The stock market reaction to layoff announcements in germany

Kohl ABSTRACT Previous studies on shareholder reaction to layoff announcements have concentrated on American stock markets.. Using event study methodology and daily return data from the

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ANNOUNCEMENTS rN GERMANY

byEdward R Kohl submitted to the Faculty of the College of Arts and Sciences

o f American University

in Partial Fulfillment o f the Requirements for the Degree o f

M aster o f Arts in

Economics

Chair:

Graham Associate Professor o f Economics

, Julia I Lane Professor of Economics

Howard M Wachtel Dean College of Arts and Sciences

1999

Date

American University

UMI Number: 13 9567 8

UMI Microform 1395678 Copyright 1999, by UM I Company All rights reserved This microform edition is protected against unauthorized copying under Title 17, United States Code.

ANNOUNCEMENTS IN GERMANY

BYEdward R Kohl ABSTRACT

Previous studies on shareholder reaction to layoff announcements have concentrated

on American stock markets This paper extends research to shareholder reactions on the Frankfurt Stock Exchange during the years 1990 to 1996 Using event study methodology

and daily return data from the Karlsruher Kapitalmarktdatenbank, the shares o f 30 firms are

tested for abnormal returns on and around the day o f a layoff announcement Daily abnormal returns were found to be significant and negative for the announcement day itself and the days just prior to it Cumulative abnormal returns were found to be significant and negative for the ten days preceding the announcement and significant and positive for the ten days following the announcement These results suggest that while layoffs are generally perceived as bad news by investors in Germany, they are also seen as a sign that a company

is heading in the right direction

TABLE OF CONTENTS

A BSTR ACT ii

LIST OF T A B L E S iv

LIST OF FIGURES v

1 INTRODUCTION 1

2 THEORETICAL CONSIDERATIONS AND PREVIOUS LITERATURE 2

3 SAMPLE D A T A 6

4 METHODOLOGY 9

5 EMPIRICAL RESULTS 19

6 C O N C LU SIO N 24

BIBLIOGRAPHY 25

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T a b le t Firm C a ta lo g u e 8

Table 2 Distributional Properties o f Daily R e tu rn s 15

Table 3 Daily Abnormal Returns and Test S tatistics 20

Table 4 Cumulative Abnormal Returns and Test Statistics 20

In the first six years following reunification, Germany experienced a period of

booming stock markets accompanied by rising unemployment The Deutsche Aktienindex

(DAX) more than doubled in value during this period while German companies, faced with high costs and foreign competition, were forced to lay off workers in record numbers Although the stock market boom was attributed to external factors, such as low interest rates,

a strong dollar, an influx o f foreign capital, and a bullish Wall Street, labor unions and politicians began to question the link between booming share prices and rising unemployment They did not fail to notice that a firm’s share price often rose following a layoff announcement

In a country where labor-management consensus traditionally ensures adequate employment, this development led to accusations that firms were not doing their fair share

in helping to reduce unemployment Several politicians, including former Labor Minister Norbert Blum, even suggested that higher share prices had come at the cost o f jobs in Germany.1 This paper puts such popular claims to the test by examining the share price response to layoff announcements made by German firms during the period 1990 to 1996

By testing market reactions on the Frankfurt Stock Exchange, this paper also complements previous studies which have concentrated on American stock markets

{Die Welt, 15 February 1995.

THEORETICAL CONSIDERATIONS AND

PREVIOUS LITERATURE The financial consequences o f layoff announcements are ultimately decided by investors and their perceptions regarding the reasons for the layoff A layoff perceived as good news will be rewarded with higher share prices while one perceived as bad news will

be disciplined with lower share prices In the former case, investors often see the layoff as

an attempt by the company to increase efficiency and profitability by reducing labor costs This is especially true for firms in decline where layoffs are seen as evidence that the organization is taking steps toward reversing the fortunes o f the firm (Cameron 1988) In

a study which examined the valuation effects o f such cost-cutting efforts, Lin (1987) showed that rationalization, including layoffs, produced positive economic benefits for a firm as measured by share price movements Likewise, a layoff can be perceived by investors as an attempt to “cut the fat” when a company has become overstaffed or inefficient Tsay (1993) found evidence that deep cuts in inefficient capital spending are associated with positive stock market effects In the eyes o f investors, efforts aimed at cutting costs and increasing efficiency will often lead to higher expected future earnings and, consequently, higher prices for the firm’s share

A layoff perceived as bad news on the other hand is often seen as a signal that a firm

2

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is actually in worse shape than was previously thought Under these circumstances, the

anno u n c e m e n t reveals to the market an unfavorable situation which management has already acted upon by laying o ff workers A layoff undertaken at this stage is perceived more as an act o f desperation than as a rational strategy to increase efficiency, and is thus met with lower share prices Worrel, Davidson, and Sarma (1991) found evidence that firms in financial distress experienced negative stock market returns following layoff announcements In a further study examining displaced workers in the United States, Caves and Krepps (1993) found that for U.S corporations announcing downsizing in the period

1987 to 1991, average daily excess returns on stocks were negative following layoff announcements

Alternatively, a layoff announcement may produce no observable reaction on the

stock market This may occur if both positive and negative reactions are present and their

effects cancel each other out It may also arise i f a layoff announcement brings no new

information to investors This is likely for a firm which is known to have problems and for which a layoff comes as no great surprise to investors In an interesting study on market perceptions o f layoffs in the United States, Chatrath, Ramchander and Song (1995) found that perceptions o f layoffs can even change over time They showed that while the market reaction to layoff announcements was generally negative in the early to mid eighties, it became increasingly positive in the late eighties and early nineties This finding is not surprising given the trend toward lean management which emerged during that period

W hen examining market reactions to layoff announcements in Germany, it is desirable to consider the legal and institutional hurdles to layoffs which are present in

4Germany and which affect how and when a firm carries out layoffs The most prominent

o f these is the Betriebsverfassungsgesetz (Works Councils Act), a law which, among other

things, guarantees workers the right to co-determination in the workplace and which stipulates specific procedures for dismissing workers A primary component o f this law is

the right o f workers to set up their own Betriebsrat (employees’ council) in firms with five

or more employees The council is a permanent liaison between workers and management and is involved in all major decisions regarding the firm, including those having to do with

layoffs It is common for the management to seek the advice and approval o f the Betriebsrat before undertaking a layoff Although the Betriebsrat, ultimately, cannot prevent a layoff

from taking place, it can influence whom the layoff affects and how the layoff is carried out Its members participate, for example, in the drafting o f a “social closing plan,” a document

required by the Betriebsverfassungsgesetz of any firm undertaking a major restructuring

involving significant job cuts

Once the layoffs proceed, the Betriebsrat also ensures that they are carried out

“socially” and in accordance with regulations of the Betriebsverfassungsgesetz Specifically,

this could mean that a worker’s familial status is considered before a layoff decision is made

or that a dismissed worker is awarded an appropriate severance payment.2 Although not

required, the Betriebsrat’s approval is always sought in cases o f layoffs since failure to do

so entitles affected workers to a hearing at the Arbeitsgericht (labor court) where the

prospects are good that he will be reinstated Although these regulations are intended to protect the rights o f workers, they often have the unwanted side-effect o f making urgently

2 See Siebert (1997) for a summary of job protection legislation for five West European countries

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needed layoffs more difficult and costlier to carry out.

Given that layoffs are more costly in Germany, it is reasonable to assume that a firm will generally only consider a layoff after its position has become fairly critical or after previous attempts to improve its position have failed Likewise, it is only under these

extreme circumstances that management will be in a position to convince the Betriebsrat

that a layoff is necessary and unavoidable Since investors are aware o f these facts and know' that layoffs are only carried out under extreme circumstances, one could speculate that investor reaction to layoff announcements would be negative

3SAMPLE DATALayoff announcements were collected by searching the business news section of the

WISO I ( Wirtschafts- und Sozialwissenschaften) CD-ROM index Key words, such as

layoff, job cut, and dismissal were used to search newspapers for articles containing layoff announcements for the pericd 1990 to 1996 The search initially yielded 73 layoff announcements to which the following criteria were then applied: (1) firms were omitted whose lays-offs were precipitated by a take-over, merger, or imminent bankruptcy, (2) only firms which are continuously traded on the Frankfurt Stock Exchange were retained in the sample,3 (3) firms were omitted whose shares had missing values on days surrounding the layoff announcement, (4) firms that were recently privatized, such as Lufthansa and Deutsche Telekom, were omitted from the sample, (5) if the layoff announcement was accompanied by another major announcement, the firm was omitted from the sample If the layoff announcement appeared in several newspapers on different dates, the earliest date was chosen Although not a criterion for inclusion in the sample, all announcements appeared

in the newspapers Handelsblatt, Frankurter Allgemeine Zeitung, and Siiddeutsche Zeitung.

The final sample consists o f 30 firms which represent 5.7 % o f the approximately

3 Continuously traded shares are bought and sold during the entire trading day The number offirms which meet this criteria is approximately 220 but varies from year to year See Gdppel and

Schutz (1995) In contrast, many shares in Germany are traded “E in h e itsku rsmeaning their

prices are determined once a day, usually at noon, based on bid-ask spreads

6

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525 firms traded on the Frankfurt Stock Exchange.4 Table 1 presents a catalogue o f the sample firms, their industry branches, the announcement dates o f the layoffs, and the size

of the layoffs, measured as a proportion o f the firm’s total workforce The industries represented in the sample reflect Germany’s overall industrial make-up with a relatively large showing o f machinery, chemical, and motor-vehicle related companies The month

o f November saw the largest number o f layoffs with six, followed by January and July with four, and December and February with three The largest layoff was made by Berliner Kraft und Licht, while the smallest ones were made by Mannesmann and Schering The average layoff size was 5.0 % o f the work force

Daily share price and return data were provided by the Karlsruher

Kapitalmarktdatenbank (KKMDB), a data bank administered by the University of Karlsruhe

which makes capital market data available to researchers for academic purposes This daily

return data for individual firms has been cleaned, meaning that returns have been adjusted

for splits, cash dividends and issuance o f new shares

4There are approximately 800 companies traded on the eight stock exchanges in Germany

These are Berlin, Bremen, Diisseldorf, Frankfurt, Hamburg, Hannover, Munchen, Stuttgart The largest firms, e.g., those in the DAX index, are traded in Frankfurt and on all other stock

8Table 1 Firm Catalogue

Catalogue o f sample firms, industry branches, layoff dates, and layoff sizes The layoff date is defined

as the date on which news o f the layoff first appeared in a newspaper Layoff size is the percentage of employees affected by the layoff.

(%)

*Exact size o f layoff not announced.

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Using the terminology o f Fama (1991), an event study examines the adjustment o f

security prices to publically available information such as stock splits or layoff announcements.5 These studies were initially used to test the information efficiency o f markets, that is, whether or not markets react to new information and how quickly this reaction occurs More recently, however, financial economists have turned their attention

to measuring the effects o f a particular economic event on the stock market value o f a firm.6 This movement away from the traditional use o f event studies was due primarily to the increasingly widespread acceptance o f the information efficiency o f security markets— an abundance o f empirical evidence from event studies have shown that, on average, stock

prices do react to new information and generally within a period o f one day relative to the

event (Fama 1991) Fama even refers to event studies as a growth industry in the financial economics literature He attributes this to the widespread availability o f financial market data, and the general applicability o f event study methodology to a variety o f situations.7

5 In his original work on market efficiency (Fama, 1970, 383), Fama uses the term semi-strong

test to describe market efficiency tests of this kind In his more recent work (Fama, 1991,1577),

he proposes a change in terminology from semi-strong test to event study in recognition of its

wide-spread use in the financial economics literature

6 For a brief history of event studies see Campbell, Lo & MacKinlay, 1997, 149-50

7 The bibliography contains references to 19 event studies See, for example, Fama, Fisher,Jensen & Roll(1969), Patell(1976), Dodd & Wamer(1983), Johnson, Magee, Nagarajan &

Newman(1985), Furtado & Rozeff(1987), Warner, Watts & Wruck(1988)

The day on which the announcement appears is called the event day and is designated

day 0 (see Figure 1) Days prior to the announcement are given negative values and days following the announcement are given positive values A date three days before an announcement is thus day -3, and a date ten days after an announcement is day 10

In addition to examining the market reaction on the event day itself, there is good reason to examine the days surrounding the event Assuming, for example, that the actual layoff announcement occurs one day prior to the article’s appearance, an initial reaction to the layoff can be expected on day -1, and further reactions on days 0 and 1 as news o f the layoff spreads Pre-event day reactions, especially those occurring before day -1, can also

be interpreted as evidence o f information leakage, that is, evidence that investors have

gotten word o f the layoff prior to its public announcement and have begun to act upon it Surrounding days are also examined in order to detect trends which may remain hidden in single day analysis Testing for such trends will be taken up later when cumulative returns

are examined The period surrounding the event day is designated the event period For this

study, the event period is defined as days -10 to 10 (see Figure 1)

In order to provide a basis for comparison, share performance is also measured for

a number o f months prior to the event period The results are then used to calculate the

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