When the Tail Wags the Dog: Industry Leaders, Limited Attention, and Spurious Cross-Industry Information Diffusion

Hou (2007) finds that within an industry, the stock returns of larger firms lead those of smaller firms, suggesting an intra-industry information diffusion process. Most industry leaders, however, have business segments in other industries (henceforth, minor-segment industries) while most small firms are pure players operating in one industry only. If cognitive resource-constrained investors trade the pure players based on the industry leaders’ returns and cannot filter out the irrelevant information from the leaders’ minor segments, the pure players will be mispriced. We document a strong lead-lag relation in stock returns between the firms from industry leaders’ minor-segment industries and pure players in the industry leaders’ major-segment industry. The effect is economically significant and is especially strong when (a) industry leaders are more diversified and more publicly recognized, and (b) pure players are smaller in firm size. Our results are not due to alternative explanations based on other potential missing common factors or economic relationships between pure players and firms in the minor-segment industries. We also document a return reversal after three weeks, which is strongest for pure players in the highest size quartile.