Corporate Strategy And Shareholder Value During Decline And Turnaround

Description
A sample of 45 turnaround firms was selected and matched against a control sample which did not face continuous decline over the time period studied.

Corporate strategy and
shareholder value during decline
and turnaround
Olivier Furrer
Nijmegen School of Management, Radboud University,
Nijmegen, The Netherlands
J. Rajendran Pandian
Department of Management, University of Wollongong,
Wollongong, Australia, and
Howard Thomas
Warwick Business School, University of Warwick, Coventry, UK
Abstract
Purpose – The paper aims to assess the impact of corporate strategy on shareholder value in decline
and turnaround situations.
Design/methodology/approach – A sample of 45 turnaround ?rms was selected and matched
against a control sample which did not face continuous decline over the time period studied. The
impact of corporate strategy on shareholder value was tested using cumulative beta excess return
measures to capture the long-term basis of corporate strategy.
Findings – The paper ?nds that the beta excess return measures captured the hypothesized
relationships between strategy and shareholder value for the sample ?rms studied.
Practical implications – Beta excess return measures are superior to case studies or event studies
for identifying the long-term effects of corporate strategy.
Originality/value – Relatively few studies have compared the strategies of turnaround ?rms with a
matched sample of non-declining ?rms. The use of cumulative beta excess returns to assess long-term
valuation of corporate strategy is original.
Keywords Corporate strategy, Shareholder value analysis, Turnarounds
Paper type Research paper
The aim of this paper is to assess empirically the impact of corporate strategy on
shareholder value. Such an examination is of importance for several reasons: ?rst,
shareholders are undoubtedly the dominant stakeholders in a publicly quoted ?rm.
They can affect the future of a ?rm by changing the management if the majority of
shareholders are not convinced of the effectiveness of their strategies (Barker et al.,
2001; Grinyer and Spender, 1979; Hedberg et al., 1976; Hofer, 1980; Nystrom and
Starbuck, 1984; Ormerod, 2005; Pajunen, 2006; Slatter, 1984). Despite the increasing
popularity of the shareholder value analysis (Rappaport, 1998; Doyle, 2000; McGee
et al., 2005), there exists little empirical research supporting Rappaport’s conclusions.
In fact, Woo (1984) concluded that the empirical ?ndings did not provide support for
the suggestion that basing strategic decisions on these models (e.g., constant growth
model, two-stage model, etc.) would result in increased shareholder value. Woo felt that
it was necessary to conduct more empirical tests of these models and to assess their
validity in order to increase users’ (practicing managers’) con?dence.
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Management Decision
Vol. 45 No. 3, 2007
pp. 372-392
qEmerald Group Publishing Limited
0025-1747
DOI 10.1108/00251740710745025
Rappaport and his colleagues have nevertheless provided a streamof research linking
corporate strategy and the maximization of shareholder value (e.g., Blyth et al., 1986;
Rappaport, 1998; Rappaport, 1981). However, much of this is case study based and
dif?cult to generalize. Consequently, large sample studies based on multiple ?rms are
essential to build users’ con?dence. A further reason for conducting such empirical
testing is that performance measurement is critical to the conduct of strategy research
(Lubatkin and Shrieves, 1986). This has led strategic management researchers to
examine the suitability of shareholder value and other ?nancial market measures in
assessing corporate performance. Most of these researchers have used event study
methodology to examine the impact of corporate strategy on shareholder value
(Chatterjee, 1986; Lubatkin, 1987; Woolridge, 1988; Woolridge and Snow, 1992;
Chatterjee et al., 1992; Kelm et al., 1995). Such a methodology is adequate to study
phenomena that occur in a narrow window (e.g., a few days at the most). However, in the
case of measuring the impact of strategy, where the phenomenon has to be examined
over a long period of time (a year to a few years), event studies are not suitable.
In this study, therefore, we examine the impact of strategy on shareholder value
using a large sample of ?rms over a long period of time in decline and turnaround
situations in order to overcome the problems mentioned above. Two important
elements focus the study: ?rst, beta excess returns (Fama et al., 1969; Van Horne, 2001;
Brearley and Myers, 2002; Petkova and Zhang, 2005), which are better suited for
long-term examination of strategy than the abnormal return measures used in event
study methodologies, are used to measure changes in shareholder value. Second, ?rms
in decline situations are compared to non-declining ?rms over time so that easily
detectable differences in corporate strategy and shareholder value can be identi?ed and
measured during the period of study.
The paper is organized as follows: ?rst, a brief review of empirical research on the
impact of strategy on shareholder value and relevant literature on decline situations is
provided. In the next section, hypotheses are developed about the link between corporate
strategy and shareholder value. In the methodology section, the measurement issues
related to capturing shareholder value over a long period of time and measuring strategy
are presented and this is followed by a brief discussion of the sample and data sources.
This is followed by an interpretation of the results. The implications of these results are
also discussed, together with a reviewof the limitations of the present study. Suggestions
of areas for future research are then proposed.
Literature review
Empirical examination of the impact of strategy on shareholder value
Rappaport (1981) argued for the use of shareholder value to guide strategic
investments. Rappaport’s objections to the use of ef?ciency of capital utilization
measures (e.g., return on assets (ROA), return on invested capital (ROIC), and return on
equity (ROE)) for such strategic decisions stem from the fact that these measures are
generally based on accounting information which accounts neither for time value of
money nor for the investment risks faced by the shareholders. He called his preferred
decision-making framework Shareholder Value Analysis (SVA) (Rappaport, 1998;
Doyle, 2000). Rappaport and others (e.g., Blyth et al., 1986; Rappaport, 1983, 1998;
Rappaport and Friskey, 1986) presented a number of case studies to demonstrate how
to use SVA successfully.
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However, it is dif?cult to generalize ?ndings from such case studies. As a
consequence, strategic management researchers directed their efforts to empirically
test various theoretical hypotheses about the impact of strategy on shareholder value.
For instance, Chatterjee (1986), Lubatkin (1987), and Chatterjee et al. (1992) examined
mergers and acquisitions and how they created or destroyed shareholder value. This
stream of research is an important part of work on diversi?cation strategies where
there are theoretical arguments that anticipate value creation due to synergy through
mergers and acquisitions.
Another stream of research concerns a ?rm’s research and development (R&D)
expenditures or R&D progress announcements and the impact of such announcements
on stock prices (Chan et al., 1990; Kelm et al., 1995; Woolridge, 1988; Woolridge and
Snow, 1992). In a similar vein, other researchers have examined announcements
regarding new product developments (Eddy and Saunders, 1980), capital expenditures
(McConnell and Muscarella, 1985), marketing activities (Chauvin and Hirschey, 1993),
and international joint ventures (Merchant, 2000; Merchant and Schendel, 2000) and
assessed the impact on stock price.
All these studies, however, used event study methodology and the measure of
abnormal returns around the event (announcements) to test the relationship
between corporate strategy and shareholder value. Findings from most studies
were in a consistent and expected direction and con?rmed that abnormal returns
were positive (and statistically signi?cant). This, in turn, suggested that investors
took the actual strategies into account in valuing the ?rm.
Therefore, one of the major advantages in examining such public announcements
from a research viewpoint is that the investors are aware of a strategic change
(“intended strategic change” in the case of expenditure announcements and “realized
strategic change” in the case of progress announcements) and can assess its likely
impact on the ?rm. In practice, however, many signi?cant ?rm level strategic changes
are “kept under wraps” in order to gain competitive advantage (i.e. in order to surprise
rivals, most strategic changes are kept a secret) and are not captured in public
announcements.
The other drawback of these studies is that their ?ndings tend to hold only for very
short windows around the public announcement and when the window of examination
is extended over ten days after the event, the stock price tends to fall (i.e. the abnormal
return becomes negative) (e.g., Woolridge and Snow, 1992). Such a problem argues for
the inadequacy of event study methodology for research related to longer-term
corporate strategy.
Indeed, to overcome these limitations, new methodologies and approaches are
needed, involving large samples and longitudinal designs. For example, Lubatkin and
Chatterjee (1991) studied the strategy-shareholder value relationship across market
cycles using MANCOVA and logistic analyses and, in a recent paper, St John et al.
(2000) used neural networks to investigate the relationship between corporate strategy
and wealth creation.
Firm decline
During ?rm decline, shareholder value is destroyed. Research on ?rm failure and
turnaround situations has viewed ?rm decline as a problem in organizational decision
making and resulting adaptation processes (Argenti, 1976; Grinyer and Spender, 1979;
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Hedberg et al., 1976; Starbuck and Hedberg, 1977; Starbuck et al., 1978; Mellahi and
Wilkinson, 2004; Sheppard and Chowdhury, 2005). The central thesis is that ?rm
decline is the result of managers’ failure to maintain the alignment of a ?rm’s strategy,
structure, and objectives with an evolving and changing environment. Such failure
may result from organizational inertia (Hannan and Freeman, 1977, 1984; van
Witteloosstuijn, 1998), which is re?ected in behaviors such as the need to be reliable
(Hannan and Freeman, 1984), escalating commitment by management (Staw, 1981),
blinded perception (Zajac and Bazerman, 1991), strategic paralysis (D’Aveni, 1989,
1990), and threat-rigidity (Staw et al., 1981).
Other researchers (e.g., Grinyer et al., 1988; Hofer, 1980; Hofer and Schendel, 1978;
Schendel et al., 1976; Schendel and Patton, 1976) have more objectively classi?ed the
causes of decline into either internal (or operational) problems or external (or strategic)
problems. Indeed they found that management-related problems (or internal causes)
outnumbered external environment-related problems (Bibeault, 1982; Slatter, 1984;
Schendel et al. 1976; Grinyer et al. 1988; Lohrke et al., 2004; Filatotchev and Toms,
2006). They argue that the internal mechanisms of failing ?rms imply that their
responses to environmental change are either too active or too passive: “Both inaction
and hyperaction seem to typify ?rms in their years prior the failure” (Hambrick and
D’Aveni, 1988, p. 15). Bankruptcy has been described as a “protracted process of
decline” and a “downward spiral” (Hambrick and D’Aveni, 1988). Indeed, there is a
considerable body of empirical evidence that shows signi?cant differences between
bankrupt and survivor ?rms as soon as ?ve years prior to the bankruptcy ?ling itself
(e.g., Aziz et al., 1988; Baldwin and Glezen, 1992; D’Aveni, 1990; D’Aveni and
MacMillan, 1990; Hambrick and D’Aveni, 1992; Moulton and Thomas, 1993). These
studies compared bankrupt ?rms with non-declining ?rms (e.g., Daily, 1996; Daily and
Dalton, 1994a, b; D’Aveni, 1990; D’Aveni and MacMillan, 1990; Gales and Kesner, 1994;
Hambrick and D’Aveni, 1988, 1992) with an emphasis on the bankrupt ?rms.
However, decline is not irreversible and bankruptcy is not the only outcome
(Cameron et al., 1988; van Witteloosstuijn, 1998). Successful turnarounds abound and
are well documented. Early researchers on turnarounds (Grinyer et al., 1988; Hofer,
1980; Hofer and Schendel, 1978; Schendel et al., 1976; Schendel and Patton, 1976)
suggested that to reverse a decline due to internal problems, a ?rm should focus on
rectifying the internal causes. For example, if the cause of decline is inef?cient
operations, management should attempt to ?nd ways of improving ef?ciency rather
than trying to increase sales as long as the external environment has not changed. Such
remedies are called operational remedies, whereas, if the decline is due to change in the
external environment, then strategies should be changed/adapted. Accordingly, such
remedies are called strategic remedies. That is, if the cause is internal, the solution
should be operational and if the cause of decline is external, the action should be
strategic.
An important stream of research on the role of strategic change in the turnaround
process was principally based on case studies (e.g. Chowdhury, 2002; Grinyer et al.,
1988; Hofer, 1980; Hofer and Schendel, 1978; Lamberg and Pajunen, 2005; Schendel
et al., 1976; Schendel and Patton, 1976). Further research (Arogyaswamy, 1992;
Hambrick and Schecter, 1983; Ramanujam, 1984; Robbins and Pearce, 1992; Schendel
and Patton, 1976; Thie´tart, 1988) based on large samples attempted to test the
important role of strategic change on turnarounds but, in fact, provided little concrete
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evidence. This lack of evidence supporting “strategic turnaround” even led some
researchers to question whether turnarounds can be accomplished through strategic
reorientations (Pajunen, 2005; Pearce and Robbins, 1993; Robbins and Pearce, 1992).
It should be noted that the greater proportion of previous large-sample studies
compared successful turnaround ?rms with unsuccessful turnaround ?rms (e.g.,
Hambrick and Schecter, 1983; O’Neill, 1986a, b; Schendel and Patton, 1976; Barker et al.
2001). And, the research studies reviewed above compare either bankrupt ?rms with
non-declining ?rms, or turnaround ?rms with bankrupt ?rms. However, to the best of
our knowledge, relatively few research studies have ever compared turnaround ?rms
with a matched sample of non-declining ?rms. Such a comparison is of particular
interest because, as it has been shown, decline may be of different types (D’Aveni, 1989;
van Witteloosstuijn, 1998) and may not lead to bankruptcy. For example, during their
decline, bankrupt ?rms have been shown to have severe pathologic strategic behavior
such as inertia, hyperinitiative, or inconsistency (e.g., Hambrick and D’Aveni, 1988).
Since the objective of this study is to investigate the relationship between strategy and
shareholder value, not to focus on strategic failures or bankruptcy, these pathologic
behaviors associated with bankruptcy are too extreme to be meaningfully compared
with the strategies of non-declining ?rms. Therefore, we chose, in this study, to
compare non-declining ?rms with declining ?rms that later successfully turnaround
and avoid bankruptcy (in the rest of the paper, these latter ?rms are referred as
turnaround ?rms).
Using Figure 1, we clarify the distinction made in this study between bankrupt,
turnaround, and non-declining ?rms. When a turnaround ?rm goes through decline
and turnaround, three phases can be identi?ed. First, the growth phase in which no
decline is evident. Then, at a particular point due to some unexpected event (external or
Figure 1.
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internal) performance starts to decline. If the management’s action(s) (strategic or
operational) do not arrest the decline, the ?rm continues the process of decline (the
decline phase). Eventually, once the ?rm’s management (old or new) takes some other
action(s) which are more appropriate, then the decline is arrested and performance
starts to recover (recovery phase). Note that comparable non-declining ?rms in the
same industry face the identical unexpected event if it is caused by a change in the
external environment. Although the turnaround ?rms decline, comparable
non-declining ?rms do not except in the rare situation of a short-term adverse effect
when the extent of change is large and unpredictable. Even in such extreme cases,
non-declining ?rms typically face decline just for that particular year, recover the
following year and maintain a continued pattern of increase in performance. However,
when the unexpected event is an internal matter, the turnaround ?rms will decline, but
the non-declining ?rms will not since their internal situations differ and are unique.
The three phases are depicted in Figure 1.
Hypotheses
Shareholder value destruction during decline
Rappaport (1987, 1998) suggested that shareholder value should be measured as a
product of the stock price and the number of shares outstanding. Since the number of
shares outstanding rarely changes, shareholder value is directly related to the price of a
stock. Since stock price movement is approximately a random walk, it is dif?cult even
to imagine that there could be a link between strategy and such a measure of
shareholder value. The random movement of stock prices con?rms that the ?nancial
market is ef?cient. Cootner (1964) suggested that the random movements in stock price
were around an “intrinsic value” (Graham et al., 1962). Graham et al. (1962) de?ned the
“intrinsic value” of a ?rm as the net present value of the future stream of income. This
is called the fundamental analysis model. Financial analysts who value stocks track a
?rm, its competition, the economy and other related factors which affect the future
stream of income and then estimate its “intrinsic value”. If the price of a stock is beyond
a given level above its “intrinsic value”, then the analyst would recommend a “sell”
decision and vice versa. According to Cootner (1964), such pro?t-taking behavior
combined with intense competition ensured that the random walk observed stays
within a narrow band around the “intrinsic value”.
In the fundamental analysis model, the “intrinsic value” of a ?rm depends on many
factors and a ?rm’s strategy is only one of them. If we wish to capture the impact of
strategy on shareholder value, then the measure used to capture shareholder value
should control for the impact of other extraneous factors. Neither the cumulative
returns to the investor (dividend plus price increase) nor the abnormal return measure
control for such extraneous variables. Cumulative returns are the cumulative value of
returns to shareholders and this does not exclude shareholder gains due to favorable
environmental changes. Since abnormal returns do not control for the impact of factors
other than an event under study, it can only be used to capture the impact of that event
over a narrow window[1]. Thus, cumulative and abnormal return measures of
shareholder value are not very useful for the purpose of assessing the impact of
strategy on shareholder value. Lubatkin (1987) recognized this issue and attempted to
use prior performance to control for these extraneous variables. However, this is not
appropriate for two reasons: First, the extraneous variables could change between the
Decline and
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period under study and the control period (when the abnormal returns prior to the
event were estimated). Second, under the assumption of an ef?cient ?nancial market,
the abnormal returns over such long periods should be zero (or at least negligibly
small) making such corrections useless. Therefore in this study, beta excess returns are
used to capture changes in shareholder value attributable to ?rm speci?c factors
(which could include dividend pay out, unexpected changes in income, retained
earnings, and corporate strategy among many other ?rm speci?c factors).
The fundamental analysis model suggests that shareholder value is the net present
value of the future stream of income (Rappaport, 1987, 1998). This implies that a drop
in income in the near future will be valued, and weighted, higher than similar drops in
a more distant future. Hence, ?rms facing a decline in their income stream will have a
sharp drop in shareholder value and this in turn will result in negative beta excess
returns. In a perfect ?nancial market, this re-valuation would occur in the ?rst year of
decline. But, according to previous research ?ndings (e.g., Fama et al., 1969), it appears
that as new information on the continued decline reaches the market, ?rm value (i.e. its
stock price) would be adjusted to account for this continued drop in income. Therefore,
if one measures beta excess returns every year during decline, it would be negative for
turnaround ?rms. Since, non-declining ?rms continue to grow and since the corporate
strategy of these ?rms would normally not be changed, their beta excess returns will
be negligibly small. Hence the following hypotheses:
H1. Cumulative beta excess returns over the decline phase for turnaround ?rms
will be negative and will be less than those of non-declining ?rms.
H2. Cumulative beta excess returns over each year during decline for turnaround
?rms will be negative and will be less than those of non-declining ?rms.
In H1, we examined change in shareholder value over the complete decline phase
whereas in H2, the same phenomenon is examined over each year during the decline
phase to evaluate how the stock market adapts to new information.
Link between strategy and shareholder value
Shareholder value depends on the future stream of income and is affected by
information on any factor that may affect the income stream. Such information may
involve economic predictions, substitute technologies, movements in currency
exchange rates, legal disputes, competitor’s moves, strategic investments, and so on.
However, as long as such information affects all ?rms with similar risk to the same
extent, the beta excess returns will not change but remain negligible. But, if the
information affects one ?rm more adversely than the rest, the beta excess returns of
such a ?rm will become negative. During decline, unanticipated changes coupled with
inappropriate strategic conduct result in a decline in performance. Therefore, we
examine the strategic conduct of such ?rms and compare them to those of
non-declining ?rms, we can test the link between strategy and shareholder value,
provided we control for changes in retained earnings or changes in income.
In order to specify clearly the direction of impact of each of the conduct variables on
shareholder value (on cumulative beta excess returns), it is important to examine each
variable separately. Following previous researchers in the turnaround literature
(Grinyer et al., 1988; Hofer, 1980; Hofer and Schendel, 1978; Schendel et al., 1976;
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Schendel and Patton, 1976), these variables are grouped into operations related
(near-term oriented) or strategic (long-term oriented).
Operations-related variables invariably focus on improving ef?ciency and should
have an immediate effect. Thus, if changes in operations related variables improve
ef?ciency and hence improve pro?tability, then shareholder value will increase. That
is, if ef?ciency improves, beta excess returns will be positive. Strategic variables focus
on improving the competitiveness of a ?rm. They are long-term oriented and their
effect on a ?rm pro?tability only accrues in the future. In this case, the improvement of
a strategic variable will be discounted by the ?nancial market and its impact on
shareholder value will be smaller than that of operations-related variables.
Manufacturing cost, accounts receivable, and accounts payable are classi?ed to be
operations related whereas capital expenditure is considered strategic. Marketing costs
are more dif?cult to classify as purely ef?ciency related or strategic since their impact
could improve both short term pro?tability through increase in volume of sales and
long-term pro?tability through market development (Harker, 1998; Robbins and
Pearce, 1992, 1993). If manufacturing expenses are controlled and decrease,
manufacturing ef?ciency increases and shareholder value increases. In the case of
marketing costs, the relationship is more ambiguous, though reductions in marketing
costs may improve marketing ef?ciency in the short term, the long-term effect could be
reduced sales and reduced brand image. In a similar vein, an increase in marketing
costs may improve sales in the near term up to a point beyond which the sales may
stagnate. In the case of a decline, we hypothesize that the short-term effect is more
important than the long-term effect and an increase in marketing costs will have a
negative impact on shareholder value. Accounts payable should be positively related to
shareholder value since they re?ect how effectively a ?rm utilizes trade credit to its
bene?t. Whereas, accounts receivable should have the opposite effect since it increases
the ?rm’s cost of capital. As far as strategic (long-term oriented) variables are
concerned, they should have a positive impact on shareholder value. However, in the
case of a turnaround situation, their impact may be more dif?cult to predict. According
to retrenchment theory (Robbins and Pearce, 1992; Pearce and Robbins, 1993),
retrenchment, de?ned as a reduction in ?rm assets and costs, is strongly associated
with a successful turnaround. This implies that during the decline phase of a
turnaround, strategic variables such as capital expenditures would have a negative
effect on shareholder value. However, retrenchment theory has been challenged by
Barker and Mone (1994) and in some cases a change in strategy is needed to
turnaround. Overall, we think that capital expenditures are likely to have a negative
effect on shareholder value at the beginning of the decline phase and a positive effect
later on. During the beginning of the decline, the stock market may consider that the
?rm is spending too much (and hence negative beta excess returns), but later in the
decline phase, it may consider an increase in capital expenditures as a needed attempt
to turnaround (and hence lead to positive beta excess returns).
The following hypotheses are based on the above discussions:
H3. The impact of manufacturing cost, marketing expenditures and accounts
receivable on beta excess returns is likely to be negative whereas, the impact
of accounts payable is likely to be positive.
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H4. The impact of capital expenditures on beta excess returns is likely to be
negative during the ?rst year of decline and positive in the years there-after.
Methodology
Sample
Turnaround ?rms were selected on the basis of a survey of the business press from
1975 through 1985. Four business publications (Wall Street Journal, Business Week,
Fortune, and Forbes) were searched for mention of decline or turnaround or any
equivalent word. Firms that were covered in the business press as turnaround ?rms
constitute the population of interest. This methodology for selecting the turnaround
?rms was selected because shareholder value was the focus of the study, and so it was
important that information on turnaround ?rms was available to investors. From the
?rms identi?ed by this phase, those publicly traded in manufacturing industries were
retained in the sample because the nature of strategic change may be somewhat
different then in service industries (Barker and Duhaime, 1997; O’Neill, 1981). Of these
manufacturing ?rms, only ?rms that underwent at least three years of decline in
operating cash ?ows were retained. Some previous studies (Barker and Mone, 1994;
Robbins and Pearce, 1992) used a two-year decline as one of the criteria for their sample
design. However, in this case because we wish to ensure that the need for strategic
change is high (Barker and Duhaime, 1997), we think that a three-year period is more
appropriate. Operating cash ?ows were used rather than the ROI or ROS measures,
used by Barker and Mone (1994) and Robbins and Pearce (1992), because operating
cash ?ows are directly related to shareholder value. In all, 58 turnaround ?rms
satis?ed all the requirements.
We constructed a control group which consisted of a sample of ?rms which did not
face continuous decline[2]. These ?rms were selected from the same industry as each of
the turnaround ?rms and were of approximately similar size during the peak year (the
year before the ?rst year of decline, see Figure 1). Since industry conditions could have
a strong impact on the future stream of income, it is necessary to control for industry
conditions (Hambrick and Schecter, 1983; Robbins and Pearce, 1992; Schendel and
Patton, 1976). Size could help a ?rm to sustain its decline; it is also an indicator of the
extent of the ?rm’s resources that are available to reorient its strategy (Barker and
Duhaime, 1997). There were industries (Porter, 1980) (e.g., the steel industry, SIC 3312)
where every ?rm had faced decline in operating cash ?ows for over three years during
1975-1985 and hence turnaround ?rms from these industries could not be included in
the sample. The resultant control sample contains 45 ?rms.
Variables and data sources
Measuring shareholder value. As mentioned earlier, we used beta excess returns to
estimate changes in shareholder value. Fama et al. (1969) used beta excess returns in
their examination of stock splits and the process of stock price adjustment to new
information. Though there have been suggestions that beta excess returns capture the
overreaction of the market, Chopra et al. (1992) have shown that such overreaction is
small for medium and large ?rms. Chopra et al. (1992) concluded that beta excess
returns could be used to assess the impact of ?rm speci?c factors on stock price over a
long period of time if the estimation controls for changes in beta (the issue of
nonstationarity). This can be achieved by re-estimating beta at appropriate intervals.
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The daily return data tapes on the security prices maintained by the Center for
Research on Security Prices (CRSP) at the University of Chicago contain the
information on beta excess returns for each stock that satis?es the minimum
requirements on data availability, trading, etc. These beta excess returns are estimated
every year by estimating the beta for each stock, using all the daily returns data
available and then grouping all the stocks into ten portfolios of the approximately
same beta level. Beta excess returns for a ?rm are then calculated as the difference
between the actual return for the day less the estimated return for a portfolio of similar
beta level. Beta excess returns remain negligibly small and around zero if there are no
?rm speci?c unanticipated events leading to very steep changes in the stock price. If
there is a industry-wide or economy-wide unanticipated event, all the stocks in the
industry or the economy will be affected to the same extent and hence the return to the
portfolio of similar beta level will re?ect it and hence the beta excess return should still
remain very small. But, if the unanticipated event is ?rm speci?c, then only this ?rm’s
stock price will be revised and hence the beta excess returns will be different from zero
(positive if the event is favorable and negative if the event is unfavorable). Thus, beta
excess returns are better suited for capturing changes in shareholder value that are
closely linked to ?rm speci?c events and not due to the impact of events common to
most stocks. To assess changes in shareholder value over any period, daily beta excess
returns are summed over that period. Such a measure is called the cumulative beta
excess return[3].
Measuring corporate strategy. Strategy may be de?ned as a pattern in a stream of
resource allocation decisions (Hofer and Schendel, 1978; Mintzberg, 1978; Mintzberg
and Waters, 1982; Venkatraman and Prescott, 1990). Since there are a large number of
resource allocation decisions, it is important to choose the most appropriate ones to
capture strategy (Arend, 2004). The measures used in this study are based on the
research by Prescott (1983) who used a set of 16 variables to capture the strategy of a
?rm. In his study, Prescott examined business units and developed a set of 16 variables
based on the Pro?t Impact of Marketing Strategies (PIMS) database. These variables
were subsequently used for several studies using the PIMS database (e.g., Prescott,
1986; Prescott et al., 1986; Venkatraman and Prescott, 1990). In this study, we used the
COMPUSTAT database maintained by the Standard & Poors Co. Since data in the
COMPUSTAT database are not available on all the 16 variables, we used a subset of
?ve variables. These strategic conduct variables used are:
(1) manufacturing costs;
(2) marketing costs;
(3) accounts receivable;
(4) accounts payable; and
(5) capital expenditure.
Manufacturing costs, marketing costs, accounts receivable, and accounts payable are
operations related variables (short-term oriented), and capital expenditures is a
strategic variable (long-term oriented). Strategic conduct variables were calculated as
the corresponding expenditure value divided by net sales so that all variables will be
dimensionless and be within the range 0 and 1. The de?nition of these variables can be
found in Table I.
Decline and
turnaround
381
Control variables. There is strong empirical evidence to suggest that shareholder
value is directly affected by unanticipated changes in income (Ball and Brown, 1968).
Moreover, there is a strong feeling that the ?nancial markets react strongly to changes in
income and hence American managers are more concerned about increasing short-term
pro?ts than increasing long-term performance. Since decline is associated with a drop in
performance, which is highly correlated to income, it could be argued that a change in
shareholder value can result from a change in income and not from a change in strategy.
Hence, it is important to control for changes in income. Following Cootner’s (1964) model,
since both income and retained earnings are strongly correlated, we used the change in
retained earnings as the control variable in this study.
Results
First, correlation analyses were carried out to assess the correlations between strategy
conduct variables for turnaround ?rms and non-declining ?rms combined as one
group. Then, multivariate regression analyses were used to assess the impact of
strategy conduct variables on shareholder value. Regression analyses were conducted
for every year over the decline period. The control variable used was change in
retained earnings, which should capture the change in the “intrinsic value”.
H1 has two parts: the ?rst part related to the absolute value of cumulative beta
excess returns of the turnaround ?rms whereas the second part related to comparing
the beta excess returns of turnaround ?rms to those of non-declining ?rms during
decline. The ?rst part of H1 is tested by carrying out a t-test, while, the second part is
performed by carrying out an analysis of variance (ANOVA). Both parts of the
hypothesis are examined for the ?rst year of decline, the ?rst two years, and ?rst three
years. The results of the t-tests as well as those of ANOVA are found in panel A of
Table II. Both parts of this hypothesis are strongly supported. The cumulative beta
excess returns over the decline phase for the turnaround ?rms are negative and
signi?cantly smaller than those for non-declining ?rms. This means that, as
hypothesized, turnaround ?rms faced a drop in their shareholder value and that
non-declining ?rms did not.
H2 essentially suggests that the valuation mechanisms will adjust shareholder
value every year rather than during the very ?rst year of decline. If shareholder value
gets adjusted during the ?rst year, cumulative returns during the latter years of decline
will not be different from zero. Just as for testing H1, t-tests were carried out to test
whether or not beta excess returns over every year were negative and ANOVA was
used to test whether beta excess returns for turnaround ?rms differed from those for
non-declining ?rms for every year of decline. The results are presented in panel B of
Table II. Cumulative beta excess returns over every year during the decline phase were
negative and signi?cantly different from zero. The results con?rm that shareholder
Strategic conduct variables De?nitions
1. Manufacturing cost Manufacturing costs/net sales
2. Marketing cost Marketing costs/net sales
3. Accounts receivable Accounts receivable/net sales
4. Accounts payable Accounts payable/net sales
5. Capital expenditure Capital expenditure/net sales
Table I.
List of strategic conduct
variables
MD
45,3
382
value gets adjusted as more and more information is made available and not on a
single occasion. Also this evidence may be consistent with Ball and Brown’s (1968)
?nding that income declines in every year of the study period.
The crux of the third hypothesis is that though shareholder value will depend on a
large number of factors, there exists a direct link between strategic conduct and
shareholder value. A series of regression analyses were carried out by regressing for
every year the cumulative beta excess return against the yearly strategic conduct
variables. This regression analysis was also carried out over a three-year period as well
as a two-year period during the decline phase. The strategic conduct variables used
were averaged over the corresponding period. The results are found in Table III.
The direction of the impact of all the strategic conduct variables on the beta excess
returns was as hypothesized. Manufacturing cost and marketing cost had a signi?cant
t-tests turnaround
?rms
t-tests
non-declining
?rms
ANOVA
non-declining ?rms
compared with
turnaround ?rms
Mean Mean Coef?cient
t-statistic t-statistic F statistic
(Pr . jTj) (Pr . jTj) (Pr . jTj)
Years No. of observations No. of observations No. of observations
A.
One year of decline 20.175 20.033 0.142
24.221
* * *
20.832 6.191
* *
0.000 0.411 0.015
33 35 68
Two years of decline 20.371 20.078 0.292
29.897
* * *
21.337 17.180
* * *
0.000 0.190 0.000
33 35 68
Three years of decline 20.483 20.121 0.362
212.24
* * *
21.789
*
20.660
* * *
0.000 0.082 0.000
33 35 68
B.
1st year of decline 20.175 20.033 0.142
24.221
* * *
20.832 6.191
* *
0.000 0.411 0.015
33 35 68
2nd year of decline 20.224 20.062 0.162
26.672
* * *
21.698
*
10.514
* * *
0.000 0.099 0.002
33 35 68
3rd year of decline 20.188 20.046 0.142
25.625
* * *
21.157 7.422
* * *
0.000 0.255 0.008
33 35 68
Notes: Dependent variable: yearly beta excess return; Independent variable: turnaround ¼ 0;
non-declining ¼ 1;
*
p , 0:10;
* *
p , 0:05;
* * *
p , 0:01
Table II.
Results of t-tests and
ANOVA
Decline and
turnaround
383
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:
0
1
Table III.
Results of regression
analyses
MD
45,3
384
impact in the hypothesized direction right through the decline phase (i.e. the higher the
manufacturing (marketing) cost, lower the beta excess return). Accounts receivable
and accounts payable did not have signi?cant impact but their impact was in the
predicted direction (i.e. the higher the accounts receivable (payable), lower (higher) the
beta excess return). The impact of capital expenditures was in the same direction as
hypothesized, though its impact was signi?cant in only the ?rst year of decline. The
impact of capital expenditures was negative (the higher the capital expenditure, lower
the beta excess return) in the ?rst year of decline, which was statistically signi?cant. It
was positive (the higher the capital expenditure, higher the beta excess return) in the
second and third year of decline (but not statistically signi?cant).
Regressions were also separately run using a control for change in retained
earnings. The regression analysis’ explanatory power increased but it did not affect the
impact of strategic conduct variables. The impact change in retained earnings was
signi?cant and positive (i.e. as expected) in the second and third years of decline.
Discussion
In this study, our main aim was to empirically test the impact of strategic conduct on
shareholder value in decline situations. Results of the hypothesis testing supported
that value changes occurred incrementally – over the three years of decline under
study. That is, investors adjusted the value of stocks as additional new information
reached them. These ?ndings are similar to those of Fama et al. (1969).
As far as the impacts of strategy conduct variables were concerned, the impact of
these variables was in the hypothesized direction though not all were statistically
signi?cant. Variables that have immediate impact on pro?ts and pro?tability had an
immediate impact on shareholder value as well. On the other hand, the variable, capital
expenditures (a strategic variable) had a signi?cant impact on shareholder value only
during the ?rst year of decline. During this ?rst year of decline, capital expenditures
were negatively and signi?cantly associated with beta excess returns. During the latter
years of decline, capital expenditures were positively associated with beta excess returns
but not signi?cantly. This means that investors may value retrenchment strategies
(which presumably have immediate effect) highly in comparison to long-term strategies.
This supports Robbins and Pearce (1992) argument that retrenchment strategies are a
prerequisite for successful turnarounds. This is consistent with the argument of Bibeault
(1982) and others who consider that arresting the “bleeding” by the required “surgery” is
an important ?rst step for a ?rm to successfully turnaround. As pointed out earlier, as
long as an action taken by the management improves ef?ciency, such an action should
have positive impact on shareholder value. To that extent, the positive link between
manufacturing ef?ciency and marketing ef?ciency is empirically supported. The results
also con?rmed that the impact of changes in retained earnings did not affect the impact
of these strategy variables.
One interesting aspect of the ?ndings is that the moderating variable included did
increase the explanatory power of the model but did not in any way reduce the impact
of the strategic conduct variables. Changes in retained earnings had a consistent
positive impact on the beta excess returns as suggested by Cootner (1964).
The lack of signi?cant impact of some of these variables on shareholder value should
not be interpreted to mean that investors were not sensitive to changes in strategy
conduct variables. It may be that the impact of some of these variables on the income
Decline and
turnaround
385
stream could be marginal and hence might not alter whether or not a ?rm successfully
turns around. If a ?rm continued to operate inef?ciently in manufacturing and
marketing, it could fail to turnaround and hence investors weigh these strategy variables
highly in comparison to accounts receivable and accounts payable. Also, contributions
from savings in accounts receivable and accounts payable could be much less
comparatively. In fact, it could also be argued that the relationship between these two
variables (accounts receivable and accounts payable) and performance is not simple and
direct. Because accounts receivable may lead to economies of scale, it could be used to
increase sales and result in an improvement in manufacturing ef?ciency. Therefore,
accounts receivable could be positively associated with shareholder value. However, if
accounts receivable increase too much, it could be because of poor debt collection
practices and hence, the impact of large accounts receivable could be negative. In the case
of accounts payable, excessive use of trade credit could result in a strained relationship
with suppliers and hence the transaction costs could increase reducing the ef?ciency.
Also, ?rms performing poorly tend to fail to meet the credit terms of suppliers and hence
may have higher accounts payable. Therefore, the higher the accounts payable, the lower
the income stream and, hence, the lower the shareholder value.
Limitations and directions for further research
One of the major contributions of the results of this research is to empirically support
the relationship between corporate strategy and shareholder value, as measured by
beta excess returns. Our results also indirectly provide empirical support for Cootner’s
(1964) model where stock price’s movements occur around the intrinsic value. In
addition, the use of beta excess returns to measure shareholder value proved to be
effective, suggesting that cumulative beta excess returns methods capture strategy
changes very effectively. In future studies, it is possible that an excess return to an
industry portfolio may prove to be a better measure, because it could highlight even
more clearly the relationship between strategy and shareholder value.
The measurement of corporate strategy could also be improved in future research.
While the measures used were acceptable and consistent in terms of previous research
studies, they could have been further assessed relative to industry norms. However,
this was not possible because of the multi-industry nature of the study. It should be
noted that, although this study used only a subset of variables which Prescott (1983)
developed, it could perhaps be enhanced through the use of survey or interview data
with top management personnel in the study ?rms, as suggested by Barker and
Duhaime (1997). This, in turn, might lead to a set of “?ne-grained” measures of
corporate strategy. The trade-off is obviously between the depth of survey-type case
study research and the more quantitative analysis offered here.
It should also be stressed that, while the choice of decline situations as the area of
study provided high-quality and easily detectable differences in strategy, it tended to
limit the sample size of available ?rms and perhaps, to some extent, the quality of data.
(This is because ?rms only report the minimum required information when they face
situations of decline, crisis and constraints in resources.) An alternative sample design,
perhaps involving random samples of ?rms, might have increased the sample size of
?rms studied but this would have been achieved at the expense of identifying a
satisfactory number of changes in strategies and strategic postures taken by those
?rms.
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Notes
1. That is, it is assumed that the extraneous variables do not change during that narrow
window.
2. Some ?rms in this control group may, in some instances, have faced a one-year decline (the
?rst year after the peak year) but were on the growth path the next year.
3. In this paper, we have used “beta excess returns” and “cumulative beta excess returns”
interchangeably. When shareholder value changes over a period is under consideration, the
measure used is “cumulative beta excess returns” over that period whatever the terminology
used.
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Corresponding author
Olivier Furrer can be contacted at: [email protected]
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