Market perception of rm

strategy
Ozer Asdemir
Opus College of Business, University of St Tomas, St Paul, Minnesota, USA
Guy D. Fernando
School of Business, State University of New York, Albany, New York, USA, and
Arindam Tripathy
Milgard School of Business, University of Washington Tacoma, Tacoma,
Washington, USA
Abstract
Purpose Research has shown that rms successfully pursuing either a cost leadership or a
differentiation strategy are better able to gain competitive advantages over other rms and
accordingly achieve superior performance. Thus, if rms actually do realize superior performance
based on their strategic orientation, capital markets should recognize this and place a positive value on
such strategy-focused rms. The aim of this paper is to empirically investigate how capital markets
perceive and reward the strategies pursued by rms.
Design/methodology/approach The paper uses Tobins Q as a measure of market perception.
By regressing Tobins Q against relevant control variables and proxies for differentiation and cost
leadership strategies, the paper evaluates the relationship between market perception and rm
strategy. Furthermore, the paper also conducts abnormal returns analyses (both portfolio and
regression analysis) to determine whether the market accurately prices the different strategies, given
the complexity in both the nature and the implementation of such strategies.
Findings The analysis shows that markets place a positive value on rms successfully pursuing
either a cost leadership or a differentiation strategy; moreover markets place a higher value on rms
pursuing a differentiation strategy compared to a cost leadership strategy. The abnormal returns
analyses show that the market is not able to fully price the superior performance generated by
pursuing differentiation strategy resulting in abnormal returns from portfolios formed based on
higher levels of differentiation.
Research limitations/implications By providing detailed information to the market about the
strategies they follow, rms will enable markets to value their strategies accurately, thus reducing
their cost of capital. Fundamental investors looking to earn abnormal returns can use rm strategy in
their portfolio selection. A variety of characteristics are conceived to inuence a rms strategic
positioning and market perception of such characteristics. This evaluation is limited to a macro level
assessment of the implications of the overall strategy pursued by a rm. Future research, in the form
of detailed eld studies, could be directed at evaluating the market perceptions and other implications
of multi-dimensional, lower level, operational strategies on a rm-by-rm basis.
Originality/value To the best of the authors knowledge, this is the rst paper to show how
nancial markets value rm strategy. The paper also provides evidence to the complexity of a
differentiation strategy, and how such complexity can lead to market mis-pricing.
Keywords Firm strategy, Differentiation, Cost leadership, Market perception, Abnormal returns,
Capital markets, Management strategy
Paper type Research paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/0307-4358.htm
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Received 7 March 2012
Revised 18 September 2012
29 October 2012
Accepted 2 November 2012
Managerial Finance
Vol. 39 No. 2, 2013
pp. 90-115
qEmerald Group Publishing Limited
0307-4358
DOI 10.1108/03074351311293972
1. Introduction
Research posits that pursuit of either of the generic strategies, differentiation or cost
leadership, enables a rm to achieve better performance (Porter, 1980, 1985; Hambrick,
1983; Miller and Friesen, 1986 and others). Allen (2007) found the lack of strategic focus to
be a major reason for the downfall of several Japanese rms. Allen (2007) also found that
iconic Japanese rms suchas Honda, Sony, andNintendo rise toglobal dominance bytheir
well-developed and dened corporate strategies. He goes on to document how other
Japanese companies (e.g. Mitsubishi) are using a commitment to Porters generic strategies
as a mechanismfor corporate renewal. However, to sustain such superior performance into
the future, rms should build effective barriers to prevent imitation of best practices that
enable such superior performance. Porter (1996, 2001) argues that cost leadership strategy
is easily replicable since best practices that enhance cost efciency can spread rapidly with
modern technological innovations. Conversely, a differentiation strategy is harder to
imitate since it is built on products or services that are perceived to be different from the
competitors; hence leadingto more sustainable performance. To the extent that the superior
performance through strategic positioning of rms could be sustained into the future,
contemporaneous measures such as earnings or ROAdo not capture this persistence. Even
so, the stock markets should theoretically recognize and reward the protability
implications of the superior performance resulting from the strategy pursued by rms.
However, as noted by Narver and Slater (2000) prior literature on this subject has
focused mainly on the contemporaneous effects of strategy on performance. In this
article, we examine the market perception of different strategies pursued by rms, and
to the best of our knowledge, is the rst article to do so. We use empirical data for a
large sample of publicly traded rms to investigate how capital markets perceive and
reward strategies pursued by rms. We evaluate the market perception using both
Tobins Q and the abnormal returns from rms pursing the strategies. In addition, we
also investigate the differential impact of different types of strategy (i.e. diversication
and cost leadership) on the market value of rms. We use the operationalization
(empirical construction) of strategy measures as dened by Balsam et al. (2011), who
use publicly available accounting information to capture the empirically realized level
of either differentiation or cost leadership strategy achieved by a rm.
Using these measures, we nd that the capital markets reward rms pursuing either
of these strategies; however it values rms pursuing differentiation higher than the
cost leadership strategy. This reects the longer term sustainability of the
differentiation strategy over the cost leadership strategy. We also show that an
investment strategy of buying high differentiation rms generate greater abnormal
returns compared to a similar strategy of buying high cost leadership rms. Thus, we
highlight that markets systematically underprice the differentiation strategy.
The rest of the paper is organized as follows. In the next section we develop our
main hypotheses on how the capital markets evaluate rms strategic positioning. In
Section 3, we discuss our data, the strategy measures and our empirical models.
Section 4 discusses the empirical results from our analysis and Section 5 presents a
discussion of our results and our concluding remarks.
2. Literature review and hypotheses development
A rm needs to possess competitive advantages over its competitors in order to
outperform them. Porter (1980) presents a framework describing two strategies that a
Perception of
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91
rm can use to achieve competitive advantage; cost leadership and differentiation.
He also discusses the structure, processes and the practices that are likely to be
identiable with rms that have a specic strategic orientation. Based on Porters
framework, a rm that chooses and pursues a strategy based on either differentiation
or cost leadership will be in a position to effectively deal with the competitive forces
that determine success within an industry. Porters framework has become very
popular in practice and academia for evaluating both macro and micro issues relating
to strategic orientation in an economy (Dess and Davis, 1984; Porter, 1985, 2000, 2001;
Miller and Dess, 1993; Allen, 2007).
Firms adopting a cost leadership strategy aim to increase market share based on
creating a low-cost position relative to their peers. Cost leadership may be achieved
throughlarge volume manufacturingutilizingeconomies of scale, process improvements,
cost minimization, total quality management, just-in-time manufacturing,
benchmarking, overhead control, etc. Conversely, a differentiation strategy may be
achieved by investing in developing products or services that offer exceptional
characteristics that the customers desire, enabling the rmto command premiumprices.
Research ndings froma number of empirical studies have also found support for the
linkage between generic strategies and organizational performance, thus validating the
claim that adopting the generic strategies result in superior performance. While testing
Porters taxonomy Hambrick (1983) and Dess and Davis (1984) nd existence of these
strategies among high performing rms. In a study of the characteristics of strategies
among successful rms in a mature industrial-products industry, Hambrick (1983)
found that asset conguration and utilization were important factors in the protability
of rms and that the characteristics of strategies of various successful rms were similar
to Porters generic strategy framework. Dess and Davis (1984), in a eld study,
comprising responses fromexecutives and panel experts fromthe academic community,
examined Porters generic strategies as a determinant of organizational performance
and found their results to conform to the premise that adopting generic strategies leads
to higher performance. In the same vein, White (1986), in an empirical study of 69
business units from 12 different multi-business rms, showed the linkage between the
generic business strategies and business unit performance. Similarly, other empirical
studies namely Miller and Friesen (1986), Robinson and Pearce (1988) and Tripathy
(2006) have found support for Porters theory. Thus, prior literature shows that rms
following either of these strategies, differentiation and cost leadership, are able to
achieve superior contemporaneous performance. Moreover, a rm that moves further
along in achievingcost leadershipor differentiation is able to achieve better performance
compared to rms stuck at the lower ends of either of the strategies.
In an efcient market, rm value is the present value of expected future net cash
ows, discounted at the appropriate risk-adjusted rate of return. Various nancial
models translate expected future net cash ows in terms of expected future earnings
where the expectation is based on a rms current earnings (Kothari, 2001). If earnings
are more persistent and current earnings are sustained into the future, then a higher
weight is placed on current earnings in valuing a rm. We expect a rm that advances
further along either the differentiation or cost leadership dimensions to produce better
performance. Moreover, research shows that capital markets are capable of valuing
intangibles such as R&D and advertising expenses (Chauvin and Hirschey, 1993;
Asthana and Zhang, 2006), IT expenses (Aboody and Lev, 1998), and even the
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regulatory environment (Henderson and Hughes, 2010). Therefore, we expect capital
markets to be cognizant of the value implications of rm strategy and we posit that
rms which are successful in pursuing either the cost leadership or the differentiation
strategy will enjoy higher capital market valuations. Formally stated:
H1. Capital markets will place a positive value on both the differentiation and the
cost leadership strategy.
The sources of achieving a cost leadership strategy (i.e. operational efciency) can be
copied (DAveni, 1994) or made ineffective due to advent of newer and better sources of
efciency (Hamel, 2000). Therefore, such strategies will only confer transitory
competitive advantage, and persistent protability over the long-term is not achievable
(Eisenhardt and Brown, 1998; Eisenhardt and Martin, 2000). The rapid diffusion of best
practices allows competitors to quickly imitate superior management techniques and
practices. A cost leadership strategy which is primarily built on generic solutions
related to operational efciency is more susceptible to imitation by competitors and
peers resulting in comparative cost advantages that will dissipate over time. Achieving
cost leadership is not likely to yield an inimitable source of competitive advantage,
especially if the means of achieving it (process and operational efciency) is developed
by suppliers and sold on the open market (Barney, 2002). Being rst with a new
process only provides a rm with a temporary cost advantage because imitation is
inevitable (Murray, 1988). Another source of cost efciency is capitalizing on learning
or experience effects and some rms may be able to create a durable advantage by
following such a strategy. However, if an industry is not characterized by a sufciently
steep learning curve, such a strategy would collapse since it would not lead to any
signicant cost advantages that can be sustained (Murray, 1988).
On the other hand, differentiation, which is achieved through unique products or
services that consumers place a premium value on, permits more sustainable
advantages to accrue to the rm since such attributes cannot be easily imitated by
competitors (Grant, 1991). A differentiation strategy typically involves rm-specic
and product-specic innovations and tailored marketing campaigns that are not
possible to replicate speedily. While competitors will respond to pricing moves almost
immediately, responses to innovation through R&D will take a much longer period.
The longer it takes for a competitor to respond to a particular comparative advantage,
the greater the opportunity for a rm to capitalize on the sustained advantages and to
create new ones. Furthermore, differentiating oneself from the competition by
concentrating on making reliable and high quality products will have a signicant
impact on sales. Porter (1985) posits that this is especially true in more mature
industries or in industries in which there is a high cost of poor performance.
To enable long-term superior performance a rm has to maintain its unique position
vis-a`-vis its competitors. Most currently unique advantages of a rm can and will be
copied and even improved upon by competitors over time. However, certain barriers
will be higher than others and hence more difcult for rivals to overcome. Competitor
and competitive information is generally available to all rms and new techniques
diffuse rapidly (Barney, 1986). Therefore, a competitive advantage can be sustained
only if it can survive attempts to replicate it by competitors (Ghemawat, 1995). Given
the discussed ease with which sources of competitive advantage may be imitated, some
Perception of
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93
rms have still been able to generate superior performance over sustained periods of
time (Wiggins and Ruei, 2002).
Based on the above discussion we expect that the performance of rms pursuing
differentiation will be more sustainable into the future. As a result, capital markets will
place a higher value on rms pursuing a differentiation strategy compared to rms
pursuing a cost leadership strategy. Formally stated:
H2. Capital markets will place a higher value on rms pursuing a differentiation
strategy than on rms pursuing a cost leadership strategy.
3. Data, strategy measures and research methodology
3.1 Data
We obtain data for the strategy and performance variables used in our study from the
Compustat data les and stock market returns from CRSP for the period 1989-2009.
Our sample excluding CRSP data (for stock market returns) consists of 31,113
rm-years (4,536 unique rms). When CRSP data is included, we get 28,582 rm-years
consisting of 4,351 unique rms.
3.2 Strategy measures
Prior studies have attempted to capture the strategic positioning of rms either through
surveys (Dess andDavis, 1984; Miller, 1987) or throughlimitedproprietarydata(Kotha and
Nair, 1995; Berman et al., 1999; Nair and Filer, 2003). We capture the strategic positioning of
the rms using realized indicators obtained through rms nancial statements. Following
Balsam et al. (2011), we use three variables (SG&A/SALES, R&D/SALES and
SALES/COGS) to measure strategic positioning based on the differentiation dimension
and three other variables (SALES/CAPEX, SALES/P&Eand EMPL/ASSETS) to measure
strategic positioningbasedoncost leadership. These measures capture the rms long-term
strategic orientation on the dimensions of differentiation and cost leadership.
Balsam et al. (2011) review the extant literature in detail and discuss the use of the six
variables to construct the strategy of the rms. Based on Balsam et al., we compute
SG&A/SALESas the selling, general andadministrative expenses scaledbynet sales. This
variable captures a rms investment in marketing activities to differentiate itself from
competitors (Berman et al., 1999; David et al., 2002; Miller and Dess, 1993; Thomas et al.,
1991). We also compute R&D/SALES as research and development expenses scaled by net
sales. R&D expenses indicate the ability of rms to offer high quality and innovative
products and services which are critical to the success of differentiators (Hambrick, 1983;
David et al., 2002; Thomas et al., 1991). SALES/COGS is net sales scaled by cost of goods
sold. Ahigher ratio captures a greater ability to command premiumprices, typically linked
with differentiators (Berman et al., 1999; Kotha and Nair, 1995; Nair and Filer, 2003).
SALES/CAPEX is net sales scaled by capital expenditures on property, plant and
equipment. SALES/P&E is net sales scaled by net book value of plant and equipment.
A higher value for these variables indicates a more efcient use of the rms assets
(Berman et al., 1999; Hambrick, 1983; Kotha and Nair, 1995; Miller and Dess, 1993).
Similarly, EMPL/ASSETS is the number of employees scaled by total assets (Hambrick,
1983; Kotha and Nair, 1995; Nair and Filer, 2003) where number of employees is used in
the numerator as an alternative proxy for size (output) instead of net sales. All three
measures capture a rms efciency in utilizing its capital investments (David et al.,
2002).
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Similar to Balsamet al. (2011), we compute the mean of the previous ve years of data
for each of the above six variables to capture the long termstrategic orientation of rms
and conduct a conrmatory factor analysis (CFA) to construct the two strategy
variables, cost leadership and differentiation. Table I tabulates the results of our CFA
and indicate reasonable levels of reliability and validity for the two strategy variables.
The factor loadings, which range from0.52 to 0.98, and the t-statistics for the two factors
suggest that the indicator measures satisfy the convergent validity thresholds
suggested in prior literature (Bagozzi et al., 1991; Phillips, 1981). The average variance
extracted (AVE), establishes the discriminant validity of constructs by indicating the
amount of variance that is captured by an underlying factor in relation to the amount
of variance due to measurement error. AVE is well above the recommended threshold of
0.5 for all factors (Fornell and Larcker, 1981). The composite reliability which measures
the internal consistency of the factors also exceeds the recommended threshold of
0.7 (Werts et al., 1974; Nunnally, 1978) for the two factors. The goodness of t index and
the adjusted goodness of t index, which evaluate whether the measurement model
provided a good t, are also above the cut-off range of 0.90 and 0.80, respectively,
( Joreskog and Sorbom, 1989). Additional t measures such as the comparative t index
(Bentler, 1989) and the non-normed index (Bentler and Bonett, 1980) are also in the
acceptable range. The results of our CFA are similar in tenor to Balsam et al. (2011).
Thus, as measured by the factor scores in each of the strategy constructs, the two
strategy constructs are continuous variables which are orthogonal to each other,
forming four quadrants of rms based on their strategies. In other words, we capture
both dimensions of differentiation and cost leadership for each rm because, consistent
with the views of Porter (1980, 1985) and others, the two strategies are not viewed as
Variables Conrmatory factor analysis
Efciency factor
loading (t-value)
Differentiation factor
loading (t-value)
Composite
reliability AVE
SG&A/SALES 0.85 (132.10) 0.75 0.51
R&D/SALES 0.69 (109.60)
SALES/COGS 0.56 (89.87)
SALES/CAPEX 0.81 (142.30) 0.83 0.63
SALES/P&E 0.98 (172.10)
ASSETS/EMPL 0.52 (74.65)
Goodness of t measures
Goodness of t index 0.9510
Goodness of t index adjusted
for degrees of freedom 0.8714
Bentlers comparative t
index 0.9281
Bentler & Bonetts non-
normed index 0.8652
Notes: Sample period: 1989-2009; denitions;SG&A/SALES average of SG&A/net sales fromt 2 1 to
t 2 5; R&D/SALES average of R&Dexp/net sales fromt 2 1 to t 2 5; SALES/COGS average of net
sales/cost of goods sold fromt 2 1 to t 2 5; SALES/CAPEX average of net sales/capital expenditure
fromt 2 1 to t 2 5; SALES/P&E average of net sales /net book value of plant and equipment from
t 2 1 to t 2 5; ASSETS/EMPL average of total asset/no. of employees from t 2 1 to t 2 5
Table I.
CFA to determine
strategy constructs
Perception of
rm strategy
95
two ends of the same continuum, but rather as two distinct platforms that can be used
in isolation or in combination with each other (which is captured by having two
strategy constructs, one for differentiation and one for cost leadership, which are
continuous variables).
3.3 Research methodology
Market perception. We measure the market perception in two ways: Tobins Q and
abnormal market returns. We use Tobins Q (Tobin, 1969) to capture the market
perception of the rms. Tobins Q, a measure of a rms market performance, is the
ratio of the market value of a rms assets (as measured by the market value of its
outstanding equity and debt) to the book value of the rms assets. If a rm has value
in excess of what it would cost to rebuild it, then that extra value is due to a premium
placed on the rm by stock markets. Hermalin and Weisbach (1998) argue that Tobins
Q is an equity-based measure of rm performance which incorporates not just the
results from contemporaneous actions of management, but also the markets
expectations of future performance. Tobins Q may also be used as a measure of a
rms market (or stock price based) performance (Yermack, 1996; Coles et al., 2008) and
future growth opportunities. Lang and Litzenberger (1989) justify the utilization of
Tobins Q as a measure of growth opportunities. They show that a Tobins Q above 1 is
a necessary condition for a rm to be at a level of investment that maximizes its value
and that a Tobins Q below 1 characterizes a rm with limited future opportunities. We
use the equation below to test the extent to which market premium on the level of cost
leadership or differentiation is reected in Tobins Q:
TQ
t
b
0
b
1*
Differentiation
t
b
2*
Cost Leadership
t
b
3*
Size
t
b
4*
Age
t
b
5*
Dividend
t
industry &year dummies 1
it
1
TQ
t
is Tobins Q for rm j in year t, computed according to Brown and Caylor (2006) as
(total assets market value of equity-total common equity-deferred taxes)/total
assets. Differentiation
t
and Cost Leadership
t
refer to the strategies pursued by a rmas
determined by individual factor scores described in the earlier section. Control
variables used are Size
t
, Age
t
(as per Brown and Caylor, 2006) and Dividend
t
(as per
Servaes, 1996). Size
t
is the natural logarithm of total assets which controls for rm size.
This is to account for the well documented size discount whereby large rms have a
relatively lower Tobins Q compared to their smaller counterparts (McConnell and
Servaes, 1990; Lang and Stulz, 1994). In accordance with these studies, we expect a
negative relationship between Tobins Q and rm size. Younger rms are generally
faster-growing, and more intangible asset-intensive, hence we expect a negative
relationship between Tobins Q and age. Age
t
is the natural logarithm of rm age in
years to control for the rms age. Dividend
t
is natural logarithm of cash dividends and
as in Servaes (1996) we use Dividend
t
as a proxy to capture the individual rms access
to capital markets. We expect a positive relationship between Tobins Q and Dividend
t
since better access to capital would result in greater rm value. We expect b
1
and b
2
to
be positive and signicant in accordance with our H1 and we expect b
1
to be greater
than b
2
in accordance with our H2. Our analyses in regression models (1) and (2)
(below) are not based on separate samples for cost leadership rms and differentiation
rms. Instead, we employ a single data sample from Compustat and using commonly
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available accounting data items from that dataset, compute proxies that measure the
degree to which each rm displays either cost leadership properties or differentiation
properties. Hence a typical rm will have both a score for the cost leadership proxy and
the differentiation proxy.
Portfolio returns. The Tobins Q analysis explained above evaluates the ex ante
market perception of rms strategy. A different way of analyzing the markets
perception of rms strategic orientation is to examine long term realized returns which
highlight the ex-post perceptions. Therefore, we evaluate whether the realized returns
of rms depend on the extent to which rms pursue their strategic orientations. We
calculate the future abnormal return for a rm as the difference between the year k
(k t 1, t 2, t 3) return of the rm, measured over a year from July of year k to
June of year k 1, and the median return of its control portfolio over the same time
period. We adopt the methodology developed by Lyon et al. (1999) and used in
Henderson et al. (2010) as a three-step approach to construct control portfolios.
According to this approach, control portfolios are formed at the end of June of each
year t 1, based on book to market ratio, market value of equity, and 12-month
buy-and-hold returns. First, we rank all NYSE/AMEX/Nasdaq stocks by their book to
market ratio (book value of equity divided by market value of equity), and assign each
stock to one of ve equally sized portfolios. Then within each book to market portfolio,
we assign stocks to one of the six portfolios based on market value. Lastly, within each
30 book to market and market value of equity portfolio, we allocate stocks to one of the
three 12-month buy-and-hold portfolios based on prior-year returns.
For each of the 90 control portfolios thus formed, we measure median return over a
period of one year from July of year k to June of year k 1. Then, we assign each of our
observations to one of these 90 portfolios based on book to market, size and returns of
the observation. We compute the abnormal returns for an observation as the raw
returns over the year from July of year k to June of year k 1 less the median portfolio
returns.
Once abnormal returns are computed for each rm, we compute a different set of
portfolios based on the rms level of cost leadership or differentiation. The entire
sample is divided into quintiles based on the degree of Differentiation (cost leadership).
Each quintile is a portfolio and we compute the mean abnormal returns for each such
portfolio. The nal computation creates hedge portfolios by going long on the portfolio
consisting of the highest quintile of Differentiation (cost leadership) rms, and going
short on the lowest quintile of Differentiation (cost leadership) rms. If the market fails
to incorporate the superior performance of either strategy completely into
contemporaneous stock price, we would expect high differentiation (cost leadership)
portfolios to yield higher abnormal returns over a long term compared to low
differentiation (cost leadership) rms. Furthermore, and in accordance with our H2, we
expect high differentiation portfolios to yield greater returns compared to high cost
leadership portfolios.
The methodology used to compute abnormal returns, by construction, controls for
size and risk. However, there are other variables that may impact abnormal returns
such as the level of R&D spending and capital expenditure. Therefore, we conduct a
multivariate analysis to evaluate the abnormal returns generated by the market for
rms pursuing differentiation or cost leadership. We use the following empirical model
based on Henderson et al. (2010) for our analysis:
Perception of
rm strategy
97
AbnormalRet
t1;t3
b
0
b
1*
DiffrentiaionD
t
b
2*
Cost LeadershipD
t
b
3*
R&D
t
b
4*
Adv
t
b
5*
CapEx
t
b
6*
LogSales
t
b
7*
SDEarnQ
t
1
it
2
AbnormalRet
t1,t 3
is abnormal returns computed as described above over a three
year period. DiffrentiationD
t
(Cost LeadershipD
t
) is a dummy variable equal to one if
the rm is in the topmost quintile according to the degree of differentiation
(cost leadership). R&D
t
is research and development expense scaled by sales revenue,
Adv
t
is advertising expense scaled by sales revenue, CapEx
t
is capital expenditures
divided by sales revenue, LogSales
t
is natural logarithm of sales revenue and
SD(EarnQ)
t
is standard deviation of quarterly earnings before extraordinary items
scaled by quarterly sales for prior three years. We include SD(EarnQ)
t
as a measure of
total risk to control for any risk factors which we might not have controlled for in
constructing abnormal returns. Further we include R&D
t
, Adv
t
, CapEx
t
and LogSales
t
as additional control variables following Henderson et al. (2010).
4. Empirical results
4.1 Descriptive statistics and correlations
Table II contains the descriptive statistics for our sample.
The rst two variables are the strategy measures, Differentiation
t
and Cost
Leadership
t
. By construction, these measures have a mean of 0 and a standard
deviation of 1. The two dependent variables are TQ
t
and AbnormalRet
t1,t 3
(abnormal returns). They have means (median) of 1.77 (1.43) and 0.12 (20.01),
respectively. Total assets and total sales have means (medians) of $2,329 million
($474 million) and $2,422 million ($554 million), respectively. The average rm spends
3 percent of its sales on R&D expenses, 1 percent of its sales on advertising and
6 percent on capital expenses.
Table III tabulates the correlation statistics between our variables. Panel A shows
the correlation statistics for analyses where Tobins Q is the independent variable and
Panel B shows the same for analyses where AbnormalRet
t1,t 3
is the independent
variable. The gures above the diagonal represent Pearson correlations while those
below the diagonal represent Spearman correlations.
In general, the correlations in panel A are not too high with the largest correlation
being 0.6963 between Log (Assets)
t
and Log (Dividends)
t
(both of which are control
variables). Differentiation
t
shows positive and signicant correlations with the
dependent variable, TQ
t
. The results are consistent for both Spearman and Pearson
statistics. Panel B again show consistent and expected results for Differentiation
t
with
the dependent variable AbnormalRet
t1,t 3
. The results are positive and signicant
for both Spearman and Pearson statistics. However, Cost Leadership
t
is negative and
insignicant for both Spearman and Pearson statistics.
4.2 Market perception of rm strategy
To test our hypotheses relating to the market valuation of the rm strategies, we
estimate model (1) on our data sample by regressing TQ
t
on the independent variables,
Differentiation
t
and Cost Leadership
t
. The results are tabulated in Table IV. The
standard errors have been corrected for heteroskedasticity, serial- and cross-sectional
correlation using a two-way cluster at the rm and year level (Petersen, 2009).
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Column 1 tabulates the results of TQ
t
regressed against control variables and
Differentiation
t
. The results showthat in accordance with H1, Differentiation
t
is positive
and signicant (estimated coefcient 0.26; t-stat. 22.7) with a very high t-statistic.
This indicates that TQ
t
increases with higher levels of differentiation. A higher TQ
t
means that the market imputes a greater differential to the rms book value and market
value, implying expectations of superior performance in the future. These results
indicate that the market places higher value on rms with higher levels of
differentiation. Column 2 tabulates the results of TQ
t
regressed against Cost
Leadership
t
. The coefcient on Cost Leadership
t
(estimated coefcient 0.03;
t-stat. 7.11) is positive and signicant. These results further support H1 and show
Variable
a
N Mean SD Min. Q1 Med. Q3 Max.
Differentiation
t
31,113 0.00 1.00 21.53 20.60 20.27 0.26 32.74
Cost Leadership
t
31,113 0.00 1.00 211.30 20.09 0.28 0.49 0.94
Tobins Q
t
31,113 1.77 1.14 0.36 1.10 1.43 2.02 27.26
Assets 31,113 2,329 5,419 5 142 474 1,776 49,379
Log (Assets)
t
31,113 6.25 1.76 1.66 4.96 6.16 7.48 10.81
Log (Age)
t
31,113 2.87 0.69 0.00 2.30 2.89 3.37 4.45
Log (Dividends)
t
31,113 1.48 1.99 26.91 0.00 0.36 2.91 9.20
AbnormalRet
t1,t 3
28,582 0.12 0.75 21.00 20.31 20.01 0.36 24.62
R&D/sales
t
28,582 0.03 0.05 0.00 0.00 0.00 0.03 0.42
Adv/sales
t
28,582 0.01 0.03 0.00 0.00 0.00 0.01 0.52
Capex/sales
t
28,582 0.06 0.11 0.00 0.02 0.04 0.07 5.20
Sales 28,582 2,422 5,365 10 171 554 1,927 49,657
Log (Sales)
t
28,582 6.40 1.70 2.35 5.14 6.32 7.56 10.81
SD(EarnQ)
t
28,582 0.06 0.55 0.00 0.01 0.03 0.05 57.39
Notes:
a
Firm subscripts are omitted; denitions; Differentiation is a construct to capture the
differentiation strategy; it is a continuous variable based on the factor analysis of the t 2 1 to t 2 5
average of the ratios of SG&A Expense to Sales; R&D expense to sales and sales to cost of goods sold;
Cost Leadership is a construct to capture the cost leadership strategy; it is a continuous variable, based
on the factor analysis of the t 2 1 to t 2 5 average of the ratios of sales to capital expenditure; sales to
net book value of plant and equipment and number of employees to net book value of plant and
equipment; Tobins Q
t
is market value of equity plus total assets minus book value of equity minus
deferred taxes, deated by total assets; Assets is total assets in $ millions. Log (Assets)
t
is natural
logarithm of total assets; Log (Age)
t
is natural logarithm of rms age; Log (Dividends)
t
is natural
logarithm of cash dividends; AbnormalRet
t1,t 3
is accumulated abnormal returns for from year
t 1 to year t 3; future abnormal return for a rm is computed as the difference between the
year k(k t 1, t 2, t 3) return of the rm, measured over a year from July of year k to June of
year k 1, and the median return of its control portfolio; at the end of June of each year t 1, control
portfolios are formed based on market value of equity, book to market ratio and 12-month buy-and-
hold returns; all NYSE/AMEX/Nasdaq stocks are ranked by their book to market ratio (book value of
equity divided by market value of equity, and assigned to one of the ve equally sized portfolios; then
within each book to market portfolio stocks are assigned to one of the six market value portfolios;
within each 30 book to market and market value of equity portfolio stocks are assigned to one of the
three 12-month buy-and-hold return portfolios; nally, median return is measured over a year from
July of year k to June of year k 1 for each control portfolio; R&D/Sale
t
is research and development
expense divided by sales revenue; Adv/Sale
t
is advertising expense divided by sales revenue; Capex/
Sales
t
is capital expenditures divided by sales revenue; Sales
t
sales revenue; LogSales
t
is natural
logarithm of sales revenue; SD(EarnQ)
t
is standard deviation of quarterly earnings before
extraordinary items scaled by quarterly sales for prior three years
Table II.
Descriptive statistics
Perception of
rm strategy
99
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(
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Table III.
Correlation statistics
MF
39,2
100
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f
D
i
f
f
e
r
e
n
t
i
a
t
i
o
n
v
a
r
i
a
b
l
e
,
0
o
t
h
e
r
w
i
s
e
.
C
o
s
t
L
e
a
d
e
r
s
h
i
p
D
t
i
s
e
q
u
a
l
t
o
1
i
f
t
h
e

r
m
i
s
i
n
t
h
e
t
o
p
q
u
i
n
t
i
l
e
o
f
C
o
s
t
L
e
a
d
e
r
s
h
i
p
v
a
r
i
a
b
l
e
,
0
o
t
h
e
r
w
i
s
e
;
C
a
p
i
t
a
l
E
x
p
e
n
d
i
t
u
r
e
;
s
a
l
e
s
t
o
n
e
t
b
o
o
k
v
a
l
u
e
o
f
p
l
a
n
t
a
n
d
e
q
u
i
p
m
e
n
t
a
n
d
n
u
m
b
e
r
o
f
e
m
p
l
o
y
e
e
s
t
o
n
e
t
b
o
o
k
v
a
l
u
e
o
f
p
l
a
n
t
a
n
d
e
q
u
i
p
m
e
n
t
;
T
o
b
i
n

s
Q
t
i
s
m
a
r
k
e
t
v
a
l
u
e
o
f
e
q
u
i
t
y
p
l
u
s
t
o
t
a
l
a
s
s
e
t
s
m
i
n
u
s
b
o
o
k
v
a
l
u
e
o
f
e
q
u
i
t
y
m
i
n
u
s
d
e
f
e
r
r
e
d
t
a
x
e
s
,
d
e

a
t
e
d
b
y
t
o
t
a
l
a
s
s
e
t
s
;
L
o
g
(
A
s
s
e
t
s
)
t
i
s
n
a
t
u
r
a
l
l
o
g
a
r
i
t
h
m
o
f
t
o
t
a
l
a
s
s
e
t
s
;
L
o
g
(
A
g
e
)
t
i
s
n
a
t
u
r
a
l
l
o
g
a
r
i
t
h
m
o
f

r
m

s
a
g
e
;
L
o
g
(
D
i
v
i
d
e
n
d
s
)
t
i
s
n
a
t
u
r
a
l
l
o
g
a
r
i
t
h
m
o
f
c
a
s
h
d
i
v
i
d
e
n
d
s
;
A
b
n
o
r
m
a
l
R
e
t
t

1
,
t

3
i
s
a
c
c
u
m
u
l
a
t
e
d
a
b
n
o
r
m
a
l
r
e
t
u
r
n
s
f
r
o
m
y
e
a
r
t

1
t
o
y
e
a
r
t

3
;
f
u
t
u
r
e
a
b
n
o
r
m
a
l
r
e
t
u
r
n
f
o
r
a

r
m
i
s
c
o
m
p
u
t
e
d
a
s
t
h
e
d
i
f
f
e
r
e
n
c
e
b
e
t
w
e
e
n
t
h
e
y
e
a
r
k
(
k

1
,
t

2
,
t

3
)
r
e
t
u
r
n
o
f
t
h
e

r
m
,
m
e
a
s
u
r
e
d
o
v
e
r
a
y
e
a
r
f
r
o
m
J
u
l
y
o
f
y
e
a
r
k
t
o
J
u
n
e
o
f
y
e
a
r
k

1
,
a
n
d
t
h
e
m
e
d
i
a
n
r
e
t
u
r
n
o
f
i
t
s
c
o
n
t
r
o
l
p
o
r
t
f
o
l
i
o
;
a
t
t
h
e
e
n
d
o
f
J
u
n
e
o
f
e
a
c
h
y
e
a
r
t

1
,
c
o
n
t
r
o
l
p
o
r
t
f
o
l
i
o
s
a
r
e
f
o
r
m
e
d
b
a
s
e
d
o
n
m
a
r
k
e
t
v
a
l
u
e
o
f
e
q
u
i
t
y
,
b
o
o
k
t
o
m
a
r
k
e
t
r
a
t
i
o
a
n
d
1
2
-
m
o
n
t
h
b
u
y
-
a
n
d
-
h
o
l
d
r
e
t
u
r
n
s
.
A
l
l
N
Y
S
E
/
A
M
E
X
/
N
a
s
d
a
q
s
t
o
c
k
s
a
r
e
r
a
n
k
e
d
b
y
t
h
e
i
r
b
o
o
k
t
o
m
a
r
k
e
t
r
a
t
i
o
(
b
o
o
k
v
a
l
u
e
o
f
e
q
u
i
t
y
d
i
v
i
d
e
d
b
y
m
a
r
k
e
t
v
a
l
u
e
o
f
e
q
u
i
t
y
,
a
n
d
a
s
s
i
g
n
e
d
t
o
o
n
e
o
f
t
h
e

v
e
e
q
u
a
l
l
y
s
i
z
e
d
p
o
r
t
f
o
l
i
o
s
;
t
h
e
n
w
i
t
h
i
n
e
a
c
h
b
o
o
k
t
o
m
a
r
k
e
t
p
o
r
t
f
o
l
i
o
s
t
o
c
k
s
a
r
e
a
s
s
i
g
n
e
d
t
o
o
n
e
o
f
t
h
e
s
i
x
m
a
r
k
e
t
v
a
l
u
e
p
o
r
t
f
o
l
i
o
s
;
w
i
t
h
i
n
e
a
c
h
3
0
b
o
o
k
t
o
m
a
r
k
e
t
a
n
d
m
a
r
k
e
t
v
a
l
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e
o
f
e
q
u
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t
y
p
o
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t
f
o
l
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s
t
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c
k
s
a
r
e
a
s
s
i
g
n
e
d
t
o
o
n
e
o
f
t
h
e
t
h
r
e
e
1
2
-
m
o
n
t
h
b
u
y
-
a
n
d
-
h
o
l
d
r
e
t
u
r
n
p
o
r
t
f
o
l
i
o
s
;

n
a
l
l
y
,
m
e
d
i
a
n
r
e
t
u
r
n
i
s
m
e
a
s
u
r
e
d
o
v
e
r
a
y
e
a
r
f
r
o
m
J
u
l
y
o
f
y
e
a
r
k
t
o
J
u
n
e
o
f
y
e
a
r
k

1
f
o
r
e
a
c
h
c
o
n
t
r
o
l
p
o
r
t
f
o
l
i
o
;
R
&
D
/
S
a
l
e
t
i
s
r
e
s
e
a
r
c
h
a
n
d
d
e
v
e
l
o
p
m
e
n
t
e
x
p
e
n
s
e
d
i
v
i
d
e
d
b
y
s
a
l
e
s
r
e
v
e
n
u
e
;
A
d
v
/
S
a
l
e
t
i
s
a
d
v
e
r
t
i
s
i
n
g
e
x
p
e
n
s
e
d
i
v
i
d
e
d
b
y
s
a
l
e
s
r
e
v
e
n
u
e
;
C
a
p
e
x
/
S
a
l
e
s
t
i
s
c
a
p
i
t
a
l
e
x
p
e
n
d
i
t
u
r
e
s
d
i
v
i
d
e
d
b
y
s
a
l
e
s
r
e
v
e
n
u
e
;
S
a
l
e
s
t
i
s
s
a
l
e
s
r
e
v
e
n
u
e
;
L
o
g
S
a
l
e
s
t
i
s
n
a
t
u
r
a
l
l
o
g
a
r
i
t
h
m
o
f
s
a
l
e
s
r
e
v
e
n
u
e
a
n
d

n
a
l
l
y
,
S
D
(
E
a
r
n
Q
)
t
i
s
s
t
a
n
d
a
r
d
d
e
v
i
a
t
i
o
n
o
f
q
u
a
r
t
e
r
l
y
e
a
r
n
i
n
g
s
b
e
f
o
r
e
e
x
t
r
a
o
r
d
i
n
a
r
y
i
t
e
m
s
s
c
a
l
e
d
b
y
q
u
a
r
t
e
r
l
y
s
a
l
e
s
f
o
r
p
r
i
o
r
t
h
r
e
e
y
e
a
r
s
Table III.
Perception of
rm strategy
101
M
o
d
e
l
a
:
T
o
b
i
n

s
Q
t

b
1
t
L
o
g

A
s
s
e
t
s

b
2
t
L
o
g

A
g
e

b
3
t
L
o
g

D
i
v
i
d
e
n
d
s

b
4
t
D
i
f
f
e
r
e
n
t
i
a
t
i
o
n
t

b
5
t
C
o
s
t
L
e
a
d
e
r
s
h
i
p
t

1
t
C
o
l
u
m
n
1
C
o
l
u
m
n
2
C
o
l
u
m
n
3
V
a
r
i
a
b
l
e
C
o
e
f
f
.
t
-
s
t
a
t
.
c
p
-
v
a
l
u
e
C
o
e
f
f
.
t
-
s
t
a
t
.
c
p
-
v
a
l
u
e
C
o
e
f
f
.
t
-
s
t
a
t
.
c
p
-
v
a
l
u
e
P
a
n
e
l
A
I
n
t
e
r
c
e
p
t
1
.
9
5
4
7
.
5
2
,
0
.
0
0
0
1
1
.
9
7
4
6
.
7
6
,
0
.
0
0
0
1
1
.
9
4
4
7
.
5
7
,
0
.
0
0
0
1
L
o
g
(
A
s
s
e
t
s
)
t
2
0
.
0
1
2
2
.
9
0
.
0
0
3
8
2
0
.
0
1
2
1
.
3
6
0
.
1
7
4
2
0
.
0
1
2
1
.
9
4
0
.
0
5
2
2
L
o
g
(
A
g
e
)
t
2
0
.
1
4
2
1
9
.
0
9
,
0
.
0
0
0
1
2
0
.
1
7
2
2
2
.
7
,
0
.
0
0
0
1
2
0
.
1
4
2
1
9
.
6
9
,
0
.
0
0
0
1
L
o
g
(
D
i
v
i
d
e
n
d
s
)
t
0
.
1
2
2
9
.
7
,
0
.
0
0
0
1
0
.
1
2
2
9
.
6
2
,
0
.
0
0
0
1
0
.
1
2
2
9
.
5
4
,
0
.
0
0
0
1
D
i
f
f
e
r
e
n
t
i
a
t
i
o
n
t
0
.
2
6
2
2
.
7
,
0
.
0
0
0
1
0
.
2
6
2
3
.
2
9
,
0
.
0
0
0
1
C
o
s
t
L
e
a
d
e
r
s
h
i
p
t
0
.
0
3
7
.
1
1
,
0
.
0
0
0
1
0
.
0
4
8
.
5
3
,
0
.
0
0
0
1
N
b
3
0
,
5
0
2
3
0
,
5
0
5
3
0
,
4
9
9
R
2
2
2
.
5
7
2
3
.
8
8
2
3
.
8
8
F
-
v
a
l
u
e
d
3
6
5
.
5
(
,
0
.
0
0
0
1
)
P
a
n
e
l
B

i
n
d
u
s
t
r
y
a
d
j
u
s
t
e
d
s
t
r
a
t
e
g
y
c
o
n
s
t
r
u
c
t
s
I
n
t
e
r
c
e
p
t
1
.
9
1
4
6
.
5
6
,
0
.
0
0
0
1
1
.
9
6
4
6
.
7
7
,
0
.
0
0
0
1
1
.
9
0
4
6
.
4
5
,
0
.
0
0
0
1
L
o
g
(
A
s
s
e
t
s
)
t
2
0
.
0
1
2
3
.
1
1
0
.
0
0
2
2
0
.
0
1
2
1
.
2
3
0
.
2
2
0
2
0
.
0
1
2
2
.
0
2
0
.
0
4
3
1
L
o
g
(
A
g
e
)
t
2
0
.
1
3
2
1
8
.
5
2
,
0
.
0
0
0
1
2
0
.
1
7
2
2
2
.
6
8
,
0
.
0
0
0
1
2
0
.
1
4
2
1
9
.
1
3
,
0
.
0
0
0
1
L
o
g
(
D
i
v
i
d
e
n
d
s
)
t
0
.
1
2
2
9
.
9
2
,
0
.
0
0
0
1
0
.
1
2
2
9
.
6
6
,
0
.
0
0
0
1
0
.
1
2
2
9
.
9
3
,
0
.
0
0
0
1
D
i
f
f
e
r
e
n
t
i
a
t
i
o
n
t
0
.
2
6
2
2
.
4
4
,
0
.
0
0
0
1
0
.
2
6
2
3
.
2
1
,
0
.
0
0
0
1
C
o
s
t
L
e
a
d
e
r
s
h
i
p
t
0
.
0
4
7
.
9
2
,
0
.
0
0
0
1
0
.
0
5
1
0
.
1
2
,
0
.
0
0
0
1
N
b
3
0
,
5
0
6
3
0
,
5
0
6
3
0
,
5
0
7
R
2
2
2
.
3
6
1
6
.
9
0
2
2
.
4
7
F
-
v
a
l
u
e
d
3
6
4
.
8
2
(
,
0
.
0
0
0
1
)
N
o
t
e
s
:
a
Y
e
a
r
c
o
n
t
r
o
l
s
(
a
n
d
i
n
d
u
s
t
r
y
c
o
n
t
r
o
l
s
a
s
w
e
l
l
i
n
P
a
n
e
l
A
)
i
n
c
l
u
d
e
d
i
n
t
h
e
e
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Table IV.
Market perception
of rm strategy
MF
39,2
102
that the market places a positive value on rms pursuing a cost leadership strategy.
Together, the results of columns 1 and 2 show that as per H1, the market placed a
positive value on rms pursing either a differentiation or a cost leadership strategy. In
column 3, we regress TQ
t
against both strategy proxies simultaneously. Both
Differentiation
t
(estimated coefcient 0.26; t-stat. 23.29) and Cost Leadership
t
(estimated coefcient 0.04; t-stat. 8.53) retain their signs and statistical
signicance. Moreover, the magnitudes of the coefcients in column 3 do not change
substantially from columns 1 and 2. Regressing both coefcients together enables us to
compare the differential impact of the two strategies on TQ
t
. Aformal comparison of the
two coefcients using Walds F-test enables us to reject the null hypothesis of equality at
a probability of less than 1 percent. The results show that in accordance with H2, the
market places greater emphasis on rms pursuing a differentiation strategy compared
to rms pursuing a cost leadership strategy. As discussed earlier, this may be due to the
potential ease with which a cost leadership strategy could be replicated compared to a
differentiation strategy.
The control variables show a negative relationship between Tobins Q and rm size
and also Tobins Q and rm age. This potentially indicates the markets perception of
lack of future growth opportunities for large older rms compared to their more dynamic
younger and smaller counterparts (Evans, 1987). The results also show a positive
relationship between Tobins Q and dividends, indicating that markets prefer high
dividend payouts. The variance ination factors (VIF) indicate that multi-collinearity is
not a problem in any of the regressions. Panel B tabulates the results of our analysis
when we include industry adjusted scores of the strategy measures. These results are
very similar to our main results conrming the robustness of our results.
4.3 Abnormal returns and rm strategy
The results discussed in Table IV indicate that the market places a premium on both
the differentiation and the cost leadership strategies; however the premium placed on
rms pursuing differentiation strategy is higher than on rms pursuing a cost
leadership strategy. We conduct additional analysis on this by forming portfolios
based on the extent to which rms pursue these strategies. First, we compute abnormal
returns for each rm by taking the difference between the 12-month returns of
individual rms and the median returns of its control portfolio (based on size, book to
market ratio and returns momentum). Next, we form ve portfolios based on the extent
of differentiation of the rm and compute the difference between the mean returns of
the portfolio with the highest Differentiation and the portfolio with the lowest
Differentiation. The portfolio return differences are computed for t 1, t 2 and t 3
years, respectively, with t being the current year. The same process is repeated with
portfolios based on the extent of cost leadership as well.
The results of our portfolio analysis tabulated in panel A of Table V show that high
differentiation portfolios signicantly outperform their high cost leadership portfolio
counterparts. The difference between the highest differentiation and the lowest
differentiation portfolios yields an abnormal return of 5.76 percent in the rst year after
portfolio formation, 5.41 percent in the second year after portfolio formation and
4.47 percent in the third year after portfolio formation. All of the returns are statistically
signicant, implying that high differentiation rms earn statistically signicant
abnormal returns compared to low differentiation rms, whereas such a relationship
Perception of
rm strategy
103
does not exist for high/low cost leadership rms. The difference in the returns for the
high/low cost leadership portfolios are statistically insignicant in all the three years;
moreover the magnitudes are less than or equal to half a percentage. The results indicate
that high differentiation rms generate signicant abnormal returns over a three year
windowcompared to lowdifferentiation rms, whereas such is not the case for high/low
cost leadership rms. We conducted similar analysis using industry adjusted scores of
the strategy measures. The results tabulated in panel B of Table V are qualitatively
similar to the results in panel A, conrming the robustness of our results. The results in
Tables IVandVtogether indicate that eventhough the market places a premiumonhigh
differentiation rms (Table IV), the market is still not fully pricing the superior future
performance of high differentiation rms as evidenced by the ability of high
differentiation rms to earn abnormal returns over the next three years (Table V). On the
other hand, the market, while placing a current premium on high cost leadership
rms (Table IV), appears to fully price the superior performance of high cost leadership
rms as evidenced by the lack of future abnormal returns by high cost leadership rms
(Table V). These two facts point to the complexity of a differentiation strategy which
may lead to:
Differentiation (t-statistic) Cost Leadership (t-statistic)
Period High Low Difference High Low Difference
Panel A
t 1 years 9.02%
* * *
3.27%
* * *
5.76%
* * *
4.81%
* * *
4.39%
* * *
0.42%
(11.62) (6.30) (6.16) (7.58) (7.58) (0.50)
t 2 years 6.55%
* * *
1.14%
* * *
5.41%
* * *
3.00%
* * *
2.50%
* * *
0.50%
(9.05) (2.13) (6.01) (4.38) (4.73) (0.58)
t 3 years 5.37%
* * *
0.90%
* * *
4.47%
* * *
1.66%
* * *
1.89%
* * *
20.23%
(8.58) (1.68) (5.43) (2.75) (3.75) (20.29)
Panel B industry adjusted strategy quintiles
t 1 years 6.84%
* * *
4.90%
* * *
1.94%
* * *
5.00%
* * *
4.60%
* * *
0.40%
(10.31) (8.35) (2.19) (9.29) (8.25) (0.51)
t 2 years 4.65%
* * *
2.35%
* * *
2.21%
* * *
3.33%
* * *
2.87%
* * *
0.45%
(6.81) (4.14) (2.60) (5.18) (5.26) (0.54)
t 3 years 3.53%
* * *
1.95%
* * *
1.59%
* * *
2.50%
* * *
2.05%
* * *
0.45%
(6.07) (3.33) (1.93) (4.31) (3.88) (0.58)
Notes: The coefcient is statistically signicant at:
*
10,
* *
5,
* * *
1 percent signicance levels;
portfolios are formed on the basis of strategy quintiles in period t; Hedge portfolios are formed by
going long on the portfolio consisting of the highest quintile of rms, and going short on the lowest
quintile of rms; denitions; AbnormalRet
k
is abnormal returns for year t 1 to year t 3; future
abnormal return for a rm is computed as the difference between the year k (k t 1, t 2, t 3)
return of the rm, measured over a year from July of year k to June of year k 1, and the median
return of its control portfolio; at the end of June of each year t 1, control portfolios are formed based
on market value of equity, book to market ratio and 12-month buy-and-hold returns; all NYSE/AMEX/
Nasdaq stocks are ranked by their book to market ratio (book value of equity divided by market value
of equity, and assigned to one of the ve equally sized portfolios; then within each book to market
portfolio stocks are assigned to one of the six market value portfolios; within each 30 book to market
and market value of equity portfolio stocks are assigned to one of the three 12-month buy-and-hold
return portfolios; nally, median return is measured over a year from July of year k to June of year
k 1 for each control portfolio
Table V.
Abnormal returns
generated on hedge
portfolios based on the
extent to which rms
pursue the differentiation
and cost leadership
strategies
MF
39,2
104
(1) high market premium due to difculty in replicating by competitors; and
(2) underpricing by the market.
We also perform multivariate analysis of three-year abnormal future stock returns to
conrm that the results we observed in Table V are robust to other variables that may
not have been adequately controlled for by the procedure employed (Lyon et al., 1999;
Henderson et al., 2010) to compute abnormal returns. The results of the model (2) are
shown in Table VI below. As in Table IV, the standard errors have been corrected for
heteroskedasticity, serial- and cross-sectional correlation using a two-way cluster at
the rm and year level (Petersen, 2009).
Column 1 of Panel A tabulates the results of AbnormalRet
t
(abnormal returns)
regressedagainst DifferentiationD
t
(adummyvariable denedas equal to 1 if the rmis in
the top quintile of the differentiation variable, 0 otherwise) and Cost LeadershipD
t
(a dummy variable dened as equal to 1 if the rm is in the top quintile of the cost
leadership variable, 0 otherwise) and other control variables that may potentially impact
long termreturns. The control variables are R&Dexpenses, advertising expenses, capital
expenditure and sales. The results in column 1 conrm those of Table V and show that
even after controlling for variables that may potentially impact abnormal returns, the
DifferentiationD
t
variable is positive and signicant (estimated coefcient 0.083;
t-stat. 7.29) indicating that the high differentiation portfolio continues to earn
statistically signicant returns, due to mispricing of the differentiation strategy. Further
conrming the results in Table V, Cost LeadershipD
t
is insignicant (albeit positive),
indicating that there is no mispricing of the cost leadership strategy. Column 2 shows
results of AbnormalRet regressed against the strategy variables, control variables
discussed in Column 1 and in addition, earnings volatility SD(EarnQ)
t
which is calculated
as the standard deviation of quarterly earnings before extraordinary items scaled by
quarterly sales for prior three years, and proxies for earnings risk. To conrm that our
results are not driven by omitted risk factors, we estimate the model with and without the
total risk measure, SD(EarnQ)
t
. Our results remain qualitatively similar to column 1 with
the alternative specications. As in Table IV, VIF show that multi-collinearity is not a
problem. Again, the results using industry-adjusted strategy factor scores tabulated in
Panel B conrm those discussed in Panel A validating the robustness of the results.
Taken together, the results of Tables IV-VI conrm our two hypotheses. The results
show that the market places a premium on rms that pursue either of the strategies;
however the results also indicate that the premium is greater for rms pursuing a
differentiation strategy compared to rms pursuing cost leadership strategy.
Furthermore, the results of our analysis show that the market initially fails to fully
price a differentiation strategy, leading to abnormal returns for rms that pursue a
higher level of differentiation.
4.4 Sensitivity analysis
Alternative formulation for rm strategy. As a sensitivity analysis, we rst compute
dummy variables based on our strategy measures, so that a rm could be classied as
following one or the other of the strategies. Hence for each rm, we create dummy
variables Differentiation
t
_D and Cost Leadership
t
_D, based on whether its
differentiation (cost leadership) score is above or below the 50th percentile. Next, we
re-estimate model (1) by replacing the continuous independent variables with the
Perception of
rm strategy
105
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N
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3
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(
,
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0
1
)
(
c
o
n
t
i
n
u
e
d
)
Table VI.
Abnormal returns
regressed against rm
strategy and relevant
control variables
MF
39,2
106
M
o
d
e
l
a
:
A
b
n
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D
(
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a
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n
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d
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n
a
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s
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c
a
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b
y
q
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a
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l
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f
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p
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r
t
h
r
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y
e
a
r
s
Table VI.
Perception of
rm strategy
107
dummy variables Differentiation
t
_D and Cost Leadership
t
_D. Untabulated results of
the analysis are qualitatively similar to the ndings in Table IV providing credence
that our ndings are robust to alternative specication of the strategy variable.
As an additional renement of the above analysis, we compute four additional, more
rened dummy variables, HighDfHighC
t
, HighDfLowC
t
, LowDfHighC
t
, and
LowDfLowC
t
. HighDfHighC
t
is a dummy variable equal to 1 if the rm is above the
50th percentile for both differentiation and cost leadership scores and 0 otherwise.
HighDfLowC
t
is a dummy variable equal to 1 if the rm is above the 50th percentile for
differentiation and below the 50th percentile for cost leadership scores and 0 otherwise.
LowDfHighC
t
is a dummy variable equal to 1 if the rm is below the 50th percentile for
differentiation and above the 50th percentile for cost leadership scores and 0 otherwise,
and nally LowDfLowC
t
, is a dummy variable equal to 1 if the rm is below the
50th percentile for both differentiation and cost leadership scores and 0 otherwise.
We re-estimated model (1) by replacing the two continuous independent variables with
the rst three dummy variables described above. Untabulated results show that all
three independent variables are positive and signicant. However, HighDfLowC
t
shows the largest magnitude, implying that performance is highest for rms that
concentrate on a differentiation strategy. Overall, the sensitivity analyses conrm the
robustness of our results to alternative model specications.
Control for rm-specic effects. Our main research hypothesis is to examine the
strategy-market performance linkage as a cross-sectional phenomenon. While there are
substantial differences in strategy across rms, strategy is a long-term phenomenon
and rms are not likely to change their orientation on a year-to-year basis; accordingly
strategy does not vary much over time within the same rm. In this regard we note
that the average correlation with lagged strategy measures is 0.99 for both
differentiation and cost leadership. Similar to the context of managerial ownership in
nance, most of the variation in our study also occurs in the cross-section rather in the
time-series. Hence, using rm xed effects will not be appropriate in our context and, if
used, can lead to erroneous conclusions (Beck, 2001; Baltagi, 2001; Wooldridge, 2002;
Hsiao, 2003). Accordingly we do a sensitivity analysis including prior performance as
an independent variable in our main empirical models. This helps to capture
rm-specic effects that do not change over time. The results of our estimations with
prior performance included in the model are tabulated in Table VII and are
qualitatively similar to our main results.
Impact of diversication. Our rms being large for the most part, operate in more
than one line of business (i.e. are diversied). Consequently, it is possible that
subsidiaries follow differing strategies across the cost leadership/differentiation
continuum. However, since we are looking at the market perception of the strategy
pursued by rms (as a whole), capital markets will typically react to the rm as a
whole, hence the overall or blended strategy is relevant. In Table VIII we tabulate the
results of our analysis incorporating the effect of diversication in our estimation
model. The results indicate that the market perception of the strategy pursued by a
rm is not impacted by the rms degree of diversication. This result signies that
investors consider rms overall strategy, not their strategy in individual sub-business
segments. We believe (and as is indicated by the results of our analysis) that
diversication strategy and the rm strategies of differentiation or cost leadership are
independent of each other. We acknowledge that there may be interesting insights
MF
39,2
108
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Table VII.
Market perception of rm
strategy controlling for
rm-specic effects
Perception of
rm strategy
109
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Table VIII.
Market perception of rm
strategy and effect of
diversication
MF
39,2
110
from a study that explores the three-way interactions between diversication, rm
strategy and performance. This however is beyond the scope of our study and could be
explored in future studies.
5. Conclusions and discussion
Porter (1980) and Hambrick (1983) posit that rms pursuing either a cost leadership or
a differentiation strategy are better able to gain competitive advantages and
accordingly achieve superior performance over competitors. In this paper we evaluate
how capital markets evaluate the strategic positioning of the rms. According to the
efcient market hypothesis, all relevant information about a rm (or stock) is
incorporated in the stock price. Accordingly, capital markets would place a positive
value on a rm pursing either a differentiation or a cost leadership strategy. In this
study, we investigate the market pricing of the strategic orientations of rms, and
further whether there is any potential mispricing of the strategies.
We use the Balsam et al. (2011) methodology to develop proxy variables for the two
types of strategies pursued by rms. These variables capture the strategic positioning
of the rms using publicly available data. We regress these strategy variables against
Tobins Q which is a widely accepted measure of markets perception of value
(Morck et al., 1988; Yermack, 1996; Brown and Caylor, 2006). We further compare the
abnormal returns based on portfolios of high differentiation (cost leadership) rms
with those of low differentiation (cost leadership) rms. For our nal analysis, we
regress abnormal returns against the strategy variables and additional control
variables. We nd that Tobins Q is positively and signicantly related to both the
differentiation and the cost leadership. However, the coefcient of differentiation is
signicantly larger than that of cost leadership. Thus, our results indicate that capital
markets place a higher premium on rms pursuing both cost leadership and
differentiation. However, it places a greater premium on differentiators compared to
cost leaders. We also nd that a portfolio made up of high differentiators will generate
positive and signicant abnormal returns compared to a portfolio of low
differentiators. However, we do not observe similar results for cost leaders. The
difference in abnormal returns for the high and low cost leader portfolios is statistically
insignicant. Similar results are observed in a multivariate analysis of abnormal
returns. These results again conrm the premium placed on rm strategy, especially
differentiation. Moreover, they show that although the market places a premium on a
differentiation strategy, the market still underprices differentiation, which leads to
abnormal returns in the future. The higher premium initially placed on differentiators
by the market shows recognition of the difculty of copying a successful
differentiation strategy. The underpricing by the market again points to the
complexity of a differentiation strategy and shows that even sophisticated capital
markets are unable to fully comprehend the protability of a successful differentiation
strategy.
This paper has several important contributions. First we point to the importance of
successfully following a competitive strategy in order to generate shareholder returns.
Second, we show that markets value both differentiation and cost leadership strategies
when successfully implemented. However, the market places a greater premium on
differentiators pointing to greater sustainability of a differentiation strategy. Third, we
demonstrate that markets systematically underprice a differentiation strategy.
Perception of
rm strategy
111
Leading directly from our third contribution, our fourth contribution is to demonstrate
an additional strategy to earn abnormal returns. A portfolio of either high
differentiation rms or high cost leadership rms will generate abnormal returns with
the former generating greater returns.
Our study has several implications for corporate managers, nancial analysts and
investors. Corporate managers of rms that follow differentiation strategies should
provide sufcient information to the market to enable it to form a better understanding
of the future potential of the rm. This will eventually reduce the cost of capital for
such rms. Financial analysts too should be aware of the strategy being followed by
rms since analysts are the nancial intermediaries who will interpret information
provided by rms. Finally, our study provides investors with another investment
strategy for earning abnormal returns.
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About the author
Ozer Asdemir is an Assistant Professor of at University of St Thomas. Dr Asdemir earned his
PhD in Management Science with a concentration in Accounting from the University of Texas at
Dallas in 2005. His research interests include intangibles and R&D valuation, impact of nancial
intermediaries on intangible valuation, impact of investor sophistication and informed trading
on intangible valuation, impact of accounting information quality on valuation.
Guy D. Fernando is an Assistant Professor at the State University of NewYork at Albany. He
obtained his PhD in Business Administration (Accounting) from Syracuse University in 2007.
His research interests cover many areas including agency theory, performance measurement,
information quality, productivity measurement, etc. He has published in the Journal of Business
Research, Advances in Accounting, International Journal of Accounting Auditing and
Performance Evaluation and the Review of Accounting and Finance. Guy D. Fernando is the
corresponding author and can be contacted at: gfernando@albany.edu
Arindam Tripathy is an Assistant Professor at the Milgard School of Business, University of
Washington Tacoma. His research interests are also in the area of management accounting
and auditing encompassing issues at the intersection of accounting, nance and business
strategy. His work has been published in premier academic journals including Auditing: A
Journal of Practice and Theory, Journal of International Business Studies and Journal of Business
Research. He worked as an auditor and a management consultant prior to pursuing his PhD from
the University of Texas at Dallas.
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