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Stock returns and product market competition: beyond industry concentration

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Abstract

The main purpose of this paper is to provide direct evidence that product market structure affects stock returns. This is not only through industry concentration, as found in Hou and Robinson (J Finance 61:1927–1956, 2006), but also based on firms’ product substitutability and industry market size. Furthermore, the predictive power of product substitutability and market size for stock returns is not subsumed by industry concentration. Our results highlight the multi-dimensional structure of product market competition and its impact on asset prices.

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Notes

  1. A notable exception is Melicher et al. (1976), who examined the relationship between concentration and stock returns for 495 firms for the period 1967–1974, and documented only “average” returns for the shareholders of high concentration ratio firms.

  2. However, some studies are skeptical that market structure affects a firm’s R&D expenditure. For example, Cohen and Levin (1989), using panel data models along with controls for technology, document that the supposed relationship between market concentration and the amount a company invests in research and development disappears.

  3. One could argue that stock returns are related to the direct measures of barriers to entry, since those firms in industries with high barriers to entry will face lesser distress risk, thereby lowering expected returns. However, Hou and Robinson (2006) argue that the direct measures of barriers to entry are either unattractive or, at best, incomplete, since barriers to entry reflect the strategic choices of incumbents firms as well as the primitive levels of industry production technology.

  4. Although the firms in higher concentration ratios have larger sales, it need not necessarily imply that industries associated with these firms also have larger sales on average. For this to happen there should also be more number of firms in the higher concentration ratio industries. In fact we found a negative correlation between Herfindhal–Hirschman index and the number of firms. This is consistent with the notion that we observe less competition in the higher concentration ratio industries partly because of fewer numbers of firms being present in them.

  5. In contrast to Table 2, Panel A that shows that a typical firm in high concentration ratio has higher sales, Table 1, Panel B relates the industry sales of all firms in aggregate to concentration ratio. Thus Table 2, Panel A and Table 1, Panel B are not inconsistent with each other.

  6. We also used the 1- and 2-year average returns from the CRSP value-weighted index in order to classify the market states; we found similar results as those reported here.

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Acknowledgments

I am grateful to C.F. Lee (the editor) and special thanks are due to two anonymous referees for many constructive and illuminating comments and suggestions, which immensely helped me improve the paper. I am responsible for any errors.

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  1. Department of Accounting and Finance, College of Business, University of Michigan-Dearborn, Fairlane Center South, Dearborn, MI, 48126, USA

    Vivek Sharma

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Sharma, V. Stock returns and product market competition: beyond industry concentration. Rev Quant Finan Acc 37, 283–299 (2011). https://doi.org/10.1007/s11156-010-0205-0

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