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Article Excerpt
Managers often have incentives to artificially inflate current-term earnings by cutting marketing expenditures, even if it comes at the expense of long-term profits. Because investors rely on current-term accounting measures to form expectations of future-term profits, inflating current-term results can lead to enhanced current-term stock price. We present evidence that some firms engage in this type of "myopic marketing management" at the time of a seasoned equity offering (SEO). In particular, a greater proportion of firms than is typical report earnings higher than normal and marketing expenditures lower than normal at the time of their SEO. Although they realize that firms might be undertaking strategies to artificially inflate current-term earnings, the financial markets are not adequately identifying and properly valuing the firms doing so. Our results indicate that myopic firms are able to temporarily inflate their stock market valuation, but in the long run, as the consequences of cutting marketing spending become manifest, they have inferior stock market performance. We propose some actions that might reduce the incentives for myopic behavior.
Key words: myopic marketing management; marketing strategy; marketing resource allocation; signal jamming; long-term financial performance; abnormal stock returns
Introduction
At times, managers face incentives that might cause them to emphasize current-term results at the expense of long-term performance. Managers might feel pressure to meet the quarterly earnings expectations of financial analysts, their compensation and job security might be tied to stock market reactions, or they might be evaluated based on current-period accounting performance measures. These conditions can cause an overemphasis on strategic options that generate immediate results at the expense of long-term profits, that is, myopic management. For example, managers might seek to artificially inflate current-term results by cutting "discretionary" spending, such as R&D and advertising. Myopic firms inflate current-term results to give the appearance of enhanced long-term business prospects. This overemphasis on short-term results has long attracted significant interest by academics, practitioners, the financial markets, and government agencies (Hayes and Abernathy 1980, Laverty 1996).
Myopic management is of particular importance to marketers. A host of marketing activities involve expenditures in the near term that have payoffs in the longer term, for example, building customer loyalty (Shugan 2005) and product quality initiatives (Mitra and Golder 2006). Some past research has suggested that firms do engage in myopic marketing management by underspending on marketing or by replacing marketing strategies that produce superior future profits with those that generate an immediate payback. (1) Aaker (1991, p. 10), for example, states that "it is tempting to 'milk' brand equity by cutting back on brand-building initiatives, such as advertising." He notes that a decline in brand equity is not immediately obvious. Furthermore, Aaker (1991) views the increased use of sales promotions (that have immediately observable results, but with potentially deleterious long-term effects) as evidence of managers' short-term bias. Pauwels et al. (2004) advance similar arguments and show empirically that sales promotions by automobile manufacturers have had negative long-term effects on firm value. Hauser et al. (1994) state that "all employees (managers, product designers, service providers, production workers, etc.) allocate their effort between actions that influence current period sales and actions that influence sales in the future. Unfortunately, employees are generally more focused on the short term than the firm would like." To change this short-term mindset, the authors advocate the use of customer satisfaction measures in employee performance evaluation as a means to motivate employee effort directed toward increasing profit in the long run. Lehmann (2004, p. 74) highlights a general "overconcern about short-term results" and advocates use of multiple metrics at all levels.
Although some past research has empirically explored myopic management, past research has been sparse (and primarily theoretical or anecdotal), (2) not focused on marketing management per se, and has not addressed its impact on financial performance. Are firms engaging in myopic marketing management? What implications does this have both for those firms undertaking these behaviors and for the financial markets? Our study seeks to answer these questions.
Our analysis focuses on firm and financial market behavior around a seasoned equity offering (SEO), that is, when a firm issues additional equity to collect additional capital. Because the amount of capital collected by the firm depends on the stock price on the day of equity issue, managers have an interest in current-term stock price and might be tempted to cut marketing spending to temporarily enhance profitability. The incentive to engage in myopic management stems from the fact that investors rely on current-term accounting performance measures to form their expectations of the future-term performance and, as such, to value equity.
We find that firms do inflate current-term accounting profits at the time of an SEO by reducing marketing expenditures. Although they are aware that earnings inflation is taking place, the financial markets appear temporarily fooled by myopic managers. Our research shows that firms with a greater likelihood to have engaged in more myopic behavior are overvalued at the time of the SEO and are subsequently devalued in later periods. Only over time, when the longer-term implications of engaging in myopic marketing management materialize in inferior performance, are the consequences of these actions impounded into stock prices. The long-term consequence of myopic marketing management is significantly lower firm value.
I. Market Signaling in the Presence of Asymmetric Information: The Theory of Myopic Management
Traditional rational expectations, efficient financial market theories predict that if managers care about stock prices, they will make efficient investment decisions, that is, they will not behave myopically. These traditional efficient market models assume that investors and managers have identical information. Introducing asymmetric information (i.e., when managers have an advantage over investors in distinguishing the true state of a firm's earnings and future prospects) changes the fundamental outcomes of traditional analysis. Managers who possess information about firm performance that is not available to the stock market have incentives to behave myopically. The extent of the myopic behavior increases with the importance managers attach to current-term stock price.
Stein (1989) provides an illustrative theoretical model showing how asymmetric information induces myopic managerial behavior. He starts with a traditional framework: (i) stock price is a function of expected future earnings; (ii) current-term stock price is a component in the managers' utility function; and (iii) current-term earnings serve as a signal of long-term performance (i.e., current earnings contain information about future earnings). (3) Under these three conditions, incentives for myopic management do not exist. However, Stein (1989) also introduces asymmetric information in the form of managers' ability to engage in intertemporal allocation of earnings that investors cannot accurately discern. That is, observed earnings are equal to "natural" earnings plus the amount of earnings borrowed from a future period, less the cost of past borrowed earnings: [Earnings.sub.t] = "Natural" [Earnings.sub.t] + "Borrowed" [Earnings.sub.t]--cost("Borrowed" [Earnings.sub.t-1]). Investors observe [Earnings.sub.t] but cannot decompose the observed amount into "natural" versus "borrowed" earnings. In other words, investors cannot distinguish whether enhanced current-term earnings are indicative of enhanced future-term performance or come at the expense of future profits.
In this setting, the managerial discount rate is determined not just by the cost of capital (as it would be in the absence of asymmetric information). Instead, it rises with the importance managers attach to current stock price and with the importance the investors place on current-term earnings as signals of long-term profits. The resulting managerial discount rate, which is higher than is justified by the cost of capital considerations, leads to a short-run bias: Managers are selecting strategies with greater current-term results over strategies with overall superior long-term profits. Managers engage in this "intertemporal borrowing" of earnings to inflate current-term results. They seek to fool the stock market into expecting higher future earnings and, thus, to increase current stock price.
The market realizes that managers have myopic incentives and that current-term earnings may be artificially inflated. Stein (1989) emphasizes that this market awareness and response does not prevent or lessen managers' incentives to behave myopically but actually further exacerbates the situation. The problem is that the market cannot distinguish between managers who engage in myopic management and those who do not (or do so to a lesser extent) and thus downgrades all firms. This, in turn, puts pressure on all managers who care about their stock price to inflate current-term earnings.
Stein (1989) posited that the assets the myopic managers are most likely to sacrifice in their attempts to inflate earnings will be those that are not on the company's balance sheet (i.e., intangible assets) and not directly related to production. Most of a firm's marketing assets would arguably fall into this category and, as such, would be likely candidates for reductions by firms engaging in myopic management. As such, myopic management is of particular importance to marketing managers.
II. Study Context: The SEO
Theoretical models allowing for asymmetric information indicate that incentives for myopic behavior increase with the importance managers place on current-period stock price. Although managers generally pay attention to stock price, certain events are likely to increase its importance. For example, the importance of the stock price will be greater to a manager when his or her compensation is linked to the stock price (e.g., option exercise dates) or on the day of a reverse leveraged buyout (LBO). An SEO--the issuing of additional stock by a public company--is another event where the current stock price is of increased importance to managers. Because the amount of capital collected by an SEO-issuing firm is determined by its stock price on the day of the issue, managers have incentives to inflate earnings to maximize SEO proceeds. An SEO provides a well-identified period of significantly increased importance of the current stock price. As such, it provides an ideal setting for studying myopic marketing management and the financial market response.
Although we are not aware of any marketing research that has focused on SEOs, because of its properties, a great deal of work in finance and accounting has been based on the SEO context. With respect to the intent and the positioning of our study, it is useful to group some of the relevant past SEO research into three categories. The first category is the initial research that highlighted an apparent anomaly in SEO pricing (e.g., Loughran and Ritter 1995, Spiess and Affleck-Graves 1995). These studies reported that SEO firms exhibited below-average long-term stock market performance in the years following the issuing.
A second category of SEO studies built on these initial findings and sought to delineate the characteristics of the SEOs being misvalued by the financial markets. These studies (e.g., Rangan 1998, Teoh et al. 1998) focused on managers' attempts to inflate reported earnings at the time of an SEO by taking (i.e., manipulating) income-increasing accrual adjustments. Rather than SEOs being generally misvalued (as implied by the first category of studies), these studies concluded that it was only those SEO firms that had unusually large accruals (motivated presumably by a desire to induce higher net income) that experienced negative long-run abnormal stock returns.
A subsequent third wave of studies (e.g., Brav et al. 2000, Eckbo et al. 2000, Shivakumar 2000) challenged the conclusions of studies reporting an SEO pricing anomaly. These studies concluded that the SEO returns were not anomalous but rather could be explained by additional risk considerations; that is, the abnormal returns vanished with alternative calculations of expected or "normal return." Fama (1998) summarized the conclusions of this wave of studies by stating that "if there is an IPO-SEO anomaly, it seems to be largely restricted to tiny firms."
Our study is in the spirit of the second category of SEO studies but differs in that we focus on changes in management practices (as opposed to accounting practices). Past research has focused on earnings management, which involves managers using judgment in financial reporting and in structuring transactions to alter financial reports with the intent to mislead some stakeholders about the underlying economic performance of the company (Healy and Wahlen 1999). Earnings management most commonly takes place via contingencies and reserve allocations and the timing of revenue recognition. A fundamental distinction between earnings management and myopic management is that although earnings management affects only the accounting numbers in financial reports and has no impact on firm actions, myopic management impacts financial results through real actions (or inaction) firms undertake. As such, our study differs from previous work in that we assess whether management is changing expenditure patterns (as opposed to accounting reporting) at the time of an SEO and the reaction of the financial markets to such changes in real activity.
In light of issues and concerns regarding assessment of long-term abnormal stock returns highlighted in general and in the third category of SEO studies specifically, our assessment of the financial market reaction involves tests and controls geared to minimize pitfalls associated with "the bad-model problem" (Fama 1998). (4) For example, we make use of the matched-firm approach to compute abnormal returns (Barber and Lyon 1997). This approach, in contrast to some alternatives, has been shown to generate well-specified test statistics in analyses involving long-term return horizons. Furthermore, we also make extensive use of sensitivity analysis to determine that our findings are not dependent on, for example, assumptions of normality, specific approaches for calculating abnormal returns, or changes in risk characteristics.
III. Hypotheses
A. Myopic Marketing Management
Given the heightened importance of current-period stock price at the time of an SEO, managers have added incentive to engage in myopic marketing management. That is, models such as Stein's (1989) show that the more managers care about current-period return, the greater the degree and extent of myopic management. This leads to the first hypothesis.
HYPOTHESIS 1. Managers will seek to inflate current-term earnings at the time of an SEO by cutting marketing expenditure.
Hypothesis 1 predicts that...
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