Alliances and Return Predictability
- Cao, Chordia, and Lin
- A version of the paper can be found here.
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A trading strategy designed to exploit the information contained in the returns of alliance partners, yields economically and statistically significant returns. A long-short portfolio sorted on lagged returns of strategic alliance partners provides a return of 89 basis points per month that is robust to a number of specifications. Increased correlation in returns after the formation of alliances is driven by increased economic links and the increased probability of mergers amongst alliance partners. Investor inattention and limits to arbitrage may be the source of underreaction of a firm’s returns to that of its partners’.
Identify firms with alliances (described in paper – basically firms working together on a deal). Each month, sort firms based on the last month’s return for their alliance partners. Go long firms whose partners had high returns, and short firms whose partners had low returns.
Results by year:
However, the weighting matters (equal weight returns are much stronger than value weight returns). Authors find results do not hold for largest firms (top quintile based on size – Panel B of Table III)
From these results, there appears to be an underreaction to the performance of an alliance partner. However, as with most anomalies, this result does not hold for the largest firms.
Overall, an interesting idea, but may be difficult to implement – shorting small stocks can get hairy!