Abstract
How does competition in firms’ product markets influence stock returns? We examine this question using firms domiciled in the UK. We find that firms in less concentrated industries earn higher returns, even after controlling for the well-known determinants of the cross-section of UK stock returns. Furthermore, we suggest a novel asset pricing model that explicitly incorporates industry concentration as a distinguished risk factor capturing important features of product markets. Our results link the explanatory power of R&D activity of stock returns to product market structure. Also, we suggest an explanation for value premium on the basis of product market structure that favours barriers to entry interpretation for the higher returns obtained by less concentrated industries.
Highlights
This study explores the link between the intensity of product market competition and asset pricing
This study proposes an industry concentration factor as a potential risk factor in asset pricing model and claims that the new four-factor model explains the time-variation of returns better than the Fama-French model
We offer out-of-sample analysis on this issue using UK non-financial firms that are listed on stock markets during the period between July 1991 and December 2007.2 the UK is one of the largest market economies and similar to that of US, limited empirical analysis has been reported on the link between product market structure and asset pricing
Summary
This study explores the link between the intensity of product market competition and asset pricing. This study proposes an industry concentration factor as a potential risk factor in asset pricing model and claims that the new four-factor model explains the time-variation of returns better than the Fama-French model It suggests an explanation for value premium on the basis of product market structure that favours barriers to entry interpretation for the higher returns obtained by less concentrated industries. Hou and Robinson (2006) report that US firms operating in less concentrated industries earn higher returns as compared to their counterparts operating in more concentrated industries They propose two risk-based interpretations, i.e., barriers to entry and innovation, they attribute the results to risk innovation. We examine the value premium across different IC levels
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