adjust slack resources downward quicker (e.g., Kama and Weiss, 2013); when faced with a negative demand shock they adjust their cost structure and engage in real earnings manipulation (e.g., Bourveau, 2015).

However, for the earnings increase signal to be credible, it needs to be costly. We posit that reporting earnings increases when sales are declining is both counter-intuitive and costly. It is counter-intuitive because a decrease in sales should be accompanied by a higher percentage decrease in earnings, given non-zero fixed costs. It is costly, because increasing earnings on decreasing sales requires managers to have operational and financial reporting flexibility, and such flexibility is limited in resource-constrained firms with deteriorating prospects.