Industry Classification, Industry Concentration and Expected Stock Returns
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2017-05
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University of Hawaii at Manoa
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I find that industry classification plays an important role in analyzing industry competition level and its relationship with expected stock returns. It also affects the outcome of industry momentum strategy. In general, industry concentration level is positively correlated with expected stock returns. This supports Schumpeter’s (1942) theory that states society must accept certain level of imperfect competition to have technology advancement. However, an industry classification that has definitions that are too narrow can artificially increase the concentration level and exposes industry portfolio strategies to undiversified firm risks. This research finds that the conflicting results on the relationship between industry concentration and stock returns in current literature are caused not only by not using unified industry classifications, but also by using different sample periods that can be characterized as industry expansion and consolidation eras. In addition, I find that classic industry momentum strategy does not work under all popular industry classifications used in current literature, especially during 1998-2016. This research, particularly, focuses on 3-digit SICCD, 2-digit SICCD and Fama French 48 industry classifications because these three classifications, among all industry classifications, strike certain level of balance between having reasonable number of industries and number of firms per industry. Not only does classic industry momentum strategy suffer short-term reversal in immediate post portfolio formation returns, but also does the weighting scheme affect the profitability of such strategy. Nevertheless, seasonality plays an important role in outcome of industry momentum strategy.
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Industry concentration, industry classification, industry momentum, short-term reversal.
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