Another oldie: Economic Links and Predictable Returns

We all see what happens to the companies that supply Apple with components the moment Apple’s newest product is opened up and it’s guts are cataloged, delight for those small firms included and disaster for the firms that have been passed by. Cohen and Frazzini dig deeper, beyond the obvious linkages you here about day in and day out (auto suppliers, tech suppliers) and capture a broad range of customer-supplier linkages. As with the research on risk sentiment in annual filings this is a fairly intuitive idea; companies that are linked financially are likely linked in their stock returns as well.

They use 11,484 customer-supplier relationships where the customer makes up more than 10% of the suppliers total sales, dated from 1980 t0 2004. They predict that a large shock to the customer’s stock price will take time to be reflected in the supplier’s price, thus creating a trading opportunity in the supplier’s stock. In their paper, the construct a long-short strategy that took long positions in 20% of customer stocks with the highest returns in month t-1, and short positions in the 20% of customer stocks with the lowest returns in t-1. They find

The customer momentum strategy that is long the top 20% good customer news stocks and short the bottom 20% bad customer news stocks delivers Fama and French (1993) abnormal returns of 1.45% per month ( t-statistic = 3.61), or approximately 18.4% per year.
At a previous firm we did the work to collect the customer-supplier relationship data, which was maddening and slow work. We found our backtest results were similar to Cohen and Frazzini’s but the effect did not work so well with larger supplier companies (the relationships were already known we surmised) and in certain sectors like financials.
here is a link to the original paper and to a follow-up paper assessing whether or not the strategy still works

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