Status and surprises: Causes of reaction to new information about firm performance

A wide range of evidence confirms that in markets characterized by high informational uncertainty a firm’s status position is a signal of that firm’s quality, and that resource holders are more likely to select and invest in high status firms. The central question of this paper is if status as a signal of the quality of the firm remains relevant when more informative data about the firm’s performance becomes public, and if so how is a firm’s status affecting market reaction to new information. To answer this question I draw from status literature, economics of information and signalling, and from decision making theory. I propose that under uncertainty investors are attentive to status as a signal of quality, but once new information becomes public there is a shift in attention from the content of the signal to the accuracy of the signal. I also propose that the perceived accuracy of the signal is positively correlated with the status position and that the reaction to surprises depends on the perceived accuracy. As a result the magnitude of the market reaction to new information is moderated by the status of the firm. I use this framework to analyze a phenomenon which has generated a wide debate across disciplines, that is the reaction to earnings announcements released by public firms at the end of the financial periods. I provide evidence that status magnifies the reaction to surprises by showing that the return on the stock of high status firms which deliver negative (positive) surprises is lower (higher) than the return on the stock of lower status firms which deliver similar results. Daniela Lup, Chicago GSB 2 Introduction The image of markets as socially constructed structures is one of the crucial insights that sociology has contributed to the understanding of economic activity (Blau 1964, Granovetter 1985, White 1981). One of the most compelling ideas growing from this body of research is that actors’ position in the social structures determines their opportunities and constraints by shaping others’ beliefs and actions toward them. A wide range of evidence confirms that social status is one of the key sources of differentiation in markets and that a high status position confers advantages and influence that often extend beyond the actor’s specific competencies (Podolny 1993, Benjamin and Podolny 1999, Stuart, Hoang and Hybels 1999). The existing literature proposes that this phenomenon is the consequence of a generalized assumption that status is a signal of quality. The most pervasive mechanism that explains the link between the status of an actor and its quality is association with prominent partners (Blau 1964:67, Podolny and Philips 1996, Stuart, Hoang and Hybels 1999, Podolny 2001, Higgings and Gulati 2003, Washington and Zajac 2005). Since most markets are characterized by informational uncertainty concerning the true worth of a firm market participants look at a firm’s relationships and assume a positive correlation between the quality of the firm and the prominence of its partners. The more prominent its partners are, the higher the status of the firm and consequently, the higher the perceived quality. While the metaphor of status as signal of quality provides a useful framework for explaining the discrepancy in advantages accrued to high status firms in settings characterized by high informational uncertainty it is not clear if status plays any role once information about the actual performance of the firm becomes public. This gap is Daniela Lup, Chicago GSB 3 surprising in the light of an increased quest for and availability of information that characterizes most markets. Even more puzzling is the fact that current theories propose contradictory answers to the question. Sociological theory of status suggests that new information is often inconsequential for status hierarchies and that, at the limit, the benefits of a high status position will prevail. Indeed the prevalent view is that a status position is relatively sticky (Podolny 2005) and therefore transitional events do not matter too much. The underlying assumption is that market participants are rather slow to recognize shifts in quality and therefore, at any given time, the relation between status and quality is quite loose (Podolny 1993). This leaves most of the prestige of the firm in the hands of its partners which tend to perpetuate the status-quo. A connected argument is that high status actors have access to a perpetual “reservoir of goodwill” (Jones et al. 2000) or “credit” (Hollander 1958, Blau 1964) which allows them more freedom of action, even if some of their actions have negative effects. Additional evidence from the sociology of deviance compounds the puzzle even further. While in some instances high status actors who violate group norms receive more severe sanctions than their low status peers, in other cases their crimes are treated with more lenience (Rosoff 1989, Shaw and Skolnick 1996, Wiggins, Dill and Schwartz 1965). Sociological evidence stands however in opposition with the view of economics of information and decision making which proposes that when more informative data about an actor’s quality becomes available the weaker signal used to assess quality receives less attention or becomes irrelevant (Milgrom and Weber 1982, Alles and Lundholm 1993). Under this view status plays no significant role once information about Daniela Lup, Chicago GSB 4 firm performance becomes available and interested resource holders react only to the type of news. Concretely, a firm which reveals positive news about its performance will see its stock price increase, while a firm with negative news is likely to witness a fall in the price of its stock (Milgrom 1981) but the status of the firm will not affect the investors’ reaction. However, finding an answer to the question concerning the role of status when information about performance becomes public is important for a number of reasons. First, existing evidence shows that information from high status actors is often treated differently and that both underand overreaction to information is present. Second, new information provided by firms is often re-interpreted and re-packaged by other market actors, actors which often are also responsible for the construction of status hierarchies (Zuckerman 1999, Basuroy, Chatterjee, Ravid 2003, Hsu 2006). In fact, firms often complain that they are victims of financial analysts, media or other information providers and mediators (Solomon and Frank, 2003). Third, because of the interconnection between market performance and status accumulation (Shipilov and Li 2008) even a short term reaction to new information about the firms’ performance can have considerable consequences for the status hierarchy. Consequently, by understanding the connection between performance and status we can account better for changes in status hierarchies. From a strategic point of view it is important for firms to know if relevant stakeholders react differently to information coming from firms of different social status; by knowing this, firms are more likely to pay attention to the type of information and the timing so that they can ensure the highest benefits and the least sanction, respectively. Daniela Lup, Chicago GSB 5 In order to answer the question if and how the relatively stable status effects observed under uncertainty change as a result of new information about performance I develop a theoretical framework and derived hypotheses about the likely market reaction to new information for firms from different status strata. My argument builds on the relational character of a status position (Podolny 1993). More precisely, I argue that a firm’s partners have a double role. On one hand they render status to the firm, by allowing their connection to the firm to be visible (ties as prisms, Podolny 2001) and on the other hand they create specific expectations about the firm’s quality by indicating the type and performance range that we should expect from the endorsed firm (Ruef and Scott 1998, Durand, Rao and Monin 2007). To explain how a firm’s status position influences reaction to new information I develop an attention shift hypothesis. My proposition is that under uncertainty investors are attentive to the content of status as signal of quality, but once new information becomes public there is a shift in attention from the content of the signal to the accuracy of the signal. I also propose that the perceived accuracy of the signal is positively correlated with the status position and that the reaction to new information depends on the perceived accuracy. As a result, the magnitude of the reaction to new information which departs from expectations (surprises) also depends on status. I use this framework to analyze a phenomenon which has generated a wide debate across disciplines, that is the reaction to earnings announcements released by public firms at the end of the financial periods. To document the difference in market reaction to new information about firms of different social standings my strategy is to compare the market response to earnings announcements issued by firms of higher and lower status at Daniela Lup, Chicago GSB 6 the end of the fiscal period. I provide evidence that the reaction to surprises is larger for high status firms by showing that the return on the stock of high status firms which deliver negative (positive) surprises is lower (higher) than the return on the stock of lower status firms which deliver negative (positive) surprises. Status as signal of quality under uncertainty Although specific definitions vary (Gould 2002, Podolny 1993, Washington and Zajac 2005) the term status typically refers to the prestige associated with a position in the social structure. In organizational theory and strategy status is usually operationalized by analyzing patterns of relations of the focal actor such that the actor with the most prominent partne