Callaway Golf is a leading producer of golf equipment; American Software is a small company specializing in software for supply chain management. Two different companies and two different industries. Yet, as it turns out, Callaway Golf’s returns have an impact on American Software. How can that be?
A study by Ling Cen, Kalok Chan, Sudipto Dasgupta and Ning Gao shows that when you look at the wider industry picture for each firm, you find conditions not obvious at first glance that lead to “spurious cross-industry information diffusion” – the transmission of impactful information from one industry to another.
These conditions involve a major player which has investments in both industries – in this case Microsoft, which operates in the software and entertainment industries. Since Calloway is a leader in the entertainment industry, when it does well this has a positive effect on Microsoft. This boost in turn is transmitted to American Software – a “pure player” in Microsoft’s major industry since it does not have segments in other industries itself.
The authors said the reason for these cross-impacts was because investors were not able to tease apart the relationships.
“Although it is natural for investors to look at industry leaders in uncovering industry-relevant information, that’s easier said than done,” they said. “Most industry leaders have fairly complicated business segments. Notably, more than 80 per cent of industry leaders have multi-segment businesses and their business segments are often not in the same industry. For the proper pricing of industry leaders’ stocks, information from both major and minor segments is relevant. Their returns reflect fundamentals in both segments.
“However, because investors have limited information processing ability, they don’t observe fundamental information about pure players in an industry – choosing instead to trade pure players based on the returns of industry leaders.
“Their cognitive constraint also implies they are unable to distinguish between the different return components of industry leaders and so they focus on the overall return, which reflects information about the leader’s major segment industry as well as minor-segment industries.”
The team showed this to be the case across a wide sample of data from January 1986 to December 2008. When there was a large firm with minor and major segments (such as Microsoft), the returns of the leader in its minor-segment industry (such as Callaway) led the returns of pure players in its major segment (such as American Software). This impact was seen in both contemporaneous and lead-lag terms, and was not due to common economic factors or economics links between the firms.
A significant test showed that when a firm was added to the Standard&Poor’s 500 Index, which indicated elevation to a leading position, the diffusion process was heightened: the returns of the firm’s minor-segment industry had a much stronger relationship with the returns of the pure players in the major segment industry in the three years after the firm was added to the index. This supports the idea that leading firms like Microsoft are a conduit for the impact of minor-segment leaders on major-segment pure players.
The study further showed that specific events surrounding minor-segment industry leaders, such as earnings announcements, had an impact on the pure players.
The authors concluded: “Our results are consistent with a particular type of bias experienced by attention-constrained investors that affects pure player returns. Investors respond to the limited attention problem by categorization, and focus on industry leaders in order to extract information about an industry category. However, if investors cannot filter out the irrelevant information from the leaders’ minor segments, the pure players will be mispriced due to spurious cross-industry information diffusion.”
The authors will next investigate the real consequences of this relationship, such as whether investment by pure players in the major-segment industry is sensitive to returns in minor-segment industries.