Newswise — Successful strategies are innovative. They combine resources or businesses in unique or complex ways that other firms may fail to recognize. Yet research from the Olin School of Business at Washington University finds that the market actually tends to undervalue companies with complex or unique strategies. The reason: they receive less analyst coverage.
"Firms pursuing more complex or unique strategies receive less market notice as measured by analyst attention," says Todd Zenger, the Robert and Barbara Frick Professor Business Strategy. "Analysts find such strategies too costly to cover, leaving the market with limited information about their stocks. As a consequence, the stocks are discounted in the market."
Investment banks have little incentive to employ extra resources to cover complex or unique strategies, Zenger says. Yet, providing accurate analysis of a complex or unique strategy often requires the use of multiple analysts with differing specialties. The returns that analysts or their employers receive from being accurate are often insufficient to overcome the added costs of thorough coverage. So when the strategy is too complicated or unique, coverage drops, resulting in a decline in market value.
"Our results suggest CEOs often face a significant paradox in choosing strategy because of this," Zenger says. "They may have to choose between a complex, difficult to analyze strategy which in the long run delivers the strongest financial returns, but in the short receives a discount, and a transparent, simple strategy that yields more limited returns in the long run, but is more accurately and highly valued in the short run."
These results provide an alternative explanation for the long term trend away from conglomeration and toward more focused firms. In truth, diversified corporations have not disappeared, they have merely transformed into private equity firms, which, of course, have no need for market analysts, Zenger says.
"If the market is structured to not fully reward the value inherent in unique or complex strategies, then it's problematic in the sense that analysts end up discouraging strategic innovation, and ultimately value creation."
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