Professor of accounting at Marshall School of Business, University of Southern California, Mark Soliman, has recently conducted research on how the financial performance of a company changes in reaction to shifts in its performance ranking.
The two main questions his research sought to answer were how investors evaluate a firm’s performance in relation to peer firms’ performances, and whether investors react positively to unexpected changes in the relative performance ranking (RPR) within an industry on dates when earnings are announced?
“I think this is the first one to do this kind of very explicit test of ranking,” Soliman said of the study which he embarked on with two other scholars.
Their findings showed that stock returns were positively associated with unexpected changes to a given firm’s relative RPR within an industry at the time that earnings are announced. As performance rankings go up, stock returns go up and vice versa.
In their study, Soliman emphasized the degree to which they controlled for many factors which might affect a company’s stock price other than performance rankings.
“[For example], you have a surprise [and] it’s a positive surprise, of course the markets are going to go up. But we control for all of these things, and we still find a reaction to only the change in the ranking. It’s a very strong result, and we can’t really make it go away and we tried everything.”
Soliman revealed that his paper was rejected by a number of journals before being able to find someone who would publish it. He humorously claimed that a particular journal’s referee rejected his paper six minutes after it was sent. That wasn’t even enough time to read the abstract, he exclaimed.
He extrapolated on one example when he presented his paper at the Wharton School of the University of Pennsylvania. “One of the editors said ‘this is a great paper, this is an amazing paper’,” Soliman said of the initial reaction. The same editor had told him that what they’d need to do is have their bit on competitive advantage to be brought to the front of the paper, since that was the real essence of the research’s findings.
“When you move up in the rankings, you beat other people, you have a competitive advantage. That’s what this paper’s about.”
Soliman said he and his colleagues in the research agreed to the editor’s recommendations and made the competitive advantage the main angle of the paper.
After they had submitted their paper with those changes, “immediately we got another editor who said ‘that’s the stupidest thing I’ve ever heard. Competitive advantage is ridiculous. How could you even say that?’ So it was very disheartening.”
But not all rejections were thanks to the referees at those journals thinking that the research was bad in any way, Soliman suggested. In fact, he claimed that most of them said the research was ground breaking, but perhaps too ground breaking for these journals to publish due to the controversial nature of the research’s findings. Nevertheless, one journal agreed to publish it as the results were too significant. “That’s why I think that paper got published, because no matter what you tried, there was there’s always something there,” he said.
Soliman and his colleagues decided to not use the term ‘competitive advantage’ in their paper anymore and instead focused on presenting their findings in more neutral terms and to state what they thought their findings meant. “When you move up in a ranking, when you beat someone, you’ve done something structurally in the industry. When Toyota has more sales than Ford and Toyota jumps ahead of Ford, something happened; Toyota is doing something better. People are buying more Toyotas. That structural change is what we think we’re capturing in this relative performance ranking.”
The sample period they studied stretched back to 1995 and included 261,000 firm quarter observations. When they compiled all the data and measured all the variables together, performance ranking changes remained the one constant that determined the performance of a company’s stock. “When your performance ranking goes up, the stock return goes up. When it goes down, the stock follows.”
They arrived at the same results even when they were measuring for surprises. “Every single way you cut it, there’s a strong reaction by the stock market to an increase in the rank.”
So why do positive changes in a company’s performance rankings cause their stocks to go up? Soliman believes that when this happens, a firm looks more competitive and effectively more attractive for investors.
“Clearly the investors care…our argument is that there’s some competitiveness. There’s an increase later so this ranking means that there’s some competitiveness, some improvement in your competitive landscape. Somehow you’re better than the other firms…it appears that investors are rational in pricing this right, because it predicts future earnings, it predicts future returns.”
So why did journals reject it on negative grounds? Why did several of these journals reject it for being ‘too good’?
“What’s ground breaking is that we’ve identified a new benchmark that I think everyone knows about in the popular press [and] in the real world but that hadn’t been really documented by the academics. The reason some of the academics didn’t like it was not so much about the story, because I think they all believe the story, [but because they perceived] some of the empirical issues to be a problem. What would have been nicer is if they had just given us a chance to fix those empirical issues, which we ended up fixing and found that they weren’t a problem. The referees speculated and thought there would be issues if we did certain things. When we did those things, there were no issues.”
One might ask why Soliman’s and his colleagues research is so significant. What does it bring to the table that’s never been done before? Why should companies, analysts, and investors pay attention to this new way of looking at the market?
“Measuring a company relative to other companies in the same industry is a very valuable thing to do, that I can [and people can] compare companies within the same industry. And they see how they’re doing relative to each other. And if you jump ahead of your competitor, that’s very interesting to the market and to market participants.”
On the issue of explicitly using the term ‘competitive advantage’ in their paper, Soliman said the many referees who looked over it simply insisted that it was something that couldn’t be measured or explained in quantifiable results. If a company performs better than a fellow company within the same industry, the assumption was that there were too many variables to consider to be able to come with a single reason.
“We know basically the theory as to what was happening. The reason they jumped ahead. I think that some of the referees wanted us to just simply say they jumped ahead and without saying why. Our research says when a company jumps ahead, this happens. We try to take it a step further and say ‘I wonder why that company jumped ahead’ and the reason we came up with was competitive advantage. They basically said ‘you can’t prove competitive advantage. You can just say that they jumped ahead. Who knows why?’.”