THE JOURNAL OF FINANCE
VOL. LXIII, NO. 4
Economic Links and Predictable Returns
LAUREN COHEN and ANDREA FRAZZINI
This paper finds evidence of return predictability across economically linked firms.We test the hypothesis that in the presence of investors subject to attention con-straints, stock prices do not promptly incorporate news about economically relatedfirms, generating return predictability across assets. Using a data set of firms’ princi-palcustomerstoidentifyasetofeconomicallyrelatedfirms,weshowthatstockpricesdo not incorporate news involving related firms, generating predictable subsequentprice moves. A long–short equity strategy based on this effect yields monthly alphasof over 150 basis points.
IRMS DO NOT EXIST AS INDEPENDENT ENTITIES
, but are linked to each other throughmany types of relationships. Some of these links are clear and contractual,while others are implicit and less transparent. We use the former of these,clear economic links, as an instrument to test investor inattention. Specifically,wefocusonwell-definedcustomer–supplierlinksbetweenfirms.Inthesecases,partner firms are stakeholders in each others’ operations. Thus, any shock toone firm has a resulting effect on its linked partner. We examine how shocksto one firm translate into shocks to the linked firm in both real quantities(i.e., profits) and stock prices. If investors take into account the ex ante pub-licly available
and often longstanding customer–supplier links, prices of thepartner firm will adjust when news about its linked firm is released into themarket. If, in contrast, investors ignore publicly available links, stock prices of
Cohen is at the Harvard Business School and NBER; Frazzini is at the University of ChicagoGraduate School of Business and NBER. We would like to thank Nick Barberis, Effi Benmelech,Judy Chevalier, Kent Daniel, Doug Diamond, Gene Fama, Will Goetzmann, Ravi Jagannathan, AnilKashyap,JosefLakonishok,OwenLamont,JonathanLewellen,TobyMoskowitz,LubosPastor,LassePedersen,MonikaPiazzesi,JosephPiotroski,JoshRauh,DougSkinner,MattSpiegel,RobertStambaugh, Amir Sufi, Jake Thomas, Tuomo Vuolteenaho, Ivo Welch, Wei Xiong, an anonymousreferee, and seminar participants at NBER, Barclays Global Investors, BSI Gamma Foundation,ChicagoQuantitativeAlliance,UniversityofChicago,AmericanFinanceAssociation,EuropeanFi-nanceAssociation,GoldmanSachsAssetManagement,LehmanBrothers,LondonBusinessSchool,New York University, Harvard Business School, Massachusetts Institute of Technology, Yale Uni- versity, AQR Capital Management, Prudential Equity Conference, and University of CaliforniaDavis Conference on Financial Markets Research for helpful comments. We also thank WooyunNam, Vladimir Vladimirov, and Jeri Xu for excellent research assistance, Husayn Shahrur andJayant Kale for providing us with some of the customer–supplier data, the Chicago Quantitative Alliance and the BSI Gamma Foundation for financial support. All errors are our own.
The customer–supplier links we examine in the paper are those sufficiently material as tobe required by SFAS 131 to be reported in public financial statements. We discuss the reportingstandard in Section II.