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Firm Behavior and Industry Evolution, by Alex Castaldo

"The Impact of Financial Markets on Firm Behavior and Industry Evolution" PhD Dissertation by C.J.Kock, 2003, University of Pennsylvania

(1) A rise in a firm's stock price allows the firm to raise money and invest more ("equity enabling effect") (2) A rise in the firm's stock price tells the firm that what it is doing is good, and that it should keep doing it ("direct alerting effect") (3) A rise in the stock price of OTHER FIRMS tells our firm that it should consider imitating the other firms ("indirect alerting effect")

The author claims to be the first to study (3), while (1) and (2) have been looked at before.

Generally speaking firms have two choices when they seek to expand their activities: "exploitation" means expanding in existing products and markets, while "exploration" refers to the more adventurous choice of trying new products or markets. The author theorizes that when the firm's own price goes up (direct alerting) it will prefer to do more "exploitation" than "exploration", and vice-versa when the prices of firms in a different area of business go up our firm is encouraged to overcome its inertia and "explore" a new approach to doing business.

Furthermore large firms have more "inertia" to overcome than small firms and firms where executive compensation emphasizes stock or options are likely to be more sensitive to stock price effects. That's the theory.

In Chapter 2 the author tells the story of the retail brokerage industry as an illustration of these effects. In the 1970's retail brokerage was dominated by large firms (ML, etc.) that offered full service. Gradually (1980's) "discount brokerage" firms such as Fidelity and Schwab developed, that offered lower prices but no trading advice. The large firms did not adopt the discount approach, since it would have threatened their existing way of doing business. In the 90's another change took place: the development of "online brokers". The stock prices of E*TRADE et al soared and this caught the attention of the discount and full-line firms. This time the change spread quickly throughout the industry, with most firms adopting the online approach. This illustrates a powerful "indirect alerting effect" of stock prices.

Since one anecdote is not enough, in Chapter 3 the author does an empirical study using regression. It is difficult to know whether a particular firm is using an "exploration" or "exploitation" strategy, so the author has to use proxy variables that hopefully are correlated with such things. For example the author thinks that an "exploitation" firm would increase advertising spending while a firm pursuing "exploration" would increase capital spending. So ad spending and capital spending are thrown into the regression, together with a number of other variables. It is all a bit artificial and unrealistic, but not uncommon in testing these academic models. The author concludes that his model is supported by the data, although there are some surprises, such as the difference between small and large firms is not as expected.

In Chapter 4 the author builds a simulation model on Cournot duopoly lines, to see how two firms would behave if they followed the theory the author developed. At his point you are probably losing interest , as I did also. After a fairly lengthy and convoluted discussion of the simulation results, the thesis concludes.

It is all presented as an academic exercise, but as readers we can ask ourselves about the investment implications. Are there any, as far as you can see?