Quality Losses Matter More to Investors Than Quality Gains

People dislike losses more than they like gains. Known as loss aversion, this phenomenon, or behavioral bias, serves as a cornerstone of Daniel Kahneman and Amos Tversky’s prospect theory.

A forthcoming paper, which I co-authored with Didem Kurt, Koen Pauwels, and Shuba Srinivasan for the International Journal of Research in Marketing, applies this theory to product and financial markets and analyzes how investors react to negative and positive changes in firms’ product warranty payments.

If investors interpret increasing warranty payments as a signal of “quality losses” and decreasing warranty payments as a signal of “quality gains,” an asymmetric stock return response is likely to occur.

To put our research into context, let’s consider some of the proposed implications of loss aversion in real life. For instance, sellers tend to ask more for an item than buyers are willing to pay for it. Why? The value of an item is believed to be higher once one possesses it. This is known as the endowment effect. That is, sellers perceive giving up the item as a loss, whereas buyers consider the exchange a gain. Because losses hurt people more than gains make them feel good, there is often a significant gap between a seller’s initial asking price and the buyer’s offer price.

But what about financial markets? Evidence shows that investors react more strongly to dividend cuts versus dividend increases, which is consistent with the notion that losses loom larger than gains. Another example is the so-called disposition effect wherein investors tend to hold on to losing stocks longer than they keep winnings stocks. However, this effect is less pronounced among sophisticated and wealthy investors. Relatedly, there is discussion as to whether loss aversion really matters to investors.

Our study is not about individual stock trading decisions. Rather, we focus on how the stock market collectively responds to quality losses versus quality gains signaled via changes in firms’ product warranty payments. Nonetheless, to validate warranty payments as a signal of product quality information, we ran an experiment with potential investors recruited from an online survey panel.

The experiment used information drawn from the published financial statements of a public company that we presented under a fictional company name. We randomly assigned participants to two conditions: high warranty payments (i.e., 6% of revenues) and low warranty payments (i.e., 1% of revenues). There was no other difference in the presented financial information between the two conditions.

Participants in the high warranty payment condition perceived the company’s product to be of lower quality and were less likely to invest in the company’s stock than those in the low warranty payment condition. This finding lends credibility to our argument that warranty payments communicate relevant product quality information to stock market participants.

Our examination of analyst reports offers additional supporting evidence. We theorized that if warranty payments capture product quality information, higher warranty payments in the current period will predict the intensity of discussion about quality-related issues in analysts’ reports published in the upcoming period. For this validation test, we analyzed over 66,000 analyst reports and searched for different word combinations, such as “quality issues,” “quality problems,” and “product problems.”

As expected, we found that the higher the current period warranty payments, the greater the discussion of quality-related issues in analysts’ future reports.

For our main analyses, we examined 666 warranty offering firms listed on the US stock exchanges, with the sample period covering fiscal years 2010 through 2016. Since investors react to unanticipated information, we estimated a first-order autoregressive model of warranty payments and used the residuals from this model as a proxy for unanticipated changes in warranty payments.

The results support the proposed asymmetric investor reaction to increasing warranty payments (“quality losses”) versus decreasing warranty payments (“quality gains”). While stock returns decrease with an unanticipated rise in warranty payments, there is no favorable stock market response when a firm experiences an unanticipated decline in warranty payments. The economic significance of the documented result is not trivial. A one standard deviation increase in unanticipated rise in warranty payments is associated with a 2.5 percentage points lower annual stock returns for the average firm in the sample.

Are there other product market signals that may alter investors’ interpretation of quality signals communicated by changes in firms’ warranty payments? We considered three potential candidates: advertising spending, research and development (R&D) spending, and industry concentration. Each factor has the potential to magnify or mitigate the information value of changes in warranty payments.

Our results show that increased advertising spending, but not R&D spending, reduces investors’ sensitivity to the bad news conveyed through rising warranty payments. One possible explanation for this finding is that while greater advertising efforts may help boost a company’s brand image in the short run, R&D investments involve significant uncertainty and may not play a positive moderating role in investors’ valuation of realized warranty outcomes in the current period.

Regarding industry concentration, we found that when an industry has recently become less concentrated (i.e., more competitive), a positive relationship exists between stock returns and declining warranty payments. This finding suggests that in the face of intensified competition, investors reward firms with improved product quality.

One final note: Offering product warranties does not necessarily ensure a high firm value. In fact, warranty offering firms with rising warranty claims have lower firm value than non-warranty offering firms.

So, unless managers have undertaken the necessary investments in product quality, myopically offering warranties in hopes of boosting current sales could prove very costly in the long run. As for investors, before getting excited about a firm’s warranty claims going down, they need to make sure that this information would translate into higher stock returns by paying close attention to changes in the industry’s competitive landscape.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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