Financial Statement Comparability and Shareholder Activism

Comparability and Shareholder Activism:

Lessons from the Racetrack

The roar of engines, the screech of tires, and then—chaos. On the first lap of the Hungarian Grand Prix, Formula 1 racer Daniel Ricciardo’s car is hit, sending him spinning and out of the race.

“Was that who I think it was?” he asks the race engineer through his headset.

“Yes,” the engineer says tersely.

“Sore loser,” Ricciardo replies in disgust.

Who was this so-called loser, who, in an interview, Ricciardo would label an “amateur” who made “a very poor mistake”?

Max Verstappen. His teammate.

Like many new fans of Formula 1, my introduction was the slickly produced Netflix series, Drive to Survive, which takes viewers behind the high-stakes, adrenaline-filled scenes of the world’s most popular motorsport.

As fun as the race coverage in the series is, equally entertaining is the glimpse viewers get into the political machinations and intrigue—not just across teams but within them. I was surprised to discover that some of the fiercest rivalries take place between teammates, as was the case with Red Bull teammates Ricciardo and Verstappen, or Mercedes teammates Lewis Hamilton and Nico Rosberg, or decades earlier and perhaps most famously, McLaren teammates Alain Prost and Ayrton Senna.

What factors lead to such animosity between teammates? Certainly, egos play a part. You don’t make it to F1 by lacking in self-confidence and aggressiveness. But perhaps the greatest contributing factor is the most primal: scarce resources.

Currently, only 10 teams with 2 drivers each have the fortune of competing at the highest level of formula racing, so competition among the 20 drivers is fierce. Over 24 races, drivers compete for the drivers’ championship and are awarded with points depending on how they finish each race, and teams compete for the constructors’ championship and are awarded with the sum of their drivers’ points. Differences in engineering often leads to wide variation in team performance, such that only the most biased of Verstappen fans would argue that the current reigning champ would have a shot at the drivers’ trophy if he were driving for one of the worst constructors like, say, Haas Ferrari instead of perennial powerhouse Red Bull. In other words, machinery matters, and while the competition between teams can be entertaining, the competition within teams is positively riveting.

Since both drivers on a team are equipped with the same machinery, any performance difference between drivers is by and large attributable driver skill. It is one of the purest—and most ruthless—“holding all else constant” scenarios in sports. This puts immense pressure on drivers to outperform their teammates because, logic dictates, if one person on the team is getting axed, it’s not going to be the fast one. Indeed, as the saying goes, when being chased by a bear, you don’t have to be faster than the bear; you just have to be faster than your friend. Of course, the biggest reward in F1 is winning a championship, but the next biggest is, as the Netflix title suggests, simply living to drive another day.

Comparison: the thief of joy, racing careers, and corporate obscurity

In my paper on shareholder activism and financial statement comparability, I transport this idea of teammate comparison from the racetrack to the boardroom to investigate the role that comparability plays in attracting or avoiding the scrutiny of shareholder activists.

Just as F1 teams use identical cars to gauge their drivers’ relative skills, investors use financial statement comparability to assess how well a company is performing compared to its peers. This study asks: How does this “comparability factor” influence activist investors’ decisions to target certain companies, and how does it affect the market’s reaction to these high-stakes corporate showdowns?

Picture activist investors as the shrewd team principals of the corporate world. Just as an F1 team boss scrutinizes lap times and sector performances to evaluate their drivers, these investors pore over financial statements, looking for companies that aren’t keeping pace with their sector rivals. The more comparable the financial statements (think: identical F1 cars), the easier it is for activists to spot underperformers ripe for intervention.

Surprisingly, I found that higher comparability is generally associated with a lower likelihood of being targeted by activists. I’m still exploring some possible explanations for this. However, a crucial caveat I find is that, for underperforming firms, higher comparability significantly increases the chances of being targeted.

Think of it this way: if you’re an F1 driver who finishes toward the top, your performance relative to your teammate isn’t going to matter a whole lot to the team principal. So long as the team is winning, the principal may not care which driver finishes first. But if you’re performing near the bottom, suddenly comparability to your teammate becomes a lot more salient to the principal. Are you slow because your car is slow or because you are slow? One of the most important clues to this question is your teammate’s performance. Are they performing well? If so, it’s time to get nervous.

My research also uncovered an interesting spillover effect, finding that companies with high financial statement comparability to a recently targeted firm are more likely to become the next target. It’s as if activists are using the performance of one company as a benchmark to identify the next underperformer in the pack.

Perhaps the most intriguing finding relates to how the market reacts to activist interventions. The study revealed that comparability has a dampening effect on market reactions to activism announcements. This is akin to how F1 fans might react less dramatically to a driver swap in a team where both drivers have been closely matched – the relative performance makes the change seem less impactful.

Who cares?

So, what are the pit lane whispers telling us about the implications of this research? For corporate executives, the message is clear: keeping pace with your “teammates” (industry peers) is crucial. Just as an F1 driver needs to at least match their teammate to keep their seat, companies need to perform in line with their most comparable peers to avoid activist attention.

For investors, this research provides a new lens through which to view potential activist targets. By focusing on highly comparable firms that are underperforming their peers, they might be able to anticipate activists’ next big move. Because it’s clear that in both Formula 1 and shareholder activism, relative performance is key.

For regulators, the research offers important insights into the impact that characteristics of accounting standards (do they make companies more or less comparable?) can have on corporate governance and capital markets.

Whether you’re racing for pole position or running a Fortune 500 company, how you stack up against your closest competitors can make all the difference. In the end, it’s not just about being fast – it’s about being faster than the guy in the same machinery.

Stay tuned for more insights as this research progresses!