Strategic Management Journal Strat. Mgmt. J., 24: 1���16 (2003) Published online 5 November 2002 in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/smj.278 IS PERFORMANCE DRIVEN BY INDUSTRY- OR FIRM-SPECIFIC FACTORS? A NEW LOOK AT THE EVIDENCE GABRIEL HAWAWINI,1 VENKAT SUBRAMANIAN2 and PAUL VERDIN1,2* 1 INSEAD, Fontainebleau, France 2 Solvay Business School, Universit�� e Libre de Bruxelles, Brussels, Belgium In this study we revisit the question of whether firms��� performance is driven primarily by industry or firm factors, extending past studies in two major ways. Firstly, in a departure from past research, we use value-based measures of performance (economic profit or residual income and market-to-book value) instead of accounting ratios (such as return on assets). We also use a new data set and a different statistical approach for testing the significance of the independent effects. Secondly, we examine whether the findings of past research can be generalized across all firms in an industry or whether they apply to a particular class of firms within the same industry. We find that a significant proportion of the absolute estimates of the variance of firm factors is due to the presence of a few exceptional firms in any given industry. In other words, only for a few dominant value creators (leaders) and destroyers (losers) do firm-specific assets seem to matter significantly more than industry factors. For most other firms, i.e., for those that are not notable leaders or losers in their industry, however, the industry effect turns out to be more important for performance than firm-specific factors. Copyright ��� 2002 John Wiley & Sons, Ltd. INTRODUCTION Explaining the sources of performance differences among firms is a key theoretical and empirical issue in the field of strategic management. The industrial organization view argues that industry factors are the primary determinants of firm perfor- mance, while the resource-based view argues that the firm���s internal environment drives competitive advantage. Since the initial works of Schmalensee (1985) and Rumelt (1991), a number of empirical studies have examined the relative importance of firm and industry factors over the last decade. An important characteristic of past studies is the measure of performance used. Research on the rel- ative importance of firm and industry effects has Key words: industry and firm effects value leaders losers and average firms *Correspondence to: Paul Verdin, Solvay Business School, Uni- versite�� Libre de Bruxelles, Avenue Franklin D. Roosevelt 21, CP 145, B-1050 Brussels, Belgium. traditionally relied on raw accounting values of return on assets (ROA) as the performance mea- sure. If the purpose of firm strategy, however, is to deliver sustainable value creation, which occurs only when firms earn returns greater than the cost of capital, then the measures used should proxy such economic performance. Raw accounting val- ues of measures such as ROA account neither for the cost of capital nor for the accounting policies that may distort the true value of the underlying measures, for instance, the value of assets. Examining what drives ROA is not equivalent to examining what drives value creation. Most accounting-based measures are not consistent with value maximization. Fortunately, recent develop- ments in corporate finance have led to new metrics of performance, which have been adopted by sev- eral firms in order to track their performance and to design their reward systems.1 The adoption of such 1 For a review, see Martin and Petty (2000). Copyright ��� 2002 John Wiley & Sons, Ltd. Received 29 January 2001 Final revision received 21 June 2002

2 G. Hawawini, V. Subramanian and P. Verdin measures and, in general, the practice of value- based management (Haspeslagh, Noda, and Bou- los, 2001), has coincided with increasing pressures from capital markets and the markets for corporate control for managers to focus their strategies on value creation, i.e., economic performance. In this paper, we investigate the importance of industry factors using alternative measures of per- formance such as economic profit and market-to- book values. The former reflects operating perfor- mance in a given year, while the latter reflects the market���s expectations of the firm���s future oper- ating performances. We also use a new data set using measures such as economic profit and total market value and implement a different statisti- cal approach using random ANOVA methods for testing the significance of the independent effects. Our study also examines the influence of ���out- liers��� on firm and industry effects. As the number of firms that outperform the industry increases, the greater will be intra-industry dispersions and lower will be the importance of industry effects. An interesting case would be when all firms devi- ate ���considerably��� from each other. But recent evi- dence suggests that such outliers are not numerous and are very few in most industries. Firms in the top 20 percent of Fortune���s rankings in terms of market value added (market value less book value of capital) enjoy double the shareholder returns of the other firms in their industries.2 Management researchers have identified the possibility of one or a few firms dominating value creation within their industries. Innovative firms have been able to invent new markets and reinvent old ones and in the process have been able to capture a large part of the industry���s profits (Kim and Mauborgne, 1997 Gadiesh and Gilbert, 1998). The present study seeks to explore to what extent the presence of these few exceptional firms within an indus- try may be responsible for the high level of firm effects found in past studies, and whether the struc- tural effects of the industry have a different level of impact for the rest of the industry���s firms. Our paper is organized as follows. In the next section we provide a brief review of the relevant literature. We then discuss performance measures, the data set and methodology. This is followed by the identification of value leaders and value losers and the empirical results. We conclude with a discussion of the results and final remarks. 2 See Jonash and Sommerlatte (1999). REVIEW OF THE LITERATURE Since the late 1970s, industrial organization (IO) economics has provided the main theoretical basis for strategic management research into the deter- minants of firm performance.3 The central argu- ment was that the structural characteristics of industries were the primary determinants of perfor- mance (Porter, 1980). Several studies investigated factors explaining the consistent differences in per- formance between industries.4 The industrial orga- nization economists��� favored theoretical frame- work was the structure���conduct���performance (SCP) model, which proposes the existence of a deterministic relationship between market struc- ture and profitability. The structural characteristics of an industry inevitably constrained the behav- ior (i.e., the conduct or strategies) of its compo- nent firms, which in turn led to industry-specific performance differentials between firms (Mason, 1939). In this framework, the industry structure in which a firm operates is the main driver of per- formance variations. An important line of research within this stream concerned the role of firm size as a factor explaining differences in profitabil- ity (Baumol, 1967 Hall and Weiss, 1967). Size was a source of competitive advantage because bigger firms are presumed to be relatively more efficient than smaller ones. However, the causal relationships between size and profitability have been widely tested, with ambiguous results.5 In the 1980s, there were major shifts in the strategic management field regarding the unit of analysis. While industrial organization economics considers industry as the main unit of analysis, strategic management focuses increasingly on the firm itself to explain profitability differentials. The main reason for this shift is the inability of the industrial organization tradition to provide a rig- orous explanation for intra-industry heterogene- ity in performance. If firms within an industry faced identical conditions of supply and demand and operated under the same market structure, then why did some firms within the same indus- try still perform better than others? Nelson (1991) 3 Rumelt, Schendel, and Teece (1996) discuss the historical evolution of strategic management research from its initial case- based orientation to a more theoretical basis, developed by concepts from industrial organization and later the resource- based view. 4 For reviews, see Scherer (1980). 5 For a review see Prescott, Kohli, and Venkatraman (1986). Copyright ��� 2002 John Wiley & Sons, Ltd. Strat. Mgmt. J., 24: 1���16 (2003)

Industry and Firm Effects 3 argues that traditional microeconomic theory, with its focus on industry factors, ignored the fact that firms can make discretionary choices and such choices are not identical across all firms within an industry. An important attempt to understand intra- industry heterogeneity came with the concept of strategic groups that classified firms based on dimensions of competition.6 Profit differentials between groups were sustained due to the presence of conditions that created barriers to mobility between groups. Asymmetries among firms within industries act to limit the contraction of differentials and the equalization of profit rates (Caves and Porter, 1977). Another significant attempt to understand intra- industry performance differences was the resource- based view of the firm, which proposes that firm- specific idiosyncrasies in the accumulation and leverage of unique and durable resources are the source of sustainable competitive advantage. Rent- producing resources determine the profit level of firms for profits to be sustainable, the resources have to be scarce, difficult to copy or substitute, and difficult to trade in factor markets (Wernerfelt, 1984 Dierickx and Cool, 1989 Barney, 1991). Firms were not seen as identical ���black boxes��� in a given market structure, but as dynamic collections of specific capabilities, which were the sources of performance differences. Company strategies and organizational structures differ between firms within an industry, and organizations evolve in different ways. In the process, the bundle of capa- bilities that each organization possesses comes to differ (Nelson, 1991). As a result, a central empirical question for strategic management has been the relative roles of industry and firm effects on firm performance. Schmalensee���s (1985) study was a first attempt to analyze empirically the contribution of indus- try and firm factors to overall profitability,7 tak- ing market share as the measure of heterogene- ity among firms, following the industrial organi- zation assumption that intra-industry heterogene- ity is uniquely due to differences in firms��� size. Using 1975 Federal Trade Commission (FTC) Line of Business data and return on assets (ROA) 6 For a review of the strategic group literature, see McGee and Thomas (1986). 7 Firm effects include any effect that has a firm-specific com- ponent such as stable and transient business-level, stable and transient corporate effects. as a performance measure, the study reported that industry membership accounted for around 20 percent of observed variance in business unit returns while market share accounted for a negli- gible amount. The study concluded that industry effects played a central role in determining prof- itability while, in comparison, firm factors were insignificant. However, Schmalensee���s (1985) study left 80 percent of the total variance in business unit returns unexplained. Rumelt���s (1991) landmark study attempted to clarify this large degree of error. One reason was the use of market share as a proxy for firm-specific factors, which probably left the research model underspecified. With a data set covering just 1 year, Schmalensee was constrained from specifying a composite firm factor that accounted for the effects of all firm- level factors. Rumelt���s study used data from 4 years, allowing the inclusion of a composite term to measure business unit effects. The study also extended Schmalensee���s descriptive statistical model by including additional terms to measure the intertemporal persistence in industry effects, year effects, corporate effects, and effects arising from corporate/industry interaction. As a result, Rumelt (1991) reported that indus- try membership explained around 9 percent of the variance in business unit returns, of which only half was stable from year to year. Business unit effects, on the other hand, accounted for more than 44 percent of business unit variations in profits. The study also reported low year effects, and neg- ligible corporate and corporate/industry interaction effects. The results were rich in interpretation. Not surprisingly, the study reignited the debate on the relevance of industry, business unit factors, and diversification as determinants of profitability. The debate has been encouraged by further empirical studies along the lines of Rumelt���s work: Powell (1996) Roquebert, Phillips, and Westfall (1996) McGahan and Porter (1997) Mauri and Michaels (1998) Brush, Bromiley, and Hendrickx (1999). While using similar methodology, they dif- fered from Schmalensee and Rumelt���s work inas- much as they used the Compustat database, which allowed service industries to be included in the analysis (the FTC data set contained only man- ufacturing industries).8 A second difference was 8 Powell (1996) uses a survey methodology that uses executives��� perceptions. Copyright ��� 2002 John Wiley & Sons, Ltd. Strat. Mgmt. J., 24: 1���16 (2003)