When Eastman Kodak filed for bankruptcy last month after years of declining fortunes, observers blamed its fate on everything from the reputed failure of top management to grasp the future dominance of digital cameras, to the irresistibility of the traditional film business' bountiful cash flow, to the firm's location in Rochester. Notably absent from the litany of blame, however, was a factor that, new research suggests, played a significant, even substantial, role in the company's downfall -- pressure from the investment community.
"How Pressures from Securities Analysts Influence Incumbents in the Face of New Technologies," is the title of a study in the current issue of the Academy of Management Journal. The influence to which the title alludes is decidedly negative, and its teeth-grinding effect on corporate managers is considerable.
"During periods of radical technological change," the new research finds, "increasingly negative analysts' recommendations are associated with subsequent decreases in firms' strategic investments... Even in the face of strong pressures to adapt to new technologies, institutional pressures from analysts outweigh the technical pressures, as incumbent firms tended to reduce their investments under increasingly negative recommendations."
Comments Mary J. Benner, an associate professor at the University of Minnesota's Carlson School of Management, who carried out the research with Ram Ranganathan, a doctoral student at the Wharton School of the University of Pennsylvania, "It's no news that managers of incumbent firms like Kodak face great challenges in adapting to technological change, having to contend, as they do, with various kinds of organizational inertia or outdated mindsets. What this study makes clear is the considerable additional problem presented by resistance from analysts and investors."
Or, in the words of the study, "Managers interested in adaptation and survival of their firms during technological upheavals face more daunting barriers than the already substantial challenge of accessing new knowledge and developing new capabilities. Analysts, reflecting the view of shareholders, may favor shorter-term, more easily valued cash flows, preferring that firms reduce their investments in lieu of responding to an uncertain new technology."
Is this another instance of the much-lamented shortsightedness of investors? Yes and no. The new study follows upon an earlier paper in the Academy of Management Review in which Prof. Benner surmised that, while analysts and investors might welcome investments in new technology by so-called "growth" companies, this was not likely to be the case with "income" stocks -- that is, "established companies [whose] source of value is current profits." As an example, she cited "the case of Kodak, facing declining stock prices and questioned legitimacy," notwithstanding the company's "strong brand name in photography, hundreds of patents pertaining to digital imaging, and many market-share-leading and award-winning digital camera products."
Subsequent research by the professor has confirmed that, in fact, analysts do ignore or respond negatively to investments by incumbent companies in new technology; now the new study in AMJ reveals the substantial effect this has on "strategic investment," measured as the sum of capital expenditures and research-and-development expenses.
To gauge this effect, Benner and Ranganathan scaled analysts' stock recommendations numerically, with "buy" and "strong buy" at the low end of the scale and "underperform" and "sell" at the upper end. For companies affected by shifting technology, a change of average analyst recommendations of only one percent in the sell direction was associated with "a 13 percent decrease in strategic investments" during the subsequent year.
The study's findings emerge from data on incumbent firms in three economic sectors experiencing radical technological change -- the photography industry, undergoing a shift from silver halide film to digital imaging; wireline telecommunications, where Internet telephony (VoIP) challenges the traditional variety; and newspaper publishing, where online media threatens to supplant print publications. In addition, the research sample includes firms in a sector not undergoing radical technology, food and kindred products, to provide a baseline comparison to the three focal industries. Ninety companies from all four industries comprised the study's full sample over the period 1993 through 2007.
The research finds that "the influence of changes in analysts' recommendations on future investments is significantly stronger for the technological-change settings than the rest of the sample," and leads the authors to observe that "our results strongly support [the hypothesis] that negative (positive) analysts' reactions will spur firms to reduce (increase) their subsequent strategic investments, and these effects will be stronger during periods of technological change."
Benner and Ranganathan also find that managers resort to stock buybacks as a means of mitigating analysts' and shareholders' resistance to investments in new technologies. As they write, "The results suggest that firms in technological-change settings announce a higher value of share repurchases when they undertake high levels of investment." Such announcements, they write, are a way "to offset the growing illegitimacy of their strategic investments by...signaling managerial commitment to shareholders and mollifying analysts."
Comments Prof. Benner: "In view of the fact that the difficulties we've identified in this study are intrinsic to the system, there is probably no completely simple way for managers to deal with them. As our study suggests is already happening, they can undertake share repurchases to cushion the stock-price hit that heavy investments in unproved technologies can prompt. Or they can ignore Wall Street altogether, make the investments they deem important, take the likely short-term hit in stock price, and hope the benefits of the investments pay off quickly. They can also attempt to educate analysts and investors about the long-term value of the investments, and seek support from blockholders, who, research suggests, tend to invest for the long haul.
"Finally, they can dispense with the public markets altogether, and try to go private. A perennial complaint of top corporate executives in recent times has been the myopia of the public markets, and certainly this study adds a further measure of credibility to that claim."
The new study, entitled "Offsetting Illegitimacy? How Pressures from Securities Analysts Influence Incumbents in the Face of New Technologies," is in the February/March issue of the The Academy of Management Journal. This peer-reviewed publication is published every other month by the Academy, which, with about 18,000 members in 103 countries, is the largest organization in the world devoted to management research and teaching. The Academy's other publications are the The Academy of Management Review, The Academy of Management Perspectives and Academy of Management Learning and Education