Industry Concentration and Average Stock Returns∗

This paper shows that differences in industry concentration help explain the crosssection of average stock returns. Firms in concentrated industries earn lower returns, even after controlling for size, book-to-market and momentum. The premium for industry concentration exhibits systematic business cycle variation. In addition, the premium on book-to-market is higher in more concentrated industries. Standard explanations based on measurement error, deregulation, capital structure, and correlation with known risk factors do not explain these findings. We hypothesize that this occurs because either (i) barriers to entry in highly concentrated industries insulate firms from aggregate shocks that lead to economic distress, or (ii) firms in highly competitive industries are riskier because they engage in more innovative activities and thus command higher expected returns. Additional tests support both these conjectures. JEL Classification Codes: G12, G33, L10 ∗We thank Anne-Marie Knott and seminar participants at Ohio State for helpful comments. This paper is a significantly revised version of a paper entitled, ”Market Structure, Firm Size, and Expected Stock Returns.” Judith Chevalier, Eugene Fama, Peter Hecht, Owen Lamont, Toby Moskowitz, Per Olsson, Per Strömberg, and seminar participants at Chicago and the Chicago Quantitative Alliance provided many helpful comments on this earlier draft. Any remaining errors are our own. Correspondence to: Kewei Hou, Fisher College of Business, Ohio State University, 2100 Neil Avenue, Columbus, OH 43210. E-mail: [email protected]. Industry Concentration and Average Stock Returns ABSTRACT: This paper shows that differences in industry concentration help explain the cross-section of average stock returns. Firms in concentrated industries earn lower returns, even after controlling for size, book-to-market and momentum. The premium for industry concentration exhibits systematic business cycle variation. In addition, the premium on bookto-market is higher in more concentrated industries. Standard explanations based on measurement error, deregulation, capital structure, and correlation with known risk factors do not explain these findings. We hypothesize that this occurs because either (i) barriers to entry in highly concentrated industries insulate firms from aggregate shocks that lead to economic distress, or (ii) firms in highly competitive industries are riskier because they engage in more innovative activities and thus command higher expected returns. Additional tests support both these conjectures. This paper shows that differences in industry concentration help explain the cross-section of average stock returns. Firms in concentrated industries earn lower returns, even after controlling for size, book-to-market and momentum. The premium for industry concentration exhibits systematic business cycle variation. In addition, the premium on bookto-market is higher in more concentrated industries. Standard explanations based on measurement error, deregulation, capital structure, and correlation with known risk factors do not explain these findings. We hypothesize that this occurs because either (i) barriers to entry in highly concentrated industries insulate firms from aggregate shocks that lead to economic distress, or (ii) firms in highly competitive industries are riskier because they engage in more innovative activities and thus command higher expected returns. Additional tests support both these conjectures. Firms generate cash flows through their actions in product markets. These risky cash flows are in turn priced in financial markets. Yet, the economic link between product markets and asset prices remains relatively unexplored. This paper explores the link between industry concentration and average stock returns, offering the first empirical evidence of the asset pricing implications of industry market structure. The main finding in this paper is that firms in highly concentrated industries earn lower returns, even after controlling for size, book-to-market, momentum, and other known risk characteristics. This is true both at the industry portfolio level, as well as at the individual firm level, and it is robust to alternative empirical specifications. Moreover, the economic magnitude of these effects is large. Our results indicate that firms in the quintile of most competitive industries earn annual returns that are nearly four percent higher than those of similar firms in the quintile of most concentrated industries. This difference is highly statistically significant. Existing asset-pricing theories do not offer explanations for this finding. Thus, our first step is to rule out likely candidate explanations for our results. One potential explanation is that industry characteristics are simply correlated with risk measures that are known to explain the cross-section of stock returns. If this were the case, industry concentration would covary with expected returns without industry concentration playing an independent role in determining asset prices. For example, this would be true if size and book-to-market ratio completely determine the cross-section of expected stock returns, and industry concentration simply described industry-level, cross-sectional differences in those characteristics. Industry concentration is indeed correlated with firm characteristics that are known to describe the cross section of average stock returns: firms in highly concentrated industries have larger market capitalizations and lower book-to-market ratios. However, controlling for these effects, as well as CAPM β and momentum, we still find strong evidence that firms in more concentrated industries earn lower stock returns. The fact that we find a significant