The other evidence on complexity is scattered over a number of different studies. There is evidence that is consistent with the notion that investors do discount stock prices for complexity, though the extent of the discount is debatable.
• Morgan Stanley, in a study of annual reports, found that stock returns were inversely proportional to the number of pages in the report. Firms with long (and often expensive reports) had the worst returns among the stocks they examined. This suggests that firms often use useless detail to bury valuable facts in reports.
• Emerging markets that change their accounting standards to increase transparency usually report strong positive reactions to these changes, with investors being willing to pay more for stocks in these markets.
• When firms in emerging markets have ADRs listed on the U.S. market, their stock prices react positively. While there are a number of possible explanations for this phenomenon, one is that these firms often have to restate their financial statements using generally accepted accounting principles in the United States.
• The positive reactions associated with spin-offs, split-offs and divestitures can also be viewed as indirect evidence that market reward transparency. Linn and Rozeff (1984) examined the price reaction to announcements of divestitures by firms and reported an average excess return of 1.45% for 77 divestitures between 1977 and 1982. They also noted an interesting contrast between firms that announce the sale price and motive for the divestiture at the time of the divestiture, and those that do not: in general, markets react much more positively to the first group than to the second, as shown in Table 5. The market clearly seems to be rewarding transparency at least about this specific action.
Table 5: Market Reaction to Divestiture Announcements
• Finally, the positive returns associated with the issue of tracking stock can be viewed as evidence that markets reward companies that provide more financial information and a market estimate of value for individual businesses that they operate in.
Some contrary evidence
Is there any evidence that complexity is rewarded by investors? It may not be a coincidence that complexity seems to increase during bull markets and periods of investor optimism. Perhaps, investors in their exuberance are willing to overlook complex financial statements and trust managers more during such periods. It is also entirely possible that these investors are being irrational, as Mr. Greenspan argued they were during the late 1990s.
Whatever the reasons, worries about complexity seem to rise in the aftermath of an investment disaster, usually caused by a firm that overreaches and implodes. There is one possible scenario where complexity may be rewarded. If investors trust managers and complexity is used to reduce the tax burden and regulatory constraints on the firm – the tax and regulatory authorities are kept in the dark with investors – you can have extended periods where the stock price rises. It is extremely unlikely, however, that any firm can pull off this feat in the long term.
15 While Enron is the latest example of this phenomenon, financial markets have a long history of firms that have used aggressing accounting (and, in some cases, illegal acts) to make themselves look much better than they truly are.
Prof. Aswath Damodaran
Information Transparency and Valuation: Can you value what you cannot see?
It is clear that some firms are more forthcoming about their financial affairs than other firms, and that the financial statements of a few firms are designed to obscure rather than reveal information.
By Prof. Aswath Damodaran