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Stock Market Reaction to Strategic Investment Decisions Author(s): J. Randall Woolridge and Charles C. Snow Source: Strategic Management Journal, Vol. 11, No. 5 (Sep., 1990), pp. 353-363 Published by: Wiley

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Strategic Managemnent Journal,

Vol. 11, 353-363

(1990)

STOCK MA/ARKETREACTION TO STRATEGIC INVESTMENT DECISIONS

  • J. RANDALL WOOLRIDGE and CHARLES C. SNOW

College of Business Administration, The Pennsylvania State University, University Park, Pennsylvania, U.S.A.

This study examines the stock malrket's reaction to pu blic anlnolulnilceml elnts of corporate

strcategicinvestmnent decisionis. It inicludes a wiide variety of strategic decisions. formnation of

joinlt yentires, researclh anid development projects, mai(jor caipital expenditures, and

diversificationi into nemiproducts -andlormai(irkets. Tb-iee alternative hypotheses conicerninig

tize stock mrlcarket's reaction to cannlounlcemiienits of tlhese decisions are tested. The Shliarelholder

Value Maximilzation hiypothlesispredicts capositive recactioni to corporate inv'estmentsbecause

the stock malrket reivards naczlageis for developing strategies tlhaitincrease slar-e/holder

wealth. The Rational Expectations hypothesis predicts nio stock price reactioni becautse

investors expect miianiagersto uidertake periodic investments in order to miainitaintheir firmls'

competitive fitness. The InistitutionialInvestors hypothesis predicts a negative reactioni to

anniiounlcemiienits of

corporate investmnents. The U. S. capital mai(irketsare domllilated by

institutional investors who, in pursuit of superior quarterly performance, may disdaini lonlg-

term-lin vestments becalse they reduce short-ternieearnlinlgs. Analysis of 767strategic in vestment

decisions anniiounlcedby 248 comiipaniiesin 102 industries indicates that the stock mwarket's

reactionito strategic investmnentsconlforms miiostclosely to the predictions

of the Shareholder

Value Maximiization hypothesis. This overall finding holds for investments of varying size

and(iduration. The imiiplicationisof a positive reactioni by the stock mrlrxrketto investment

announcements are drawniifor corporate strategy reseairchanld mii(iiangemiienit practice.

For over a decade, American managers have been urged to make investment decisions that improve the long-run competitiveness of their firms (e.g. Hayes and Abernathy, 1980). Advo- cates of this view frequently point to examples of Japanese managers deliberately sacrificing short-run profits in order to gain substantial market shares for their companies. Many Amer- ican managers, however, argue that it is difficult to adopt a long-run perspective in today's business environment. The biggest obstacle to long-run or strategic decision-making, they claim, is the stock market. For example, in a survey of 100 chief executive officers of major corporations, 89 agreed that America's competitive edge has been 'dulled' by failure to emphasize long-term investment. Ninety-two percent of this group believed that Wall Street's preoccupation with

quarterly earnings was the cause (Wall Street Jourtial, 1986). Are American managers forced to manage for the short-term in order to meet the demands of Wall Street? In other words, do they make long- term investments that increase the satisfaction of all their firms' stakeholders, or do they merely take actions that result in short-run profitability in order to please securities analysts? This distinction has been drawn very clearly in the business press. Some writers have claimed that the stock market forces managers to take a short- run view in their decision-making (e.g. Blusiniess Week, 1984; Drucker, 1986; Pennar, 1986). Conversely, others have maintained that man- agers can develop long-run strategies for their companies that will be rewarded by the stock market (e.g. Hector, 1988). However, to date,

0143-2095/90/060353-11$05.50

?

1990 by John Wiley & Sons, Ltd.

Received11 Septemiiber1987

Finialrevisioni received 3

November1989

  • 354 J. R. Woolridge and C. C. Snow

neither view has been solidly grounded in empirical research. The present study attempts to provide such evidence by examining the stock market's reaction to the announcements of a wide variety of strategic decisions.

THEORETICAL BACKGROUND

Strategic investments and competitive advantage

In perfectly competitive factor and product markets, strategic investment projects with posi- tive (or negative) net present values are nonexist- ent. If a strategic investment is perceived to have a positive net present value, then it instantly attracts new entrants to the industry. This in turn increases factor prices and capacity and drives product prices down. Higher factor prices and lower product prices reduce returns to all firms, forcing the weaker ones to leave the industry. With fewer competitors, factor prices decline and product prices rebound, increasing returns for the surviving firms until once again actual and required returns are equal. Therefore, strategic investment decisions with positive net present values have no sustainable competitive advantage. The ability of strategic investment decisions to generate positive net present values rests on imperfections in product and factor markets that permit a firm to gain a competitive advantage over other firms in the industry. A firm can gain competitive advantage, for example, by becoming the low-cost producer, differentiating its product or service, and/or situating itself as a profitable link in an industry's value chain (Porter, 1980, 1985). Competitive advantages form barriers to potential entrants and result in an imperfectly competitive industry in which strategic investment decisions with positive net present values are possible (Shapiro, 1985).

Strategic investments and stock valuation

Accordingto

traditionalvaluation theory, the market

value of the firm is the sum of (a) the discounted

value of future cash flows expected to be

generated from assets in place and (b) the

net

present value of expected

cash flows from

investment opportunities that are expected to be available to and undertaken by the firm in the future (Brealey and Myers, 1988). The value of a firm changes as the stock market receives

general or firm-specific information that changes the market's expectations about the cash returns from current and future assets. The pricing efficiency of the stock market has been one of the most studied topics in corporate finance. The vast majority of the empirical research supports the belief that the market is informationally efficient with respect to publicly available information (Brealey and Myers, 1988). This means that stock prices reflect all public information and respond rapidly to releases of new information that may affect the risk and return of securities. This phenomenon is normally examined by assessing the reaction of stock prices to corporate events. For example, many studies have shown that stock prices adjust upward (downward) to increases (decreases) in dividend payments on the day of the announcement and fluctuate in a random fashion thereafter (Brealey and Myers, 1988), indicating that the information in the dividend announcement is fully reflected in the stock price on the day of the announcement. Thus, in an informationally efficient market, stock price responses to corporate announcements represent the market's evaluation of corporate decisions. However, to isolate the effect of a particular firm's announcement, its security return must be adjusted for the expected return on the stock. The actual return, minus the expected return, is called the 'abnormal' or 'excess' return. Recent financial theory posits that managers are compelled by capital market forces to make investment decisions aimed at maximizing firm value (Fama and Jensen, 1985; Rappaport, 1986; Reimann, 1987). According to this view, accounting-based performance measures such as earnings per share, return on investment, and return on equity do not properly measure the value of managers' investment decisions. The true test of the long-run value of an investment decision is whether it creates economic value for shareholders as measured by abnormal stock returns (Rappaport, 1986). Therefore, the Share- holder Value Maximization1 hypothesis predicts that the stock market will react positively to corporate announcements of strategic investment decisions. Such decisions increase a firm's market value by enhancing its ability to generate future cash flows. An alternative hypothesis, which we call the InstitutionialInvestors hypothesis, makes exactly the opposite prediction from that of the Share-

Stock Market Reaction to Strategic Investment Decisions

355

holder Value Maximization hypothesis. It has been argued that U.S. investors-especially large, powerful financial institutions-focus primarily on quarterly earnings and thereby discourage managers from pursuing strategies aimed at long- term competitive advantage (Ellsworth, 1985). According to this view, much of the short-term orientation of the stock market comes from professional money managers such as pension and investment-fund managers and bank trust departments. Their short-run orientation is pre- sumably derived from their own requirements to make successful quarterly investment decisions in order to retain their current customers and attract new ones. Increased trading volume on the exchanges and higher turnover rates for institutional investment portfolios usually are cited as evidence in support of the short-run orientation. Managers who do not maintain quarterly earnings to satisfy institutional investors will see their companies' stock prices decline. They may then face the threat of hostile takeover offers from corporate raiders. Therefore, the Institutional Investors hypothesis predicts that announcements of corporate investment decisions with long-term, uncertain payoffs (such as research and development projects) will be associated with negative stock returns.' A third hypothesis, derived from the economic theory of perfect competition, might be called the Rational Expectations hypothesis. It predicts that the stock market will not react quickly or strongly to corporate announcements of strategic investment decisions. The logic of the Rational Expectations hypothesis is that across a variety of industries, companies, and strategic decisions, competitive advantages are at best temporary. If corporate investment announcements produced insignificant stock returns, then it would appear that investments serve to maintain competitive

' An alternative inter-pr-etationof negative stock returns is that managers may be engaging in activities with negative net present values. These may result from traditional agency problems in which managers' interests conflict with those of stockholders. For example, it has been argued that managel-s may enact mergers simply to increase the size of their firms rather than create value for stockholders (Malatesta, 1983). This would be especially true in the area of capital expenditures, since these appear on the balance sheet (unlike joint ventures or R&D expenditures). Therefore, the 'size maximization' hypothesis would be supported in the present study if stock prices are discovered to react negatively to capital expenditures announcements.

fitness rather than generate competitive advan- tage.

Empirical evidence

Strategic investment decisions are major commit- ments of current resources made in anticipation of generating future payoffs. By definition, such decisions involve a current resource outflow and an uncertain payback. Therefore, any significant

corporate investment depresses current earnings and increases uncertainty about the firm's future performance. Only three empirical studies have investigated the relationship between strategic investment announcements and stock prices. One study examined the relationship between joint- venture formation and announcement-day stock prices (McConnell and Nantell, 1985). It treated joint ventures as one type of capital expenditure, a special form of intercorporate 'merger,' in which only a subset of the resources of two (or more) firms are joined together to accomplish some strategic objective. The sample was 210 firms involved in 136 joint ventures during 1972-79. Joint-venture formations were positively and significantly correlated with announcement- day returns. This finding was consistent with the Shareholder Value Maximization hypothesis. Another study analyzed the relationship between research and development (R&D) pro- jects and stock prices (Jarrell, Lehn, and Marr, 1985). The sample was 62 R&D announcements

made in the Wall Street Journal

during 1973-83.

The primary hypothesis was that a negative stock price reaction to R&D expenditure announce- ments would support the 'short-term argument' or the Institutional Investors hypothesis. Research

and development announcements were found to be significantly associated with positive stock returns. This finding refuted the 'short-term argument' about the stock market. The third study examined the reaction of stock prices to 658 announcements of increases or decreases in the dollar amount of planned capital expenditures (McConnell and Muscarella, 1985). Announcements of increases (decreases) in capital budgets were significantly associated with positive (negative) abnormal stock returns for industrial firms but not for public utilities. The overall conclusion was that, for industrial firms, the stock market's reaction was consistent with the Shareholder Value Maximization hypothesis. For

356

J.

R.

Woolridge

and

C.

C. Snow

public utilities, on the other hand, regulatory pricing mechanisms reduced the likelihood that capital projects with positive net present values would be available. Thus, for three different types of strategic investment decisions (joint ventures, R&D pro- jects, and major capital expenditures), the empiri- cal evidence conforms most closely to the Shareholder Value Maximization hypothesis. That is, when corporations announce their stra- tegic investment plans, the stock market usually reacts positively. The present study attempted to add to this emerging research stream in three ways: (a) considerably expand the size of the empirical data base; (b) examine stock market reaction to an additional type of strategic decision (diversification into new products and/or markets); and (c) determine the impact on stock prices of two important contingency variables, the size and duration of corporate investments.

HYPOTHESES

There are three general hypotheses that pertain to the relationship between strategic investment announcements and stock market reaction. Each hypothesis has a corollary prediction concerning investment size and duration.

Hypothesis 1

(Shareholder

Value

Maximi-

zation): The stock market will react positively

to corporate announcements of strategic invest- ment decisions.

Hypothesis la: There will be positive abnor- mal returnsfor both small and large investments with little or nio difference between the two size categories. There will be positive abnormlal returns for both short- and long-term invest- ments with little or nio difference between the two duration categories.

Hypothesis 2 (Institutional Investors): The stock market will react negatively to corporate announcements of strategic in vestment decisions.

Hypothesis 2a:

There will be negative abnior-

mal returnsfor both small anldlarge investmenlts with large in vestments havinig greater niegative returnis.There will be negative abnormal returns for both short- and long-term investments with

long-term in vestmenits having greater negative returns.

Hypothesis 3 (Rational Expectations):

The

stock

market

will

not

react

to

corporate

announcements of

strategic investment

decisions.

 

Hypothesis 3a: There will be insignificant abnormal returns for all investments whether small, large, short-rtn, or long-run.

There is as yet no direct evidence that relates the size and duration of corporate investments to changes in stock price. The Shareholder Value Maximization and Rational Expectations hypotheses do not differentiate among corporate investments by either their size or duration. The former hypothesis predicts that all investments will be positively valued by the stock market; the latter hypothesis predicts no stock market response because investments are required to maintain competitive fitness. Because institutional investors are presumed to focus on short-term profitability, the Institutional Investors hypothesis predicts that the stock market will react negatively to larger and longer-term investments because (a) larger investments have a more detrimental effect on short-run profitability and (b) profits from longer-run investments will be realized in the more distant future.

METHODOLOGY

Data and sample

To examine the relationship between investment announcements and stock prices, a sample of corporate investment decisions was developed from articles that appeared in the Wall Street Joulrn-alduring June 1972-December 1987. This 15-year span showed substantial variation in economic activity and stock market behavior. The 'What's News' column of the paper was surveyed for announcements that described cor- porate investment decisions, specifically those pertaining to joint ventures, R&D projects, capital expenditures, and product/market diversi- fication. If an announcement was found in the 'What's News' column, then the full article was consulted to confirm the type of investment decision and to see whether other information about the company was also published. If the

Stock Market Reaction to Strategic Investment Decisions

357

announcement included information about the firm's sales or earnings, or if another announce- ment concerning the firm's sales, earnings, personnel changes, etc. appeared in the paper within one day (before or after) of the investment decision announcement, it was excluded from the sample. This procedure was used to minimize the effect of extraneous influences on stock prices. The final sample contained 767 announcements made by 248 companies in 102 industries.

Method of analysis

The impact of an event on the value of a firm's common stock is usually assessed by measuring the difference between the actual and expected returns on the stock during a relevant time period surrounding the event. The analytic method used in this study is known as the market-adjusted returns approach (MARA).2 Using this approach, the return for security i on day t (rit) is specified as:

rit =

Ui, +

ei,

where uit is the expected return on security i on day t, and ei, represents a stochastic error term that has an expected value of zero and is uncorrelated over time. Solving for eit in the above equation yields the following:

eit -=:: t'it-

uit

In MARA, ri, is the actual return on security i on day t, and uiit is estimated as the mean return on the stock market (the Standard and Poor 500) for day t. Since ut, is the expected return on security i on day t, the error term (ei,) represents the abnormal or unexpected return. Hence, the impact of new information on the price of security i on day t can be discovered through an evaluation of the ei, values. To investigate the effect of strategic investment announcements on stock prices, the sample of investment decisions was arranged in 'event time' around the day that the announcement appeared

2 This approach is a variant of the well-kinownievent-study methodology pionieered by Fama, Fisher, Jensen, anid Roll (1969). Brown and Warner (1985) have shown that the MARA is as powerfUl as other more restr-ictive models of expected stock returns in detecting significant stock price movement associated with specific events.

in the Wall Street Journal. In the analyses below, day 0 is the Wall Street Journal announcement date, and ei, represents the actual return on security i minus the return on the Standard and Poor 500 for that day. The average abnormal return (AR,) across announcements of strategic investment decisions (where the number equals n) for event day t is computed as follows:

AR,=

E

i=1

To assess information effects over time, these abnormal returns typically are cumulated over event days. The cumulative abnormal return (CAR,,) as of event day n is expressed as:

,,

CAR,, = E

AR,

All stock return data were obtained from the daily returns file of the Center for Research in Security Prices' (CRSP) data base.

RESULTS

Daily stock returns during a period surrounding the announcement of a corporate investment were analyzed for the four types of strategic decisions. In all cases, announcements appeard in the Wall Street Joturnialon day 0. However, most announcements actually were made prior to the close of trading on the previous day (day -1). Therefore, the mean and cumulative abnormal returns on these two days (-1 and 0) were used to evaluate the market's reaction to a strategic investment announcement. These two days are referred to as the 'announcement period.' In addition, returns were calculated for the succeeding two trading weeks in order to ensure that the full announcement effect was captured. The cumulative abnormal returns (beginning with day -1) are reported for days 5 and 10. Mean abnormal returns (AR), cross- sectional T-tests (T), and cumulative abnormal returns (CAR) are shown in Tables 1 and 2. For descriptive purposes, mean unadjusted returns (R) and the percentage of unadjusted returns greater than zero are also shown.

  • 358 J. R. Woolridge and C. C. Snow

All strategic investment announcements

Summary statistics for the daily stock returns of the entire sample of 767 strategic investment decision announcements are given in Section A of Table 1 for days -1, 0, 5, and 10. The average ARs for days -1 and 0-the announcement period-were 0.30 percent (T = 3.46, p < 0.01) and 0.35 percent (T = 4.55, p < 0.01), respectively. These were the two largest ARs over the 12-day period (-1 through 10). The CAR for the 2-day announcement period was

  • 0.64 percent. Through day 10, the CAR was 0.57

percent, which indicated that ARs subsequent to

the announcement period were negligible. The average unadjusted returns (Rs) were consistent

with these positive announcement-period results, with day -1 and 0 averages of 0.38 percent and

  • 0.35 percent, respectively, and a relatively higher

percentage of daily returns greater than zero. Whereas the T-tests indicate the statistical significance of the results, the practical or economic significance of these findings can be

illustrated in two ways. First, the annual return equivalent of a 2-day abnormal return of 0.64 percent is 220 percent. Second, the 0.64 percent abnormal return for a large company with a

market value of,

say, $25 billion, results in an

increase in market value (adjusted for overall market movements) of $160 million in 2 days.

The overall results strongly supported the Shareholder Value Maximization hypothesis. That is, when corporations announced their strategic investment decisions, the stock market usually reacted quickly and positively. In some cases, however, investors reacted negatively to corporate announcements of strategic decisions. Thus, it appeared that the stock market attempted to differentiate between good and bad investment decisions; it did not behave monolithically.3

Specific types of investment announcements

summary statistics for the daily stock returns associated with

Section

B

of

Table

1 contains

the

3 A negative reaction perhaps is best exemplified by the stock market response to oil companies' announcements of their exploration and development programs in the early 1980s. At that time the petroleum industry was generating tremendous cash flow from high crude oil prices and was investing the cash in expanded exploration and development. Investors, however, regarded the price of crude to be artificially high and therefore responded negatively to these R&D announcements.

the announcements of joint venture formations, research and development projects, captial expend-

itures, and product/market diversifications.

These broad investment decisions were further classified into appropriate subcategories as shown. Both the ARs and CARs indicated that the stock market responded positively to the announcement of joint venture formations. The ARs for days -1 and 0 were 0.42 percent (T = 2.45, p < 0.01) and 0.38 percent (T = 2.17, p < 0.05), respectively. There was no evidence of stock price declines during the 10 days following

the announcement of a joinlt venture (the CAR over the entire 12-day period was 1.27 percent). As shown in Table 2, joint ventures were formed for three main purposes: research and development, shared assets/resources, and asset construction. Of the three types of joint venture,

the 2-day CAR associated with firms that announced plans to share assets or other resources was the largest (1.40 percent). The ARs for days -1 and 0 of R&D projects were 0.80 percent (T - 2.36, p < 0.05) and 0.33 percent (T = 1.34, ns), respectively. There was no evidence of stock price declines for the subsequent 10 days, with the CAR growing from

  • 1.13 to 1.53 percent. As shown in Table 2, R&D

expenditures were announced for ongoing as well as new projects. The 2-day CAR associated with additional allocations to ongoing R&D programs was 1.68 versus 0.69 for allocations to new

projects. For the 277 announcements of major capital

expenditures, the ARs for days

-1 and 0 were

  • 0.06 percent (T = 0.38, ns) and 0.31 percent (T

= 2.64, p < 0.01), respectively. Between days 0 and 10, the CAR declined a mere 0.07 percent (from 0.36 to 0.29). As shown in Table 2, capacity expansion and capital budget increases were evaluated most positively by investors.4 The last part of Section B, Table 1 shows the daily stock returns associated with announcements of product and/or market diversification. For all 241 announcements the ARs for days -1 and 0 were positive (0.33 and 0.35 percent, respectively) =

and significant (T =

2.41, p

<

0.01

and T

2.59,

p

<

0.01,

respectively).

Between

days 0

and 10, however, the CARs declined; over the

4The positive returns associated with capital expenditure announcements, and especially the results for the capacity expansion subsample, did not support the size-maximization hypothesis discussed by Malatesta (1983)-see footnote 1.

Stock Market Reaction to Strategic Investment Decisions

Table 1.

Strategic investment announcements and stock returns

359

 

Day

Mean

Percentage

Mean

T-test

Cumulative

 

unadjusted

unadjusted

abnormal

(T)

abnormal

return

return greater

return

return

(R)

than zero

(AR)

(CAR)

Section

A:

Oveerall

results

All investment

announcements

(n=767)

 

-1

0.38

48.01

0.30

3.46**

0.30

0

0.35

51.74

0.35

4.55*

0.64

5

0.66

10

0.57

Section

B: Specific

types

of investmiient annouincements

 

Joint venture (n=197)

 

-1

0.55

50.25

0.42

2.45

0.42

0

0.40

52.79

0.38

2.17k'

0.80

5

1.05

10

1.27

R&D project (n=52)

 
 

-1

0.90

53.85

0.80

2.36

0.80

0

0.43

46.15

0.33

1.34

1.13

5

0.81

10

1.53

Capital expenditure

 

(n =277)

 

-1

0.12

41.52

0.06

0.38

0.06

0

0.23

50.54

0.31

2.64

'

0.36

5

0.63

10

0.29

Product/market

 

diversification (n=241)

 

-1

0.43

51.87

0.33

2.41* S

0.33

0

0.41

52.70

0.35

2.59"

0.69

5

0.26

10

0.01

entire 12-day period they were nearly zero. The results for the three subcategories old products targeted toward new markets, new products developed for old markets, and new products announced for new markets-are shown in Table 2. These results indicated that investors responded positively to new product introductions, both in new and old markets (2-day CARs of 0.86 and 0.78 percent, respectively), but not to expansion into new markets with old products (2-day CAR of -0.08 percent). However, one could argue that the latter type of diversification is the one most easily predicted by investors. Therefore, the fact that no significant price reaction was detected may indicate that investors anticipated such moves and stock prices already reflected this information.

Size and duration of investment

For some of the investment announcements, the Wall Street Journal article provided information on the size or the duration of the investment. In 365 of the 767 cases, information about the dollar size of the investment was given. To incorporate investment size into the analysis, the dollar amount of the investment was first divided by the total assets of the firm so that each investment was expressed as a relative percentage. Ihen the entire subsample of 365 investment announce- ments was dichotomized at the median (5.3 percent). This permitted the assessment of stock market reaction to announcements of small versus large investments (i.e. less than or greater than 5.3 percent of total firm assets).

360

J.

R.

Woolridge and C. C. Snow

Table 2. Strategic investment announcements and 2-

day cumulative abnormal returns

 

Number of

Two-day

announcements

cumulative

 

abnormal

returns

(percentage)

All investment

767

0.64

announcements

Joint venture formation

197

0.80

R&D

40

0.40

Shared assets/resources

68

1.40

Asset construction

89

0.52

R&D project

52

1.13

Ongoing

23

1.68

New

29

0.69

Capital expenditure

277

0.36

Capacity expansion

204

0.33

Plant modernization

36

0.13

Capital budget

37

0.75

increase

Product/market

241

0.69

diversification

Old product/new

30

-0.08

market

New product/old

168

0.78

market

New product/new

43

0.86

market

The expected life span or duration of a corporate investment was provided in 287 cases. This subsample was divided into two categories, short-term (less than 3 years) and long-term (more than 3 years), and the stock market valuation of each group was calculated. It should be noted that in both the size and duration subsamples, over 95 percent of the investments came from the R&D and capital expenditures categories. Very few joint venture and diversi- fication announcements contained size or duration information. Summary statistics for the stock returns on the size and duration subsamples are given in Table 3. The 2-day ARs for small and large investments were 0.37 percent (T = 2.95, p < 0.01) and 0.34 percent (T = 2.14, p < 0.05), respectively. The 2-day CARs for small and large investments were 0.47 and 0.46 percent, respectively, both of which were of substantial practical or economic import. The 2-day ARs for short- and long-term invest-

ments were 0.26 percent (T = 1.90, p < 0.05) and 0.46 percent (T = 2.21, p < 0.05), respectively. The 2-day CAR of long-term invest- ments (0.59 percent) was especially strong. Given that the stock market's reaction to small and large investments was positive and virtually identical, and that the market reacted positively and significantly to long-run investments, these results provided additional support for the Share- holder Value Maximization hypothesis and clearly refuted the Institutional Investors hypothesis.

DISCUSSION

The findings have several implications for strategic management research and practice. They indicate a very clear and strong relationship between strategic investment decision announcements and stock market valuation. However, the study dealt with stock market reactions to announcements of corporate decisions and not to the outcomes of those decisions. Using Mintzberg's (1978) terminology, announcements are intended strat- egies that can either be realized or unrealized. Further, intended strategies may be modified during implementation (Mintzberg and Waters, 1985; Quinn, 1980). It would be helpful for future researchers to track a set of announced decisions, determine the outcomes of those decisions, and attempt to assess when and by how much market valuation changed. Such research would measure the effectiveness of strategy implementation as well as formulation. In some cases the stock market reacted negatively to a firm's investment announcement. The market may have lacked confidence in that firm's strategy or future prospects, management's ability to implement the investment project successfully, or the timing of the proposed investment. Future research that sought to identify investment characteristics that differen- tiated positive from negative stock returns would help managers understand better how the market assesses strategic decision-making. From an economic standpoint the objective of corporate strategy is the selection of industries to participate in, whereas the purpose of business strategy is to achieve a sustainable advantage over competitors in an industry (Porter, 1985). The study of investment announcements can aid in understanding relationships among industry,

Stock Market Reaction to Strategic Investment Decisions

361

Table 3.

Size and duration of strategic investment announicements and stock returns

Day

Sectioni A: Investnmentsize

Small (n=183)

Large (n

182)

Short (n=194)

Long (n=93)

p <

0.05;*p

-1

0

-1

0

Sectioni B: Investment duiration

<

0.01.

-1

0

-1

0

Mean

Percentage

Mean

T-test

Cumulative

unadjusted

unadjusted

abnormal

(T)

abnormal

return

return greater

return

return

(R)

than zero

(AR)

(CAR)

0.17

43.2

0.11

0.84

0.11

0.33

50.3

0.37

2.95'

0.47

0.16

42.3

0.12

0.58

0.12

0.28

51.7

0.34

2.14

0.46

-0.02

43.3

-0.04

-0.22

-0.04

0.16

47.4

0.26

1.90

0.23

0.16

41.9

0.13

0.69

0.13

0.31

52.7

0.46

2.21

0.59

strategy, and firm performance. The apparent methodology for this type of research is a matched-pair sample of companies. Those com- panies that made investment decisions could be compared in key ways to competitors that did not make such decisions during the same time interval. Relevant matching factors might include type of industry, industry profitability, market shares of the matched firms, type of corporate strategy, type of investment announcement, and the business strategies of the units to which the announcement applies. This methodology would facilitate more fine-grained analyses of the stock market's reaction to corporate investment announcements. With the exception of capital expenditures, which can be undertaken by any type of firm, favorably received investment announcements tended to involve actions taken by firms that Miles and Snow (1978) called prospectors (early movers) and analyzers (fast followers). This was especially true of diversification decisions, where new product and market development generated significantly more returns than the extension of current products to new markets. Even though empirical studies have indicated that the stock market's assessment of information is unbiased and rational (Fama, 1970, 1976), analysts may generally prefer prospector and analyzer strat- egies over defender strategies. Future research could be directed at this issue. If this observation is found to be correct, then defender firms, which have been shown to be highly profitable (Hambrick, 1983), may need to engage in joint

ventures or other strategic alliances in order to be viewed more favorably by the stock market. The results of this study also have implications for practitioners. The most obvious implication is that managers of successful companies need not worry unduly about the stock market as they formulate corporate and business strategies. As evidenced in the diverse array of industries and companies examined in this study, announce- ments of large, long-run investment projects created, on average, substantial value for stock- holders. To be sure, managers cannot ignore the

market's expectations of short-run earnings, but it is clear that they are not being compelled to develop short-term strategies aimed only at producing profits. The stock market appeared to favor announce- ments regarding investments in R&D and joint ventures over those in product/market diversi- fication and capital expenditures. This suggests that the market may be in favor of lowering mobility barriers among firms because these forms of investment often involve alliances with other companies (including domestic or foreign competitors). Traditional business strategy is predicated largely on how firms within an industry should attempt to erect mobility barriers in order to achieve competitive advantages over their rivals (Caves and Porter, 1977). Managers have been encouraged to understand how firms in

their strategic group operate,

and to read the

signals and moves of firms in other strategic groups (Porter, 1980, 1985). In the future, managers may be able to generate greater returns

  • 362 J.

R.

Woolridge and C. C. Snow

 

by developing collective strategies (Astley, 1984),

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CONCLUSION

 

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'Some

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economy. The findings from this study indicate

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ACKNOWLEDGEMENTS

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