Welcome to Scribd, the world's digital library. Read, publish, and share books and documents. See more
Download
Standard view
Full view
of .
Look up keyword
Like this
2Activity
0 of .
Results for:
No results containing your search query
P. 1
Economic Links and Predictable Returns

Economic Links and Predictable Returns

Ratings: (0)|Views: 45|Likes:
Published by greg
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 constraints,
stock prices do not promptly incorporate news about economically related
firms, generating return predictability across assets. Using a data set of firms’ principal
customers to identify a set of economically related firms, we show that stock prices
do not incorporate news involving related firms, generating predictable subsequent
price moves. A long–short equity strategy based on this effect yields monthly alphas
of over 150 basis points.
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 constraints,
stock prices do not promptly incorporate news about economically related
firms, generating return predictability across assets. Using a data set of firms’ principal
customers to identify a set of economically related firms, we show that stock prices
do not incorporate news involving related firms, generating predictable subsequent
price moves. A long–short equity strategy based on this effect yields monthly alphas
of over 150 basis points.

More info:

Published by: greg on Nov 26, 2008
Copyright:Attribution Non-commercial

Availability:

Read on Scribd mobile: iPhone, iPad and Android.
download as PDF, TXT or read online from Scribd
See more
See less

07/09/2010

pdf

text

original

 
THE JOURNAL OF FINANCE
VOL. LXIII, NO. 4
AUGUST 2008
Economic Links and Predictable Returns
LAUREN COHEN and ANDREA FRAZZINI
 ABSTRACT
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.
F
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
1
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.
1
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.
1977
 
1978
The Journal of Finance
related firms will have a predictable lag in reacting to new information aboutfirms
trading partners. Thus, the asset pricing implications of investors withlimited attention is that price movements across related firms are predictable:Prices will adjust with a lag to shocks of related firms, inducing predictablereturns.Two conditions need to be met to test for investor limited attention: (i) anyinformation thought to be overlooked by investors needs to be available to theinvestingpublicbeforepricesevolve,and(ii)theinformationneedstobesalientinformation that investors should be reasonably expected to gather.While the latter of the two conditions is clearly less objective and more dif-ficult to satisfy, we believe that customer
supplier links do satisfy both re-quirementsandprovidea naturalsettingfortestinginvestorlimitedattention.First, information on the customer
supplier link is publicly available in thatfirms are required to disclose information about operating segments in theirfinancialstatementsissuedtoshareholders.RegulationSFASNo.131requiresfirms to report the identity of customers representing more than 10% of theirtotal sales in interim financial reports issued to shareholders. In our linkedsample, the average customer accounts for 20% of the sales of the supplierfirm. Therefore, customers represent substantive stakeholders in the supplierfirms. Furthermore, in some cases, the customer
supplier links are longstand-ing relationships with well-defined contractual ties. Second, and more impor-tantly,becauseweexaminematerialcustomer
supplierlinks,thelinkisinfactsalient information when forming expectations about future cash flows and inturn prices. Not only is it intuitive that investors should take this relationshipinto account, we provide evidence that real activities of firms depend on thecustomer
supplier link.To test for return predictability, we first group stocks into different classesfor which news about linked firms has been released into the market. We thenconstruct a long
short equity strategy. The central prediction is that returns of linked firms should forecast future returns of the partner firms
portfolios.To better understand our approach, consider the customer
supplier link of Coastcast and Callaway, which is shown in Figure 1. In 2001, Coastcast Cor-poration was a leading manufacturer of golf club heads. Since 1993 Coastcast
smajorcustomerhadbeenCallawayGolfCorporation,aretailcompanythatspe-cialized in golf equipment.
2
 As of 2001, Callaway accounted for 50% of Coast-cast
s total sales. On June 7, 2001, Callaway was downgraded by one of theanalysts covering it. In a press release on June 8 Callaway lowered second-quarter revenue projections to $250 million, down from a previous projection of $300 million. The announcement brought Callaway
s expected second-quarterearnings per share (EPS) down to between 35 cents and 38 cents, about half of the current mean forecast of 70 cents a share. By market close on June 8,Callawaysharesweredownby$6.23tocloseat$15.03,a30%dropsinceJune6.In the following week the fraction of analysts issuing
buy
recommendationsdropped from 77% to 50%, and going forward, nearly 2 months later, when
2
Both firms traded on the NYSE and had analyst coverage.
 
 Economic Links and Predictable Returns
1979
0.50.60.70.80.91.01.1
20010501200105152001053020010613200106272001071220010726Callaway ELY (customer)Coastcast PARJune 8, 6 am. Callaway announcesearnings will be lower than expected(market closed).July 25. Company announces EPSat 36 cents.No revision in annual EPS forecast ($2)July 19. Company announcesEPS at -4 centsJune 8. At close Callaway’ s price dropped30% from June 6. Quarterly EPS forecastrevised from $0.70 to $0.36July 5. CEO and founder ofCallawaydies.June 7 , 11.37 am.Callaway isdowngraded.
Figure 1. Coastcast Corporation and Callaway Golf Corporation.
This figure plots thestock prices of Coastcast Corporation (ticker
=
PAR) and Callaway Golf Corporation (ticker
=
ELY)between May and August 2001. Prices are normalized (05/01/2001
=
1).
Callaway announced earnings on July 25, it hit the revised mean analyst esti-mate exactly with 36 cents per share.Surprisingly, the negative news in early June about Callaway
s future earn-ings did not impact Coastcast
s share price at all, despite the fact that the cus-tomer accounting for half of Coastcast
s total sales lost 30% of market value intwo days. BothEPS forecasts ($2) and stock recommendations (100% buy) werenot revised. Furthermore, a Factiva search of newswires and financial publi-cations returned no news mentions for Coastcast at all during the 2-month pe-riodsubsequenttoCallaway
sannouncement.Ultimately,CoastcastannouncedEPS at
4 cents on July 19 and experienced negative returns over the subse-quent 2 months.In this example, we are unable to find any salient news release about Coast-cast other than the announcement of a drop in revenue of its major customer.However, it was not until 2 months after Callaway
s announcement that theprice of Coastcast adjusted to the new information. A strategy that would haveshortedCoastcastonnewsofCallaway
sslowingdemandwouldhavegenerateda return of 20% over the subsequent 2 months.The above example represents a pattern that is systematic across the uni- verse of U.S. common stocks: Consistent with investors
inattention to com-panylinks,therearesignificantlypredictablereturnsacrosscustomer
supplier

You're Reading a Free Preview

Download
scribd
/*********** DO NOT ALTER ANYTHING BELOW THIS LINE ! ************/ var s_code=s.t();if(s_code)document.write(s_code)//-->