Competition Network, Distress Propagation, and Stock Returns

A new study analyzes the effects of cross-industry links through common market leaders.

Abstract

We build a competition network that links two industries through their common market leaders. Industries with higher centrality on the competition network have higher expected stock returns because of higher exposure to the cross-industry spillover of distress shocks. The competition intensity on the network is endogenously determined by the major players’ economic and financial distress.

We examine the core mechanism — the causal effects of firms’ distress risk on their product market behavior and the propagation of these firm-specific distress shocks through the competition network — by exploiting the occurrence of local natural disasters and enforcement actions against financial frauds to identify idiosyncratic distress shocks. Firms hit by natural disasters or enforcement actions exhibit increased distress, then compete more aggressively by cutting profit margins. In response, their industry peers also cut profit margins, then become more distressed, especially in industries with high entry barriers.

Crucially, distress shocks can propagate to other industries through common market leaders operating in multiple industries. These results cannot be explained by demand commonality or other network externality.