Herd Behavior In Voluntary Disclosures of Capital Expenditure Forecasts

Research by Nerrisa Brown

Within a two-day period in July 2001, UAL Corp., AMR Corp., and Northwest Airlines all released their capital expenditure plans. In October of 2000, SBC Communications, Verizon Communications and Time Warner Telecom released their capital expenditure plans in the same week. This wave-like pattern of voluntary disclosure, known as “herding,” can also be seen in companies’ disclosures of their revenue warnings and accounting misstatements.

Firms are required to disclose information to shareholders, regulatory agencies and the general public through mandated financial reports and other regulated filings. But firms can also selectively disclose information through news releases, shareholder meetings, analyst presentations, and conference calls. Nerissa Brown, a PhD candidate in the accounting and information assurance department at the Robert H. Smith School of Business, examines the disclosure patterns of firms’ capital expenditure plans in her paper “Herd Behavior in Voluntary Disclosure of Capital Expenditure Forecasts.”

Brown is believed to be the first to examine how firms in the same industry tend to herd in their timing of capital expenditure forecasts. Information on future capital expenditures can be highly proprietary, and disclosure of such information may affect a firm negatively if competitors use that information to their advantage. Disclosure of asset/capacity expansions, for example, may signal to rival or potential market entrants a firm’s growth strategies. In response to this signal, rivals may undertake similar capacity expansions, which could then hinder the firm’s growth plans or even reduce its performance. Because of these disclosure costs, Brown expected that herding would be more prevalent in proprietary capital expenditure forecasts as opposed to earnings and revenues forecasts.

Brown used 742 forecasts by 354 firms across 26 industries between the fourth quarter of 1999 to the third quarter of 2001 to examine the association of a firm’s forecast release decision with the past disclosure decisions of firms in the same industry.

Brown observed that a firm’s decision to release capital budgeting information is strongly associated with the proportion of firms within its industry that have already disclosed such information. As more firms choose to voluntarily release information, the more pressure there is on other firms in the same industry to follow suit. “This trend is especially apparent for high-technology firms, which exhibit a greater tendency to follow the prior disclosure decisions of same-industry firms,” Brown says. “Because the nature of their business is based on innovation, they have particularly high proprietary disclosure costs.”

A company’s reputation seems to affect the degree to which it chooses to follow the crowd rather than set the standard. Using a number or reputation indicators such as the Fortune Reputation Index, Brown distinguished firms that were highly reputable and those that were less reputable. She found that less reputable firms are more likely to herd on other firms’ disclosure decisions. According to Brown, managerial desire to increase or maintain a company’s reputation is a major contributing factor in the decision to herd in capital expenditure disclosures.

Brown also noticed a tendency toward “informational herding,” where firms use the content of their peers’ disclosures to decide not just when to release information, but what information to release. When peer firms release information from which indicate that capital expenditures will be lower this year in comparison to last year, there is a corresponding increase in the number of firms who issue a forecast in the current period. Firms are also less likely to disclose information if the information released by their peers is imprecise.

Herding is a rational behavior, but it can lead to poor decisions if a firm infers the wrong information or follows the bad choices made by others. This may induce managers to disclose even when private signals indicate that disclosure is not in the best interest of the firm, or it can lead managers to withhold information even when private signals suggest that disclosure is beneficial.

Herding can also have a detrimental affect on the economy. If managers disclose their information only when others have released similar information, the amount of relevant information available to stakeholders is lower. In extreme cases, the release of information by firms in a rapid wave-like manner can lead to increased stock market volatility.

With the recent push for higher levels of reporting transparency, Brown’s work may act as a cautionary tale to firms, which tend to follow the crowd in voluntary disclosures. “I hope my work encourages companies to put in place mechanisms such as corporate governance structures which induce managers to disclose relevant information when it is deemed beneficial to do so and less in response to the disclosure decisions of other firms,” says Brown.

Brown continues to explore the interactions of voluntary disclosure behavior across multiple firms, the dynamics of disclosure behavior across time, and the impact of corporate governance mechanisms on patterns of herding in disclosures.