Maryland Smith Research / March 23, 2021

The Cost of Being Transparent

Competitors Seize On Clues Public Companies Reveal in SEC Disclosures

The Cost of Being Transparent

Public companies have often complained about regulators’ requirements that they disclose certain information, saying the disclosures give their competitors too many clues to their successes. Now new research from Maryland Smith supports that claim, showing that revealing the information cuts down a public company’s competitive advantage faster.

Maryland Smith accounting professor Michael Kimbrough worked with Maryland Smith PhD graduates Ruyun (Ivy) Feng, now at University of Wisconsin-Madison, and Sijing Wei, now at Creighton University. They looked at competitive markets and what happens when information is shared about specific companies, either by the companies themselves through SEC public disclosure requirements, or by Wall Street analysts and the media.

Their findings, forthcoming in the Review of Accounting Studies, show that public companies that were forced to share more information because of regulations lost their profit advantage faster than private companies because their competitors could better understand their competitive edge and level the playing field faster.

That’s because in competitive markets, firms take the best ideas of the top performers and eventually compete away to the profit advantage of those best performers by replicating the strategies and technologies that made the top firms the best in the first place, says Kimbrough.

Certain barriers to entry inhibit competition – things like legal restrictions, patent protections, strong brand identity, or monopoly rights over some resources that others don’t have – make some companies more profitable than others in an industry.

“If there’s a firm out there that has out-sized profits, that means it has some sort of strategic advantage,” says Kimbrough. “Others who see that are going to try to understand how the firm is able to generate those profits, and then they are going to take actions to eat away at your profits and steal your market share, so over time the end result will be that everyone will be earning nearly the same.”

Transparency provides the information that firms need to be able to compete, and this research proves that, says Kimbrough.

“People can see your profitability, but if they don’t have any clue as to the source of that profitability, then they don’t know on what basis to compete against you. The more transparent an economy is or the more transparent an industry is, the faster and more efficient that competitive process will be and the more quickly profitability differences will be eliminated.”

For underperforming companies, the outcome could be that they fail or get acquired by another company.

The researchers used U.S. Census data about firms to test whether public firms are less able to maintain their profitability advantages than private firms. Their results showed a clear advantage for private firms that weren’t required to share as much information, says Kimbrough.

“When public firms have that profitability advantage, the story that they tell – and our evidence is consistent with – is that private firms are readily able to replicate whatever market opportunities the public firms have seized on because there are so many clues from the information that the public firms have to provide. But when private firms generate abnormal profits due to some market opportunities or specific practices that they engage in, public firms cannot compete away those profits as readily because they don’t have as many clues. It’s much more costly.”

Companies with a competitive advantage – an innovative product, a new technology, anything that gives them an edge over other firms in their industry – may want to think about staying private, says Kimbrough.

“The rate of companies going public has been declining in recent years, and this could be one reason why,” he says. “We show that by staying private, you’re able to maintain your profitability advantage for longer. And certainly if there are other sources for financing besides the public capital markets, that consideration might push you toward accessing those other sources.”

He says if regulators want to encourage participation in public capital markets, they shouldn’t dismiss public companies’ claims that more disclosures hurt them.

“From a policy maker’s standpoint, they may think more information is better,” says Kimbrough. “From the point of view of investor protection, that’s probably true. But on the other hand, there is this cost to public companies, and ultimately, to investors.”

“When we think of reporting requirements and disclosures, we think of them as being neutral – they are just reflecting what’s going on in a company and that they don’t have a real impact. But our paper shows that they do have a real impact.”

Read the full research, “The Role of Information Transparency in the Product Market: An Examination of the Sustainability of Profitability Differences,” in the Review of Accounting Studies.

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