Tuesday 21 September 2021 12:29 pm CFA Institute Talk

‘Quality losses’ matter more to investors than ‘quality gains’

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These are articles written by professionals for investment professionals. They are contributions from external subject matter experts who do not work for CFA Institute, but may be a CFA charterholder as well as a member of a CFA Society. All are experts in their field and strive to deliver useful insights that help investment professionals make better decisions.

People dislike losses more than they like gains. Known as loss aversion, this phenomenon, or behavioural bias, serves as a cornerstone of prospect theory, developed by Daniel Kahneman and Amos Tversky more than 40 years ago.

A forthcoming paper, which I co-authored with Didem Kurt, Koen Pauwels and Shuba Srinivasan, applies this theory to product and financial markets and analyses how investors react to negative and positive changes in firms’ product warranty payments.

If investors interpret increasing warranty payments as a signal of ‘quality losses’ and decreasing warranty payments as a signal of ‘quality gains’, an asymmetric stock-return response is likely to occur.

To put our research into context, let’s consider some of the proposed implications of loss aversion in real life. For instance, sellers tend to ask more for an item than buyers are willing to pay for it. Why? The value of an item is believed to be higher once one possesses it. This is known as the endowment effect. That is, sellers perceive giving up the item as a loss, whereas buyers consider the exchange a gain. Because losses hurt people more than gains make them feel good, there is often a significant gap between a seller’s initial asking price and the buyer’s offer price.

Examining product warranty payments

What about financial markets? Evidence shows that investors react more strongly to dividend cuts versus dividend increases. Another example is the so-called disposition effect wherein investors tend to hold on to losing stocks longer than they keep winnings stocks. However, this effect is less pronounced among sophisticated and wealthy investors. Relatedly, there is discussion as to whether loss aversion really matters to investors.

Our study is not about individual stock-trading decisions. Rather, we focus on how the stock market collectively responds to quality losses versus quality gains signalled via changes in firms’ warranty payments.

To validate warranty payments as a signal of product quality information, we ran an experiment with potential investors recruited from an online survey panel.

The experiment used information drawn from the published financial statements of a public company that we presented under a fictional company name. We randomly assigned participants to two conditions: high warranty payments (i.e. six per cent of revenues) and low warranty payments (i.e. one per cent of revenues).

Participants in the high warranty condition perceived the company’s product to be of lower quality and were less likely to invest in the company’s stock than those in the low warranty condition. This finding bolsters our argument that warranty payments communicate relevant product quality information to stock market participants.

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Warranty payments rising? The markets’ view

Our examination of analyst reports offers additional supporting evidence. We theorised that if warranty payments capture product quality information, higher warranty payments will predict the intensity of discussion about quality-related issues in analysts’ reports published in the upcoming period.

For this validation test, we analysed more than 66,000 analyst reports and searched for different word combinations, such as ‘quality issues’, ‘quality problems’ and ‘product problems’. As expected, we found that the higher the current period warranty payments, the greater the discussion of quality-related issues in analysts’ future reports.

For our main analysis, we examined 666 warranty-offering firms listed on the US stock exchanges from 2010-2016. The results support the proposed asymmetric investor reaction to increasing warranty payments (‘quality losses’) versus decreasing warranty payments (‘quality gains’). While stock returns decrease with an unanticipated rise in warranty payments, there is no favourable stock market response when a firm experiences an unanticipated decline in warranty payments.

The significance of this result is not trivial. A one standard deviation increase in unanticipated rise in warranty payments is associated with a 2.5 percentage points lower annual stock returns for the average firm in the sample.

Further factors to consider

Are there other product market signals that may alter investors’ interpretation of quality signals communicated by changes in firms’ warranty payments? We considered three potential candidates: advertising spending, research and development (R&D) spending and industry concentration. Each factor has the potential to magnify or mitigate the information value of changes in warranty payments.

Our results show that increased advertising spending, but not R&D spending, reduces investors’ sensitivity to the bad news conveyed through rising warranty payments. One possible explanation for this finding is that while greater advertising efforts may help boost a company’s brand image in the short run, R&D investments involve significant uncertainty.

Regarding industry concentration, we found that when an industry has recently become less concentrated (i.e. more competitive), a positive relationship exists between stock returns and declining warranty payments. This finding suggests that in the face of intensified competition, investors reward firms with improved product quality.

One final note: offering product warranties does not necessarily ensure a high firm value. In fact, warranty-offering firms with rising warranty claims have lower firm value than non-warranty-offering firms. So, unless managers have undertaken the necessary investments in product quality, myopically offering warranties in hopes of boosting current sales could prove very costly in the long run.

As for investors, before getting excited about a firm’s warranty claims going down, they need to make sure that this information would translate into higher stock returns by paying close attention to changes in the industry’s competitive landscape.

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By Ahmet C. Kurt, PhD, assistant professor of accounting at Bentley University.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Obradovic