Quality Losses Matter More to Investors Than Quality Gains

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People dislike loss more than profit. Known as harm avoidance, this phenomenon, or behavioral bias, served as a cornerstone of Daniel Kahneman and Amos Tversky. prospect theory.

a upcoming paper, which I co-authored with Didem Kurt, Koen Powells and Shuba Srinivasan. International Journal of Research in Marketing, applies this principle to product and financial markets and analyzes how investors react to negative and positive changes in firms’ product warranty payments.

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If investors interpret the increasing warranty payment as a sign of “quality loss” and a decreasing warranty payment as an indication of a “quality gain”, an asymmetric stock return reaction is likely to occur.

To put our research into context, let’s consider some of the proposed implications. avoid harm in real life. For example, sellers ask more for an item than what buyers are willing to pay for it. Why? It is believed that the value of an item is more after it is possessed. it is known as endowment effect. That is, sellers view giving up the commodity as a loss, while buyers view the exchange as a gain. Because losses do more harm to people than benefits make them feel good, there is often a significant difference between the seller’s initial asking price and the buyer’s offering price.

But what about the financial markets? Evidence shows investors react more strongly Dividend Deduction vs. Dividend Increase, which is consistent with the assumption that the loss is greater than the gain. Another example is the so-called temperament effect In which investors tend to lose shares over a longer period of time than winning stocks. However, this effect is less clear Sophisticated and wealthy investors. Relatedly, there is a discussion about whether avoiding losses really matters to investors.

Our study is not about individual stock trading decisions. Instead, we focus on how market share reacts collectively versus quality gains indicated through changes in firms’ product warranty payments. Nevertheless, to validate warranty payments as an indication of product quality information, we conducted an experiment with potential investors recruited from an online survey panel.

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The experiment used information derived from published financial statements of a public company that we presented under a fictitious company name. We randomly assigned participants to two conditions: high warranty payment (ie, 6% of revenue) and low warranty payment (ie, 1% of revenue). There was no other difference between the two conditions in the financial information presented.

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

Our examination of analyst reports provides additional supporting evidence. We theorize that if warranty payments outweigh product quality information, higher warranty payments in the current period will predict the intensity of discussions about quality issues in the analysts’ reports published in the coming period. For this validation test, we analyzed more than 66,000 analyst reports and searched for various word combinations, such as “quality issues,” “quality problems,” and “product problems.”

As expected, we found that the higher the warranty payment for the current period, the more likely analysts are to discuss quality issues in future reports.

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For our key analyses, we examined 666 firms offering warranties listed on US stock exchanges with sample periods ranging from fiscal year 2010 to 2016. As investors react to unexpected information, we estimated a first order autoregressive model of warranty payments and used the remainder of this model as a proxy for unexpected changes in warranty payments.

The results support the proposed asymmetric investor response to increasing warranty payment (“quality loss”) versus decreasing warranty payment (“quality gain”). While stock returns diminish with an unexpected increase in warranty payments, there is no favorable stock market reaction when a firm experiences an unexpected decline in warranty payments. The economic importance of the documented result is not trivial. A one standard deviation increase in an unexpected increase in warranty payments is associated with a 2.5 percentage point lower annual stock return for the average firm in the sample.

Are there other product market signals that could change investors’ interpretation of quality signals communicated by changes in firms’ warranty payments? We considered three potential candidates: advertising spend, research and development (R&D) spend, and industry concentration. Each factor has the potential to increase or decrease the information value of a change in warranty payment.

Our results suggest that increased advertising spending, but not R&D spending, reduces investors’ sensitivity to bad news reported through increased 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 term, there is significant uncertainty involved in R&D investment and investors’ evaluation of actual warranty results in the current period. cannot play a positive middle role.

With respect to industry concentration, we found that when an industry has recently become less concentrated (i.e., more competitive), a positive correlation exists between stock returns and decreasing warranty payments. This finding suggests that in conditions of intense competition, investors reward firms with better product quality.

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One final note: Providing a product warranty does not necessarily ensure a high firm value. In fact, warranty firms with escalating warranty claims have a lower firm value than firms offering non-warranties.

Therefore, unless managers have made the necessary investment in product quality, offering warranties in the hopes of boosting existing sales may prove too costly in the long run. As far as investors are concerned, before getting excited about a firm’s warranty claims going down, they need to ensure that this information translates into higher stock returns by noting changes in the industry’s competitive landscape. Will go

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

Image credit: © Getty Images / jayk7


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Ahmet C. Kurt, PhD

Ahmet C. Kurt is an assistant professor of accounting at Bentley University. He holds a PhD degree from the University of Pittsburgh and an MBA degree from the University of Alabama. His research has been published in such journals as: Journal of Accounting and Economics And European Accounting Review and cited in various media outlets, including wall street journal, Bloomberg, and CFO.com.



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