The Truth About the Seven-Percent Rule

The New Yorker’s James Surowiecki recently devoted a column to the notorious “Seven Percent Rule.” For those unfamiliar with the phrase, it refers to the assumption that after a company announces major layoffs, its stock price will rise roughly 7% in an apparent correlation between employee downsizing and Wall Street enthusiasm. Surowiecki notes, however, that the rule’s validity took a hit recently when both Circuit City and Citigroup saw their stock prices fall after announcing lots of job cuts. His conclusion? The rule isn’t much more than a corporate myth.

He proceeds to debunk the idea that fewer employees, and thus lower payroll costs, equal higher profits, citing University of Colorado management professor Wayne Cascio‘s study of three hundred downsizing firms in the 1980s. The data indicated that, three years after the layoffs, profit margins, costs, and returns on assets hadn’t improved. While Surowiecki acknowledges that it’s possible the companies would have fared even worse had they failed to downsize, he concludes that the effects of layoffs on the average company’s profit margins seem negligible at best.


frankenduf

why on earth would an announcement of layoffs be a harbinger of future success?- I would assume the opposite- that the company has problems enough to self amputate- unless the major layoffs are a summary layoff of middle management, I would steer clear of rosy outlooks

hyrumberg

That myth probably comes from people who hate capitalism and want to smear its leading people. In this case they want to make corporations sound like heartless entities led by those who thrive on getting rich at the costs of others.

furiousball

My own guess would align with Surowiecki's points. The real company's ability to turn a profit will eventually come out in the watch. Unless there was a major change in corporate mission or leadership that 7% rise (if it actually even happens) will only fool traders for a limited about of time.

econ2econ

I agree with the previous statements. Layoffs are usually a sign of a sinking ship. Unless Circuit City has a serious overhall of their strategy, I don't see this recent move doing anything to help their current situation. They still have to combat the image of bad customer service, not to mention doing something to differentiate themselves from Best Buy and Wal-Mart.

amit

There's two ponts jammed into this post. It's impossible to generalize for either.

1. Do cuts drive a stock price up ?
2. Do cuts result in higher earnings ?

1. Bad news can override good news. In the case of C and CC the stock price was subject to "bad news" and not just the "good news" of job cuts.

Singletoned

I would have guessed that layoffs get you into the news and into people's awareness temporarily. And that being in the news and in people's awareness tends to drive up your stock price a little.

Also, bear in mind that it doesn't matter what the three year projection is for companies laying off staff. People who buy stock immediately after 'news' tend to be after shorter term gains.

Or it could be a self-fulfilling myth.

zbicyclist

"Notorious seven percent rule"? Notorious to whom?

1. I've spent an unfortunate amount of time in downsizing public companies and never heard of this "rule".

2. Putting "seven percent rule layoffs" into Google doesn't turn up anything on the first five screens -- except references to the New Yorker article.

unknownprofessor

I did some preliminary work in this area in the late 1990's. The average return in the 3 days surrounding the announcement of a layoff (depending on the time frame, type of company, and characteristics of the layoff) was slightly negative (about -1/2%, from my recollection). The vast majority of layoff announcements that I looked at had market returns between -2% and +2%. From my recollection of the article mentioned in Surowiecki's piece, it looks like numbers are about the same.

While the returns upon a layoff announcement are statistically significant, a -2% market reaction isn't that large in economic terms.

And since this was touched on by a couple of commenters, the reaction to layoffs depends a lot on the other information found in the announcement. In a 1997 Financial Management piece, Palmon, Sun, and Tang found that the market reaction was negative for layoffs that could be classified as "declining-demand driven", but were positive for anlayoffs that were driven by efficiency concerns. So, not all layoffs are created equal.

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jim_carson

I don't know if you've ever seen Satirewire (R.I.P.), but they did an excellent parody of this concept as applied, in the extreme sense, to AT&T.

At best, the layoffs are a temporary cash flow bandage to bide time for management to pull something out of their executive hats. (Though one might ask if they let the situation get so dire, how will they not do it again?)

dolcevita1972

It would be interesting to study the numbers, but I were to guess, typically companies lay off people as their company is no longer growing or its sales are shrinking. Many labor costs are fixed so as sales shrink that cost as a percentage goes up. Conversely, as companies are growing typically they are adding more staff to handle the load, fund projects, etc. I would guess that their stock prices would correlate in this manner as well.

Kent

Enough with this Marxist folderol!

711buddha

This tripe assumes all layoffs are equal, but there are two distinct flavors. First is the slashing associated with a failing business.

Is this good or bad? Well, its neither - it's necessity. There are bad ways to do it (a la Al Dunlap) but if executed correctly (per Lee Iacocca for instance) it can give a business time to change its basic value proposition into something meaningful and the result can be a reinvigorated vital company. The key here is that layoffs aren't a strategy, they are an enabler of other strategies.

But there is another flavor of layoff. In this the kind where a healthy company prunes its staff to eliminate underperformers, bureaucracy and redundancies. (Think Jack Welch at GE.) This kind of layoff can be tremendously powerful. (And yes, middle management and executives are included.)

So without knowing the condition of the business before the layoff, its pretty silly to suggest that it can't help.

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ImFromGuam

In the 1987 movie 'Wall Street', Gordon Gekko the corparate raider quips, 'Greed is good.' If we took out all the hipe and drama and concentrate on how Gekko made his fortune you will find:

1. His wealth came from raiding textiles, manufactures, and production industries.

2. Once Gekko moved into the airline industry, more importantly, the 'service' part of the industry, that's when his skills failed him. Circuit City and Citigroup are 'service' industries.

As for the 7 percent rule, is it possible that it could be related to the 5 second rule to food being dropped on the floor?

chemistry

http://ssrn.com/abstract=985735 is a recent study showing that employee satisfaction leads to superior long-term shareholder returns, again casting doubt on the 7% rule:

Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices
ALEX EDMANS
Massachusetts Institute of Technology (MIT) - Sloan School of Management

"This paper analyzes the relationship between employee satisfaction and long-run stock performance. A portfolio of stocks selected by Fortune magazine as the Best Companies to Work For in America in January 1998 earned average annual returns of 14% by the end of 2005, over double the market return, and a monthly four-factor alpha of 0.7%. The portfolio also outpeformed industry- and characteristics-matched benchmarks. These findings have two main implications. First, they suggest that employee satisfaction improves corporate performance rather than representing inefficiently excessive non-pecuniary compensation. Second, they imply that the stock market does not fully value intangibles, even when they are made visible by a publicly available survey. This suggests that intangible investment generally may not be incorporated into short-term prices, providing support for managerial myopia theories."

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Bruce Hayden

I think that maybe part of the problem here is viewing the downsizing as indicia of a failing company, versus as a response to such. The difference here is in the timing. In some cases, the company is known to be in trouble in a declining business, industry, etc. For example, sales can be decreasing over time, and revenue targets missed. I would suggest in those cases, the company's stock would already reflect this. The downsizing them might in some cases be seen as finally addressing the problem, and, thus, positively.

On the other hand, if the situation is less well known, and thus less well internalized in the market for the stock, then the downsizing may be the indicia that makes the problems obvious.

Thus, the distinction may be whether the downsizing leads or lags knowledge in the market of a company's problems.

frankenduf

why on earth would an announcement of layoffs be a harbinger of future success?- I would assume the opposite- that the company has problems enough to self amputate- unless the major layoffs are a summary layoff of middle management, I would steer clear of rosy outlooks

hyrumberg

That myth probably comes from people who hate capitalism and want to smear its leading people. In this case they want to make corporations sound like heartless entities led by those who thrive on getting rich at the costs of others.

furiousball

My own guess would align with Surowiecki's points. The real company's ability to turn a profit will eventually come out in the watch. Unless there was a major change in corporate mission or leadership that 7% rise (if it actually even happens) will only fool traders for a limited about of time.

econ2econ

I agree with the previous statements. Layoffs are usually a sign of a sinking ship. Unless Circuit City has a serious overhall of their strategy, I don't see this recent move doing anything to help their current situation. They still have to combat the image of bad customer service, not to mention doing something to differentiate themselves from Best Buy and Wal-Mart.

amit

There's two ponts jammed into this post. It's impossible to generalize for either.

1. Do cuts drive a stock price up ?
2. Do cuts result in higher earnings ?

1. Bad news can override good news. In the case of C and CC the stock price was subject to "bad news" and not just the "good news" of job cuts.