A challenge for financial analysts and investors is teasing out how the stock returns of individual firms move with the changing conditions of their industry, and whether some are more sensitive to industry-wide news than others.

Shengquan Hao, Qinglu Jin and Guochang Zhang explore this question by looking at the role of relative profitability in determining a firm's sensitivity to industry returns. It's a new approach and it reveals some useful insights.

By looking at more than 40,000 firm observations from 1973-2004 and developing a model that considers the importance of relative firm profitability in determining the sensitivity of its returns to industry-wide shocks, they show that less-profitable firms in a given industry are more affected by industry-wide news than more profitable ones.

"Stock returns depend not only on aggregate level and firm-specific information separately, but also on the interaction between them," they say. "Relative firm profitability within an industry determines the degree to which returns respond to industry news."

That response can be tempered, though, by the type of news and the type of industry involved. The differential impact of industry news on firms with low (versus high) profitability is more pronounced when the news is positive rather than when it is negative because the more profitable firms may have less room to maneuver due to capacity constraints in the event when the news is good.

"The more profitable firms are likely to reach capacity sooner. Capacity limits prevent firms from raising their output to a new desired level. Furthermore, the more profitable firms will already have a higher output and be affected more severely by the capacity limit. A consequence of this is greater variation in return sensitivity to industry-wide news across firms with different levels of profitability," the authors say.

This impact is also greater in industries that are more capital intensive. In the high capital intensive group, for instance, the interaction term between relative profitability and industry returns obtains a coefficient of -1.135 conditional on positive industry news, and -0.233 conditional on negative news. In the low-capital intensive group the coefficients are -0.798 conditional on positive news and -0.351 conditional on negative news.

"We may view a firm's return sensitivity to industry returns as a form of systematic risk faced by investors. By demonstrating how the return sensitivities of firms in the same industry are driven by their competitive positions (as indicated by relative profitability), we shed light on the link between a firm's systematic risk and its business fundamentals," the authors say.

The findings have implications for investment management because investors who have information about the future development of an industry that has not yet been reflected in market prices, can use this when selecting stocks.

"They should shift their investment allocation toward less profitable firms in the industry when they expect the overall conditions of the industry to improve, to capture more capital appreciation. Conversely, they should shift to more profitable firms when they expect the industry's conditions to deteriorate, to better preserve capital," the authors say, adding: "This strategy is distinct from the contrarian strategy that relies on a stock's past performance rather than industry outlook."