Constraints to Adoption of Innovation
Corporate Strategy, Analyst Coverage, and the Uniqueness Paradox
Managers generate economic value as they discover and create valuable resource and activity combinations. These combinations or strategies are then assembled by acquiring resources (activities, assets, or entire businesses) in strategic factor markets such as the market for corporate control at prices presumed as below their value in this new, strategic use. Beyond simple luck, a capacity to acquire assets at such “discounted” prices logically arises through one of two paths: 1) unique foresight about the value of alternative asset combinations or 2) an initial asset endowment that is uniquely complementary to other assets available in markets. In either case uniqueness in strategy choice, at least at the time of asset and resource acquisition, combined with some impediment to perfect replication are necessary conditions for deliberate value creation.
Managerial incentives to adopt unique, value-creating strategies, however, are only as effective as the capital market’s efficiency in accurately assessing the value of the strategies selected. In valuing strategies, actors in capital markets confront a significant information problem. Market participants may have weak incentives to fully uncover all information about a particular strategy. Managers are more proximate to information about the value of asset bundles than market participants. Indeed, if managers do not possess proprietary insights and instead, all opportunities are transparently obvious to the market, replication of strategies will occur and arbitrageurs will buy the resources required by the managers and sell them to the firms at prices near their value added in the manager’s strategy.
In this paper, the authors focus on constraints to the adoption of valuable innovation, specifically strategic innovation that stems from behavior in capital markets and the surrounding institutions that support them. While incentives clearly exist for market participants to uncover value in unique asset combinations, the sizable costs involved in generating detailed analysis cause investors to delegate this task to securities analysts employed by brokerage firms. A novel strategy elevates the effort costs faced by those who must conduct the evaluation. This elevated cost tempers incentives for analysis, leaving the market less informed about firms with costly-to-evaluate strategies.
If managers are patiently focused on the long run, the accuracy of the firm’s present valuations may have little bearing on the selection of strategy. However, present day valuations do have an important bearing on managerial rewards, managerial careers, and capital costs and are thus a likely focus of managers’ attention. Hence, we hypothesize that managers face a dilemma when choosing strategy: assembling a truly novel combination of resources that are “underpriced” due to unique foresight regarding value maximizes the expected value of cash flows from investment. However, such a strategic choice may require so much effort by the market to evaluate that the market remains uninformed, leaving equity prices to poorly reflect the future returns from the firm’s novel strategy. Thus, the market actually discounts the equity of firms pursuing novel strategies, relative to competitors with more common or familiar strategies. Managers therefore face what the authors define as a uniqueness paradox. They must choose between long run value maximizing strategies and strategies that are more easily assessed, but less valuable in the long run.
The objective of this paper is to empirically investigate this hypothesized tradeoff faced by managers in the context of corporate strategy choices. The authors empirically test propositions relating to the manager’s strategy choice tradeoffs using a panel dataset linking 7,630 firms between 1985 and 2007 with their corresponding analysts. They find results consistent with the existence of a strategic tradeoff. While on average, firms with novel strategies trade at a premium to those with common strategies, consistent with the argument in strategy literature about the necessity of uniqueness for value creation, these more unusual strategies receive less coverage by analysts. The reduced analyst coverage then creates a corresponding decrease in market valuation, consistent with our hypothesis that managers face a tradeoff when pursuing novel strategies.
Lubomir Litov is an assistant professor of finance with the Eller College of Management, University of Arizona. Patrick Moreton and Todd R. Zenger are with the Olin Business School, Washington University in St. Louis.
Published in Management Science.