abstract
We compare the buy-and-hold abnormal returns (BHARs) among the deciles portfolios of firms based on their product market power. We document that the value-weighted portfolios (equally-weighted portfolios) of firms with the strongest product market power generate one-year BHARs ranging from 13.96% (8.85%) to 16.90% (10.63%) higher than the portfolios of the weakest firms. The abnormal returns persist even when we control for industry concentration level (as suggested by Hou and Robinson (2006)), common firm characteristics and alternative industry classifications. The higher returns accrued to the portfolios of firms with the strongest product market power can be attributed to the higher future standardized earnings surprises generated by these firms and their lower idiosyncratic volatility.
4. Conclusion
In this paper, we study the profitability of investing in portfolios of firms with the strongest product market power in their respective industries. We define dominant firms as those that control the highest proportion of sales in their respective industries based on the two- and four-digit SIC codes as well as the Fama-French 48 sector classification codes, alternatively.We find thatthe difference in buy and hold abnormal stock returns between the portfolios of the dominant and weak firms ranges between 8.85% and 16.90% depending on the measure used. The differences are statistically significant at the 1% level. The abnormal returns persist after controlling for industry concentration level (as in Hou & Robinson, 2006), firm characteristics and industry classification methods. The firms inthedominantproductmarketpowerdecile exhibit superior standardized earnings surprises post-portfolio formation years, as well as lower idiosyncratic risk. Our results corroborate previously documented evidence of higher profitability and lower idiosyncratic volatility among firms that are exposed to less competition and has more market power. The differences in stock returns between the firms that generate most oftheir industry sales and those that generate too little are too big to ignore. Our study suggests that there is a definite advantage to dominant firms regarding their ability to reward their shareholders through increases in stock prices. Our findings are limited to investment portfolio construction and management. We provide compelling evidence that firms that dominate their industry sales add to investors’ wealth in the stock market. Our paper, though, neither attempts to explain why firms should maintain a lead in industry sales and nor explores the fundamentals that lead some firms to become market leaders and generate a lot of wealth. It further ignores the intricacies of industry composition bar industry concentration level.
