Bandwagon effect: Special dividend payments

https://doi.org/10.1016/j.iref.2019.04.002Get rights and content

Abstract

The objective of this study is to determine whether there is a bandwagon effect of special dividends in United States industries. Specifically, we investigate whether the predictions of the information-signalling hypothesis or the agency theory account for the special dividend behaviour at the industry-level. Out of a broad sample of publicly listed firms in the US market, our results show that rival firms in concentrated industries follow other firms' special dividend announcements. The intra-industry effects of special dividend events indicate positive contagion effects on a rival firm's abnormal returns. Our findings lend credence to the information-signalling hypothesis, rather than to agency theory. This is because special dividends act as signals to convey information to the market on the sustainability of growing industry-wide earnings. The propensity to follow occurs because of industry homogeneity: comparable firms aim to validate the industry signal.

Introduction

Many major industries in the United States are oligopolistic, dominated by a tier of large firms that lack the control possessed by unregulated monopolists. A firm's success depends on its position relative to its competitors. This means that firms must consider the reactions of their competitors when they draft payout policies, pursue investment opportunities and deliberate on other corporate announcements (Beladi et al., 2016c, Graham and Harvey, 2001, Hu et al., 2017, Khanal and Mishra, 2017, Lang and Stulz, 1992, MacKay and Phillips, 2005). In short, individual firms are mindful of what their competitors are likely to do in the event of a corporate announcement and will adopt tactics to maximise their returns or minimise those flowing to their competitors. Barriers to entry that restrict the number of firms that can dominate also contribute to the competitive nature of corporate announcements. The result is that corporate announcements are often followed by similar announcements from industry rivals. In other words, firms behave in a similar way in respect to corporate events in oligopolistic industries. An economic theorist might say that this commonality results from collusive behaviour inherent in any oligopolistic industry. While this is possible, an alternative explanation for this conformity is that firms emulate corporate announcements to offset possible losses, minimise competitors' profits, and increase their own market shares. That is, firms will simply follow their rivals—the bandwagon effect.

The bandwagon effect occurs when an action gains momentum; it is the result of a firm's fear of appearing different from its competitors, possibly performing at a below-average level. Special dividends provide management with a financially flexible means to uplift stock performance (Jagannathan, Stephens & Weishbach, 2000). Recent literature advocates the special dividend announcement as a popular action, with an increasing prevalence of firms paying special dividends almost as predictably as regular dividends (DeAngelo, DeAngelo & Skinner, 2000) (DDS). In this paper, we use the special dividend to explain the largely unresolved question of why firms follow corporate announcements. The answer to this question requires analysis of the intra-industry spillover of special dividends on abnormal returns of competitor firms. The difference between this paper and DDS is that we examine whether there is an industry following effect in special dividend payments, whereas DDS show that special dividends are paid as frequently as regular dividends, which implies the importance and commonality of special dividends. Balachandran, Faff, and Nguyen's (2003) empirical evidence reveals that a firm's special dividend announcement can affect the valuation of other firms in the same industry, and offers a persuasive explanation for a special dividend counter-announcement.

Our research intends to examine which of the two predominant explanations—agency cost theory or information-signalling—best explains special dividend payout policies. Agency theory asserts that event firms have a positive regard for special dividend announcements because they reveal the mitigation of agency costs. However, the announcement sends a negative signal about the rival firm, suggesting that they face a potential free cash-flow problem. Accordingly, the rival firm's share price declines. As non-event firms are associated with less profitable economic prospects than event firms, they act to placate negative returns and follow their rivals by issuing a special dividend—in turn creating an industry-wide wave of special dividends. Agency theory presumes that mature firms have limited growth potential and face substantial risk of wasting excess cash. From this perspective, the special dividend should generate a pronounced announcement-day return for mature organisations. Conversely, mature firms that do not declare a special dividend generate more pronounced negative returns. The tendency for firms to follow special dividend payments could also be aligned with investor expectations. The information-signalling hypothesis posits that investors derive information about increasing earnings directly from the special dividend announcement. As investors draw conclusions about a booming industry, positive announcement-day returns spread from firm to firm. The bandwagon effect comes into play because non-event firms are inclined to validate the industry signal, becoming the basis for the special dividend payment. The idea is to examine whether exceptionally large or surprise special dividend announcements will encourage mimicking among firms. DDS found that large or surprise special dividends do send larger information signals.

To ascertain whether a special dividend bandwagon exists, it is necessary to examine the relevant industry's current market structure, determine the degree of competition, and investigate the impact a special dividend is likely to have on the returns and decision making of rival firms. Kohers (1999) suggests that because concentrated oligopolistic industries have comparable market players competing for industry hegemony, one can expect better-equipped and more strategically driven firms to respond in a like manner. Consistent with Lang and Stulz, 1992, Laux et al., 1998, and Hou and Robinson (2006), this current study employs the Herfindahl–Hirschman Index (HHI) concentration measure as a proxy for product market competition. HHI directly accounts for the number of firms and sales revenue in a product market, making it a suitable measure to capture an industry's competitive balance. We investigate whether the abnormal returns are influenced by the degree of concentration in an industry. Lang and Stulz (1992) contend that abnormal returns are more pronounced in highly concentrated oligopolistic industries, where rivalry among firms is high and market share is relatively equal. However, given the barriers that restrict new firms from entering concentrated markets, the question arises as to whether firms can place high prices on their products, thereby lowering risk and returns.

This research examines publicly listed companies in the United States from 1926 to 2012 using data from the Centre for Research in Securities Prices (CRSP) and CRSP/Compustat. The utilisation of binary logistic regression analyses shows that, in concentrated product markets, firms respond to competitors’ announcements by expending funds to initiate their own special dividends. Using multivariate regression, the evaluation of special dividend size finds that the resultant effects lead to firms in concentrated industries paying significantly larger special dividends than firms in less-concentrated industries. Further, firm maturity is an important determinant of followership. Moving to the intra-industry analysis, our evidence reveals that a positive contagion effect spreads across the industry at the announcement date. In the short term, special dividend announcements in concentrated industries have stronger contagion effects than in unconcentrated industries, with non-event firms averaging returns of 0.26% in the three-day event window and 1.79% in the four-week event window. Long-run abnormal returns for special dividends are relatively immaterial but still yield positive and significant results, averaging 0.23% for non-event firms. This suggests that the underlying motivation for special dividends stems from industry signals rather than from mitigation of agency costs, because firms become more inclined to increase payouts when there is favourable market response. In general, the information-signalling hypothesis explains the U.S. evidence: special dividends are used to gain investor popularity when an industry is experiencing exceptionally strong transitory earnings.

The results of this research reveal an industry-following effect in relation to special dividend announcements. This result is in agreement with research conducted by Massa, Rehman, and Vermaelen (2007) (MRV). While this current study and that of MRV are both concerned with examining how mimicking firms cause corporate event waves, the specific focus of each study is different: MRV proposes that the negative effect of repurchases on industry counterparts causes rival firms to follow and announce their own stock buyback. Our research is unique because it reports on how special dividend announcements induce an industry-wide contagion effect. This is significant and suggests that the propensity to follow is not necessarily linked to placation of negative returns for corporate events. A majority of explanations about widespread popular corporate events are dependent on stock market valuation, such as mergers and acquisitions,1 seasoned equity offerings2 and initial public offerings.3 If stock undervaluation is common to firms throughout the industry, this may explain the wave of repurchases documented.4 However, this explanation would not hold for special dividends because the lifecycle theory is the impetus for the event. Therefore, the present research broadens our current understanding and enriches the literature by providing a fresh perspective on factors playing a constitutive role in the wave enigma. Inspired by Harford's (2005) argument that waves occur in response to industry shocks, our hypothesis agrees that adequate capital liquidity is equally necessary for waves to occur.5 Higher capital liquidity is often associated with oligopolistic industries because large firms that act strategically to dominate market share also divide industry profits. While we acknowledge that economic considerations primarily drive wave activity, our interest is in examining firms' competitive motivation to follow the special dividend wave.

Three groups can benefit from this research: managers, investors and regulators. As to the first, this research is useful for management engaged in corporate payout policy. Managers can improve the competitive position of their firm if they have a proper understanding of the industry structures and the way they differ. A comprehensive analysis of several special dividend variations enables corporate managers to address the opportunities and threats in their respective industries. Specifically, the large special dividend represents an attractive short-term tactic to mark a company as a step ahead of its competition while minimising the benefits of rival firms. As to the second group, this research provides a view by which investors can potentially profit from the net effect on the industry. To provide one illustration, the results confirm that special dividend announcements lead to a positive increase in a competitor's stock price (Balachandran, Faff, & Nguyen, 2003). Individual investors can earn abnormal profits and exploit industry information by temporarily changing stock holdings to reap excess returns from the announcing firm. Finally, this study has important implications for regulators. A primary concern for regulators (and for investors) is that, because of the flexibility and modest disclosure requirements associated with special dividend announcements, there are ample opportunities for companies to collude and use special dividends in a tactical milieu. Such possibilities generate concerns about whether disclosures ought to be more stringent in order for small emerging firms to survive in concentrated industries.

The paper proceeds as follows. Sections 2 Literature review, 3 Hypotheses development review the literature and develop the agency cost versus information-signalling hypotheses. Section 4 describes the sample. Section 5 discusses empirical methodology and the test results. Section 6 provides robustness checks. Finally Section 7 concludes the paper.

Section snippets

Literature review

In theory, Special dividends are one-off payments made by companies to reward shareholders after increases in transitory earnings (Brickley, 1983, Gombola and Liu, 1999, Lie, 2000). In contrast, regular dividends represent a portion of a company's permanent earnings routinely paid to shareholders. Companies avoid increasing regular dividends as subsequent cuts can indicate lower long-term operating cash flows (Brav et al., 2005, Jagannathan et al., 2000, Lintner, 1956). Mature companies with

The agency theory

Agency theory is based on the idea that managers pursue their interests by wasting free cash flows, to the detriment of their firms (Jensen, 1986). Howe et al., 1992, Gombola and Liu, 1999, and Lie (2000) argue that shareholders view share repurchases and special dividends positively because they mitigate agency costs by reducing the funds available for projects with negative net present value. In an extended agency cost-based analysis, MRV discovered that stock repurchases send negative

Sample selection and data

The majority of the data are collected from The Centre for Research in Security Prices (CRSP) for special dividend announcements from publicly listed firms in the U.S. covering the period between 1926 and 2012. Following DDS and Baker, Mukherjee, and Powell (2005), special dividend announcements were classified using a distribution code of either 1262 or 1272. This allows the sample to encompass ordinary common shares only, and to exclude other types of securities, such as American Depositary

Short-term market reaction

This section investigates how a firm's share price reacts to its rivals' special dividend announcements. In accordance with the agency theory (information-signalling hypothesis), the expectation is that short-term negative (positive) returns can motivate non-announcing firms to initiate their own special dividends. To provide a thorough analysis, the study considers various subgroups' excess returns. In accordance with the agency-based explanation, big, mature firms will mimic others to reduce

Robustness checks

This research employs various models to determine whether industry concentration can affect the incidence of special dividend announcements and associated returns. Given the extensiveness of the period(s) examined, as a robustness check the Hausman test (1978) adjusts for fixed year effects in the data. To obtain consistent standard errors, this research corrects for the clustering of special dividend announcements in calendar time. The White (1980) test minimises the effect of

An alternative interpretation of special dividend incidence

Although regular dividends are traditionally the primary means by which firms distribute cash to stockholders, the proportion of firms' paying dividends has fallen dramatically in recent years (Fama & French, 2001). Baker and Wurgler's (2004a) catering theory suggests that this happens because companies accommodate time-varying investor demand. This involves companies within the same industry sharing a common payout practice in response to investor preference. The literature demonstrates the

Concluding remarks

A considerable amount of research is directed towards identifying possible reasons for the popularity of various corporate events in an industry. This paper evaluates two possible explanations for the increased use of special dividends: the agency and information signalling theories. The former maintains that disbursements mitigate agency problems between managers and shareholders, whereas the latter maintains that firms provide disbursements to signal positive information about the health of

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