The Stock Market Causes Herd Behavior — Among Managers

SMITH BRAIN TRUST — Does the stock market encourage corporate conformity? Yes, according to new research from the Robert H. Smith School of Business, at the University of Maryland. The study, by Laurent Frésard, an assistant professor of finance at the Smith School, and Thierry Foucault, of HEC Paris, adds to the literature on the connection between the stock market and decisions by corporate managers.

One contribution of the stock market is informational: It aggregates "the wisdom of the crowd." Thousands of investors analyze a company and make bets on its future performance. The information produced by all those decisions, in the form of a stock price, should be stronger than information possessed by any one analyst or even manager. The catch, Frésard and Foucault observe, is that stock-market prices provide more information when multiple companies follow similar strategies. That reduces the problem of "noise" in the signal of any single stock.

In such cases, managers can monitor the stock prices of rivals, in addition to their own stock price, to learn about the effectiveness of their strategies.

That dynamic incentivizes corporate managers to follow a herd. The intuition is similar to the conundrum faced by someone weighing ideas for a new business, Frésard notes. "Should you do something that is really, really new, or do you do something that is similar to what someone else is doing?" he asks. "If the idea is truly new, you may not be able to get funding, because investors may not understand it." Likewise, investors in a unique company that's gotten off the ground are likely to be feeling their way in the dark to some degree. The information produced by decisions by those investors is likely to be less accurate than information produced by investors in a company with a more common strategy.

The pre-IPO period is when the incentive to mimic a public company is strongest. Companies that don't have a stock price to track can gain insight into the markets' judgment of their strategies by aping public companies. Post-IPO, these managers gain their own stock price, they have a fresh source of information, so they should feel more free to diverge from their rivals.

The theory behind these arguments seemed sound. Frésard and Thierry confirmed them by analyzing the performance of 1,231 firms that went public from 1996 to 2011. They used text analysis of product descriptions, taken from companies' 10-K filings, to identify peer companies and to measure product similarity.

They found that companies did, indeed, mimic their peers' strategies much more before their IPO than after it. The researchers also found that the stock price of firms with highly differentiated products were less informative than those of firms with imitative products. (They measured the accuracy of the information provided by a stock price by how well the current price predicted future performance. A perfectly informative stock price would predict future performance almost exactly.)

The findings has implications for everything from the diversity of products offered to consumers to "the scope for diversification for investors," Frésard and Foucault have written.

"Corporate Strategy, Conformism, and the Stock Market," by Thierry Foucault and Laurent Frésard, is a working paper.