[This is another of a series of editorials by Executive Editor Andrew Karolyi at the Review of Financial Studies featuring forthcoming or recent papers at the journal. This editorial features “Strategic Investment and Industry Risk Dynamics” by Cecilia Bustamante of the University of Maryland and London School of Economics. It is the lead article in Issue 28 (2) for February 2015. It was selected as an Editor’s Choice article on the Oxford University Press web site for RFS.]
There is a large and growing literature on peer effects in Economics. Many scholars in Finance may have first encountered this intriguing research, like I did, in work on peer effects in the classroom. Are students “good” peers if they produce positive learning spillovers so that students exposed to them gain more for each investment in their education, or “bad” peers if they have the reverse effect? The challenge in this research is the problem of correlated effects. Are the externalities we observe true peer effects or endogenous social effects?, asks Charles Manski in his classic (1993) “reflection problem” study. Ever increasingly, Finance scholars are evaluating the potential existence and consequences of peer effects in corporate financial decision making.
Cecilia Bustamante’s paper falls into this line of inquiry, but with a twist. The paper focuses on firms’ strategic interactions with their product market peers. We are in an imperfectly competitive industry setting and the decision making is about the firm’s own investment strategy and that of its industry peers, an oligopolistic model of strategic capacity choice. Where is the twist? This joint dynamic of strategic interaction among firms studied in the industrial organization world becomes a tool to explain potential regularities in the cross-section of expected returns. Theoretical asset pricing studies regularly overlook the impact of firms’ strategic behavior on asset prices by focusing on monopolies or perfectly competitive industries.
So that becomes the key insight of the model Bustamante builds. A firm’s marginal product of capital or marginal q reflects a firm’s relative position with respect to its industry peers or its relative ability to increase its market share in the future. Its exposure to systematic risk is jointly affected by its own investment strategy and the investment strategy of its industry peers and the intensity of that interaction depends on the dispersion in the marginal q across firms within the industry and how that evolves over time. The testable prediction is that firms’ betas and returns correlate more in industries with low value spreads (book-to-market ratios) within the industry. And this is exactly what her empirical findings uncover.
What inspired Bustamante to pursue the question in the first place? She writes to me that she was inspired by a number of empirical studies that “cross-sectional regularities in returns are predominantly intra-industry, hinting at significant peer effects.” When I asked her about where these findings may take research in the future, she saw the potential to stir up new projects examining portfolio sorting techniques for asset pricing tests defined by a firm’s relative position within its own industry, whether size, market-to-book, gross profitability, investment-to-assets, or even other dimensions. Bustamante proposes future work to extend the analysis to more complex industry structures or to explore alternative intra-industry interactions along the supply chain.