Impact of operational fragility on stock returns: Lessons from COVID‐19 crisis

• Published date: 01 June 2022
• Author: Avijit Bansal,Balagopal Gopalakrishnan,Joshy Jacob,Pranjal Srivastava
• Date: 01 June 2022
• DOI: http://doi.org/10.1111/irfi.12374

ORIGINAL ARTICLE

Impact of operational fragility on stock returns:

Lessons from COVID-19 crisis

Avijit Bansal

1

| Balagopal Gopalakrishnan

2

| Joshy Jacob

3

|

Pranjal Srivastava

3

1

Finance & Control Area, Indian Institute of

Management Calcutta, Kolkata, India

2

Finance Accounting & Control Area, Indian

Institute of Management Kozhikode,

Kozhikode, India

3

Finance & Accounting Area, Indian Institute

of Management Ahmedabad, Ahmedabad,

India

Correspondence

Joshy Jacob, Finance & Accounting Area,

Indian Institute of Management Ahmedabad,

Ahmedabad, Gujarat, India.

Email: joshyjacob@iima.ac.in

Abstract

We examine how the market valuation of firms varies on

account of their operational fragility that makes them vul-

nerable to the COVID-19 pandemic. Using the data on plant

location that uniquely identifies the vulnerability of firms to

operational disruptions, we find that firms with plants

located in zones susceptible to higher infections earn signif-

icantly lower returns. For firms with high operational fragil-

ity, the marginal value of financial flexibility and operating

flexibility is higher. The adverse impact of the operational

fragility is lower for firms affiliated with the larger business

groups. The paper identifies unique channels associated

with the pandemic that impact firm value.

KEYWORDS

COVID-19, financial flexibility, group affiliation, India, operating

leverage, operational fragility

JEL CLASSIFICATION

G14, G31, G32, D81, G41

1|INTRODUCTION

The COVID-19 pandemic is an unprecedented health crisis that has severely impacted global financial markets and

heightened the uncertainties for firms. Production and supply chain disruptions are widespread, owing to lockdowns

and infections in production facilities. The sudden shifts in consumer preferences have intensified the market uncer-

tainties. An increase in risk-aversion in financial markets has upset the capital raising plans of firms. Firms are also

exposed to legislative changes that are rapidly altering their business environment. Given the surge in the

Received: 22 September 2020 Revised: 21 September 2021 Accepted: 15 January 2022

DOI: 10.1111/irfi.12374

© 2022 International Review of Finance Ltd.

International Review of Finance. 2022;22:365–398. wileyonlinelibrary.com/journal/irfi 365

uncertainty within a short time, the expected impact of COVID-19 on firms is best understood through a study of

the changes in their equity market value.

We primarily investigate the cross-sectional variation in stock returns on account of firms' operational fragility

that makes them vulnerable or resilient during different stages of the pandemic. The study allows a comparison of

the impact of the characteristic on the market value of firms relative to pre-COVID-19 period. We employ a unique

identification of the vulnerability of firms to the spread of infection in their operating locations so as to assess their

operational fragility. Furthermore, we investigate how the impact of operational fragility on firm value is accentuated

or attenuated by other well-documented firm characteristics such as financial slack, operating flexibility, ownership,

and governance attributes. The joint influence of the pandemic specific variables, such as government-mandated

containment zones and the other firm characteristics, allows us to identify unique channels through which the pan-

demic impacts the market value of firms.

Unlike the developed economies, a developing one such as India is particularly vulnerable to the adverse impact

of the COVID-19 crisis. First, it has a relatively poor public health infrastructure. For instance, India spent only 3.5%

of the GDP on healthcare compared to the global average of 9.9% at the end of 2017, as per the World Bank data.

Second, India implemented the strictest nation-wide lockdown in the world, which strongly impacted the economic

activities.

1

Third, the high population density makes social distancing difficult for a large fraction of its population,

and this makes them relatively more vulnerable to infections in the post-lockdown period (Jha & Kawoosa, 2020;

Pandey, 2020). Fourth, the stimulus package announced by the Government of India was largely focused on liquidity

support rather than direct fiscal support (Iyer, 2020). The higher vulnerability to the spread of infections and low fis-

cal support expose the country to the likelihood of greater economic contraction and higher loss of market value for

its firms. Furthermore, India has a stressed banking system and a shallow bond market (Das & Nath, 2020;

Lele, 2020). Reflective of such challenges, the Indian equity market (NIFTY) rapidly shed nearly 40% of its market

value by March 24, 2020, compared to its value at the beginning of the year (see Figure 1).

2

These factors make it a

valuable context to examine how the firm-level characteristics impact the market value during the pandemic.

Our research examines how the varying degree of operational disruptions, due to the pandemic, impacts the

stock return of firms. Specifically, we first examine whether there is an exacerbated adverse impact on firms located

in hotspots of infection, which were designated as “red zone”by the Ministry of Health and Family Welfare,

FIGURE 1 Comparison of index returns during different stages of COVID-19 pandemic. The figure shows the

normalized (normalized on the first trading date of the FY 2020) index values of NIFTY, S&P 500, SSE Composite

and FTSE. The different stages of the pandemic are as defined in Table 1.(Source: Yahoo Finance)

366 BANSAL ET AL.

Government of India (MOHFW, 2020). The classification of “red zones”is based on the number of active cases, the

time taken for the number of cases to double and the test rate in the district. Commercial operations in “red zones”

remained restricted. For instance, in its mandatory disclosure on the impact of COVID-19, Coal India Ltd., the largest

mining firm in India, stated that “Operations in major coal fields like Korba and Ib valley were disrupted due to decla-

ration of ‘Red zone’in some of the areas of these coalfields.”(Figure 2)

Second, we ask how the market value of cash holding differs across firms due to their susceptibility to opera-

tional disruptions. A high degree of financial flexibility would offer considerable strength to firms in a stormy eco-

nomic and operational environment. Third, how does the inflexibility in the cost structure exacerbate the impact of

operational fragility on the market value of firms? The flexibility in the cost structure is likely to be priced by the mar-

ket, given the unprecedented demand contraction. Finally, we examine whether the business group affiliation of a

firm, a distinct feature of emerging markets, make it more resilient to the crisis. Governance and ownership charac-

teristics, such as affiliation to a business group, could make firms more resilient in a crisis.

FIGURE 2 Geographic map of the red zones in India. The figure provides the geographic location of the “red

zones”in India. The categorization of the “red zones”is done by the Ministry of Health and Family Welfare on April

30, 2020 (Source: MOHFW (2020))

BANSAL ET AL.367