Product Market Competition And Expected Return—Evidence And Mechanism

Only the fittest can be survived from natural selection.Competition is an invariable survival law in the evolution of nature and human society.In market economy,the natural selection accompanied with competition is widely regarded as an effective mechanism to promote the efficiency of resource allocation.However,it can not be ignored that in the wave of competition,led by scientific and technological innovation,the business risks of individual enterprises also increase.To some extent,the essence of enterprise competition lies in product.Microsoft,Apple,Google,Amazon and other enterprises win the market with competitive products,while Kodak,Nokia and other formerly brilliant giants are eliminated because their products are out of date.In the basic pricing formula,P=C/r,the net profit from sale income is the basis of future cash flow(C).The intensity of product market competition can inevitably affect the risk of C,and thus the discount rate r.In an efficient market,future payoffs with higher exposure to the systemic risk priced with higher the expected returns,and vice versa.In this research,I am interested in the question that,is the competitive risk in the product market priced in the stock market?To answer the question,the first task is to measure the market competition of products.The essence of competition between companies is product competition.It has the characteristics of dynamic and refinement,which obviously can not be captured by the existing measurements.Among the two most popular measures,the method based on industry structure can only get industry-level indicators,what’s more,the classification of industries is lagging and not precise enough.The Lerner index only attributes excess profits to competition,and the marginal cost can only be calculated by approximate indicators.In this paper,we come up with a new measurement of competition for individual firm.Firstly,product vocabulary is extracted from the annual report,and product similarity between companies is used to directly measure the intensity of competition.This measure can not only penetrate into the firm level,but also has the characteristics of dynamic and refinement.It is a more accurate measure of the intensity of product market competition.With this new measurement,this paper uses the sample of Chinese A-share listed companies from 2007 to 2016 to confirm the positive relationship between the intensity of product market competition and the expected return of stocks.On this basis,we explore the underlying two mechanisms of company fundamentals risk and investor pricing process.Product market competition has pushed up the company’s fundamental risk from two aspects.One is the risk of performance fluctuation.In imperfect market,the most direct result of competition is the high fluctuation of company performance.The essence of intense competition is high homogeneity of products and strong substitutability of products and low demand stickiness of customers,which leads to high fluctuation of sales revenue and net profit.Moreover,when facing demand shocks,companies with intense product market competition need to adjust prices to avoid excessive decline in sales,which further promotes the volatility of performance.In line with this conjuecture,we find that the more intense the product market competition,the higher the volatility of the company’s sales revenue,net profit and operating net cash flow.Second,Product market competition has pushed up the company’s decision-making risk.To avoid being kicked out in fierce competition,managers are more likely to engage in more net cash-positive venture capital activities in order to improve their performance.We focus on three types of effective but risky behaviors:R&D,advertising investment and M&A.Among them,R&D investment enables enterprises to produce differentiated high-quality products,increase added value and customer viscosity,and enhance the market competitiveness of enterprises’products.Advertising can enhance brand image and visibility,enhance the market attractiveness of products,and to a certain extent,get rid of competition with ordinary brands.M&A activities can effectively achieve benefits from synergistic effect and survive in fierce competition.Accordingly,we find that the more intense the product market competition is,the more frequent the high-risk behaviors such as R&D investment,advertising investment and merger and reorganization are.The asset price in capital market is the direct result of investors’trading behavior.Product market competition also increases the complexity of investor analysis.Specifically,the operating conditions of listed companies with fierce competition are more disturbed by the behavior of their peers.In addition,when demand shock comes,the more companies in the industry,the more difficult it is to predict the impact of the shocks on different companies.What’s more,there is a complex game process between competitors in response to shocks,so investors have a higher uncertainty about the company’s earnings expectations.Using analyst behavior as agent of information processing complexity,we find that analysts tracking competitive companies have more firm site visits,more research texts and frequent earnings revisions.But the prediction EPS is less accurate,and opinions diverge is huge.Furthermore,according to the rational expectation model,the high uncertainty of information requires a high expected return.At the same time,it causes a lag effect for information to be involved into the stock price.In line with this,we find that the returns of highly competitive companies lag behind those of similar businesses in normal conditions and in the face of information shocks.The paper consists the following eight chapers:Chapter 1 introduces the realistic and theoretical background,research significance,research methods and main contents of the research questions,as well as the main innovations of this paper.Chapter 2 combs the relevant literature according to the following logical ideas:product market competition leads to high volatility of corporate profits.In order to smooth the volatility of profits and improve profitability,management tends to take positive NPV risk decisions,such as R&D investment and M&A.Frequent R&D investments and M&A increase the risk of future cash flows.According to the capital asset pricing model,this will lead to high expected return.On the other hand,competition increases the uncertainty of company’s fundamental information and the complexity of investment decision-making,which leads to the low efficiency of stock price.Chapter 3 chapter develop the basic hypothesises of this paper by introducing product market competition degree into the rational expectation model.On this basis,we further elaborate the above hypothesises from the economic sense and develop the core research hypothesises of this paper.Chapter 4 introduces the specific methods of measurement of product market competition.Firstly,the product vocabulary of listed companies is extracted from the annual report and vectorized by TF-IDF method.Then the product similarity matrix of all A-share listed companies is calculated.Based on the product similarity matrix,we use hierarchical clustering algorithm to divide the listed companies into competing groups,and use"elbow rule"to solve the number of groups when R~2 is optimized,and get the intermediate measure of product market competition.Finally,the measure of product market competition is calculated by combining the Herfindahl index.At the same time,this chapter verifies the validity of the measurement in terms of timeliness and information efficiency.Chapter 5 tests the core hypothesis that the market competition risk of listed companies will be priced in the capital market step by step.Firstly,this chapter uses portfolio analysis and Fama-Macbeth regression to test the relationship between product market competition and stock expected return.The empirical results of both methods support the hypothesis that the more intense product market competition,the higher stock expected return.Chapter 6 explains the positive relationship between product market competition and stock returns from a fundamental point of view.The verification of this mechanism is carried out from two perspectives.Firstly,the fierce product market competition intensifies the fluctuation of company performance.At the same time,this paper finds that the more intense the product market competition,the more frequent the R&D and M&A activities of the company.These risks are priced as higher expected return in the capital market.At the same time,we verify that competition promotes advertising and sales expenses.Advertising and sales expenses have a significant role in promoting the short-term performance of enterprises,but at the same time,as"sunk costs",they also increase the company’s financial risk.Chapter 7 further explores the underlying mechanism for the positive relationship between competition and expectation from the perspective of rational expectation.For listed companies with fierce product market competition,investors have greater uncertainty in fundamental analysis,which leads to two consequences:one is higher expected return(verified in Chapter 5),and the other is that the return lags behind that of monopolistic listed companies.In this chapter,we find that under normal circumstances,the return of the first 30%stock portfolio with the lowest degree of competition has significant predictive power in 1-2 month for the return of the first 30%stock portfolio with the highest degree of competition.Further,we explore the reasons for the lead-lage effect from two aspects,i.e.,investor attention and information processing complexity,and finds that the leading lag relationship is caused by the complexity of information processing.Chapter 8 summarizes the research contents of this paper,and puts forward corresponding policy and investment suggestions according to this research.The innovation and contribution of this paper are mainly embodied in three aspects:First,we come up with a novel measurement for the product market competition.We extract product vocabulary from annual reports by text mining method,and measures the fierce competition degree of product market faced by each listed company from the level of product segmentation.This measurement has better timeliness and higher information efficiency,which provides a new idea for the measurement of product market competition.The second is the innovation of research topics.We find a significant and stable positive relationship between product market competition and expected stock return in China A-share market.The research on competitive risk and expected return of stock in the existing literature focuses on mature market,but the research on A-share market in China has not yet appeared.This paper enriches the research on asset pricing,especially deepens the understanding of the relationship between market competition risk and capital market pricing in China.Third we deduce the linkages between market competition risk and asset pricing by mathematical modeling and logical deduction.By doing this,this paper provides a bridge between firm’s competitive risk and asset pricing,thus depicting the overall picture of firm’s behavior and consequences under the competition law,which helps to deepen the understanding of the breadth and depth of firm risk.