The Blind Spot of Investing in What You Know

Young, Danqing（楊丹青）, Zhang, Yinglei（張英蕾）

CUHK research reveals lack of familiarity may lead U.S. investors to significantly discount the valuation of foreign firms listed in the country’s stock exchanges

By Jaymee Ng, Principal Writer, China Business Knowledge@CUHK

The U.S. has the two largest stock exchanges in the world that attracts companies from all corners of the globe to list. This interest has been strong especially among Chinese companies, which have accelerated their entry into U.S. stock markets particularly in the last decade.

Foreign (including Chinese) companies choose to list on the NYSE or NASDAQ for a variety of reasons. Some seek access to a broader shareholder base, while others value the prestige associated with trading on the world’s largest stock exchanges. On the performance side, foreign companies tend to see their market valuations benefit when they cross-list in New York. Finally, there’s the highly sought-after New York “pop”, where it is not uncommon for firms to do exceptionally well on their U.S. stock debut. Despite these advantages, a recent study has revealed a lack of familiarity with foreign companies that trade on U.S. exchanges may lead the country’s investors to penalise the share price of these firms.

The research study Familiarity Bias and Earnings-based Equity Valuation was co-conducted by Young Danqing, Professor and Director of Executive Master of Professional Accountancy Programme; and Zhang Yinglei, Associate Professor in the School of Accountancy at The Chinese University of Hong Kong (CUHK) Business School; as well as Prof. Dong Yashu at Shanghai University of Finance & Economics.

“Our study provides evidence that companies that list outside their home market suffer a ‘penalty’ in their share price simply because local investors don’t really know enough about them.” – Prof. Young Danqing

As of May, there were 248 Chinese companies listed in the U.S. as of May 2021, representing a total market value of US$2.1 trillion. In the first half, a total of 34 Chinese companies raised a record US$12.4 billion in New York. Many of China’s most high-profile companies trade their shares in the U.S., from e-commerce giant Alibaba, tech giant Tencent, search provider Baidu, to ride-hailing app DiDi, the recent IPO of which has led the company to be embroiled in a crackdown by Chinese regulators. In turn, this has put a pause on the lucrative pipeline of Chinese firms keen to raise capital on Wall Street.

“A listing in any country is a major business decision for any firm, and it’s something that involves legions of accountants, lawyers, bankers and other support roles. Our study provides evidence that companies that list outside their home market suffer a ‘penalty’ in their share price simply because local investors don’t really know enough about them,” says Prof. Young.

The researchers sampled close to 5,000 annual earnings announcements made by over 900 U.S.-listed foreign firms from 56 countries and regions from 1992 to 2014. They then matched each non-U.S. firm’s earnings announcement with an equivalent U.S. firm’s earnings release and found that the earnings response coefficient (ERC) of non-U.S. firms, which measures the relationship between equity returns and the unexpected portion of companies’ earnings announcements, is about 54 percent of that of the matched U.S. firms. In other words, the stock values of the non-U.S. firms based on their earnings have been discounted by 46 percent.

Because markets tend to reward companies that outperform and penalise those that underperform, the researchers then sought to control for the possibility that this result was due to more foreign firms reporting negative earnings surprises. Even after accounting for this, they found that the valuations of non-U.S. firms were still discounted by about 50 percent.

Familiarity Bias

The concept of a “familiarity bias” is fairly well documented in investing. It is not uncommon for investors to only buy stocks from their home country or companies that they work for or the firms that produce their favourite products. However, the researchers specifically choose to examine how it affected companies that were listed in the same market, but were less well known because of their foreign origins.

The researchers considered two factors that may have contributed to a lack of familiarity among U.S. investors when looking at foreign companies listed in the country, which are country-specific and firm-specific.

For the country-specific factor, the research team constructed an index to measure how different the U.S. firms and foreign firms were based on four elements: geographical distance, economic structure, trade and language. A higher value would indicate a higher lack of familiarity among U.S. investors towards the other country.

For the firm-specific factor, as many overseas companies also sell their products in the U.S., the researchers did another set of calculations based on the proportion of the foreign firms’ sales in the U.S. to its total sales and separated the firms into two groups. Those firms with zero sales in the U.S. (and thus U.S. investors are highly unfamiliar with) and those with more.

According to the results, U.S. investors significantly discounted the values of foreign U.S. listed firms that are very different from their home country in terms of the four elements mentioned previously. They also did the same for the foreign firms that have zero or little sales in the U.S.

Effect on Investors

But how exactly does a familiarity bias affect the valuation of foreign stocks by investors? To be more specific, does it affect their estimation of the cost of capital – the required return necessary to justify the risk investors take, or does it affect their future cash flow projections?

The researchers first looked at cost of capital. After comparing the cost of capital between non-U.S. firms and U.S. firms, the study found that U.S. investors still placed about a 25 to 40 percent discount on the valuation of non-U.S. firms. In other words, cost of capital can partially explain the valuation discount of non-U.S. firms.

More importantly, the researchers found that familiarity bias led U.S. investors to have less faith in the future operating cash flows for foreign firms listed in the U.S., even when these firms report positive earnings.

The research team used analyst forecast revisions for firms’ future earnings immediately after earnings announcements as a way to measure whether familiarity bias affected how investors looked at future cash flows of foreign firms. They found that these analyst forecast revisions for the two and three year-ahead earnings were significantly lower for non-U.S. firms than U.S. firms. Again, the discounts are only significant among non-U.S. firms that U.S. investors are highly unfamiliar with.

They tweaked the data to make the firms comparable in terms of total operating cash flow in addition to being in the same industry, years of operation and other firm characteristics. The results show that the valuation of non-U.S. firms were still discounted by 44 percent.

“Where uncertainty lurks, a gloomy outlook is sure to follow and this is especially true in financial markets. That’s why even where a foreign company is reporting strong earnings, if they’re listed in market that is unfamiliar with it, it’s going to lead to a more muted response to earnings announcements than that for a company they are highly familiar with,” Prof. Zhang says. “

Prof. Young explains that although prior studies may have highlighted the benefits of listing in the U.S., their new study reveals that these benefits may be offset by preference amongst U.S. investors for investing in familiar stocks.

“The fact that foreign firms continue to rush to list on Wall Street despite this ‘handicap’ speaks volumes about the perceived benefits of being on markets such as the NYSE and NASDAQ, but firms seeking to cast their stock fundraising activities abroad would do well to carefully weigh its drawbacks, especially with cross-listings increasingly becoming of public concern as a result of rising global geopolitical tensions,” Prof. Zhang adds.