The impact of industry concentration on the market’s ability to anticipate future earnings. International evidence

• Date: 03 October 2016
• DOI: https://doi.org/10.1108/IJAIM-04-2016-0034
• Pages: 443-475
• Published date: 03 October 2016
• Author: In-Mu Haw,Bingbing Hu,Jay Junghun Lee,Woody Wu
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

The impact of industry

concentration on the

market’s ability to anticipate

future earnings

International evidence

In-Mu Haw

Texas Christian University, Fort Worth, Texas, USA

Bingbing Hu

Hong Kong Baptist University, Kowloon, Hong Kong

Jay Junghun Lee

University of Massachusetts Boston,

Boston, Massachusetts, USA, and

Woody Wu

Chinese University of Hong Kong, New Territories, Hong Kong

Abstract

Purpose – The existing literature has established the importance of industry concentration in

explaining rm performance and information environments. However, little is known about whether

and how industry concentration affects investors’ ability to anticipate future earnings. This paper aims

to investigate this query by identifying and testing two channels, product market power and

intra-industry information transfer, through which industry concentration affects the informativeness

of stock returns about future earnings.

Design/methodology/approach – The paper measures the informativeness of stock returns about

future earnings by the future earnings response coefcient (FERC)). This study estimates the FERC

using a rm-level sample from 38 economies.

Findings – The authors nd that industry concentration signicantly enhances investors’ ability to

predict future earnings. Further tests show that both product market power and intra-industry

information transfer contribute to explaining the positive association between industry concentration

and the FERC, with the former playing a more salient role. Finally, the authors show that a country’s

effective competition law attenuates the positive impact of industry concentration on the FERC by

weakening the economic impact of the two underlying channels.

The authors would like to thank Kamran Ahmed (editor), an anonymous reviewer, Bok Baik,

Jong-Hag Choi, Simon Fung (JCAE discussant), Lee-Seok Hwang, Woo-Jong Lee, Jong Chool Park

(KAA discussant), Gord on Richardson, Heibatollah Sami (AAA discussant) and seminar

participants at Seoul National University, the Annual Summer/International Conference of

Korean Accounting Association, the Journal of Contemporary Accounting and Economics

Symposium, and the American Accounting Association Annual Meeting for their comments and

suggestions on the earlier versions of this paper.

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

Ability to

anticipate

future

earnings

443

Received 5 April 2016

Revised 28 June 2016

Accepted 3 August 2016

InternationalJournal of

Accounting& Information

Management

Vol.24 No. 4, 2016

pp.443-475

©Emerald Group Publishing Limited

1834-7649

DOI 10.1108/IJAIM-04-2016-0034

Originality/value – This study contributes to the growing literature on the price-leading-earnings

relation, industry concentration and international corporate governance.

Keywords Industry concentration, Competition laws, Future earnings response coefcient (FERC),

Intra-industry information transfer, Product market power

Paper type Research paper

1. Introduction

Stock prices lead accounting earnings in reecting information about rm value (Collins

et al., 1994;Kothari and Sloan, 1992;Wareld and Wild, 1992). This recognition that

current stock returns incorporate future earnings information (i.e. the price-

leading-earnings relation) has inspired a stream of research that explores the

cross-sectional variations in the informativeness of stock returns about future earnings

(Gelb and Zarowin, 2002;Lundholm and Myers, 2002;Ettredge et al., 2005;Tucker and

Zarowin, 2006;Choi et al., 2011)[1]. Haw et al. (2012) further examine the cross-country

differences in the informativeness of stock returns about future earnings and show that

the price-leading-earnings relation is a global phenomenon.

A recent line of research has identied industry concentration as an important

industry characteristic in explaining a rm’s prot-generating ability and disclosure

activity, the properties of income streams and information dissemination among

industry peers, all of which could conceivably affect the informativeness of stock

returns (Baginski et al., 1999;Hou and Robinson, 2006;Irvine and Pontiff, 2009;Peress,

2010)[2]. Building on the existing literature, this study investigates the impact of

industry concentration on investors’ ability to anticipate future earnings in a

cross-country setting[3]. We measure the informativeness of stock returns about future

earnings through the association between current stock returns and future earnings,

after controlling for lagged and current earnings [hereafter, referred to as the future

earnings response coefcient (FERC)].

Recent studies provide conicting results on the relation between industry

concentration and the predictability of future earnings. Firms that operate in

concentrated industries are likely to earn persistently higher prots and experience less

volatility in earnings and stock returns, suggesting that investors predict the future

earnings of those rms with less information costs (Hou and Robinson, 2006;Gaspar

and Massa, 2006;Irvine and Pontiff, 2009;Peress, 2010). In contrast, rms in

concentrated industries provide fewer voluntary disclosures and have greater levels of

forecast errors and dispersion, which implies a lower predictability of future earnings

(Harris, 1998;Bamber and Cheon, 1998;Botosan and Harris, 2000;Ali et al., 2014). Thus,

it is ex ante ambiguous whether and how industry concentration affects the ability of

market participants to predict a rm’s future performance. Our study aims to provide

direct evidence on this query. The objectives of this study are threefold:

(1) to examine whether industry concentration shapes investors’ ability to

anticipate future earnings (proxied by the FERC) in an international setting;

(2) to identify and test the mechanisms through which industry concentration

affects the FERC; and

(3) to explore the effect of country-level competition laws on the relationship

between industry concentration and the FERC.

IJAIM

24,4

444

Drawing upon the existing literature, we identify two potential channels through which

industry concentration affects investors’ ability to anticipate future earnings: product

market power and intra-industry information transfer. The strong product market

power inherent in concentrated industries allows member rms to earn high prots and

realize more persistent earnings over time (Lev, 1983;Baginski et al., 1999). The prior

research has found that product market power built by entry barriers or through

collusion among competitors delays the decline of high protability to the norm

(Mueller, 1977;Eaton and Lipsey, 1981;Cheng, 2005b) and allows rms to benet from

monopolistic rents (Strickland and Weiss, 1976). These rms are likely to experience

less volatility in rm performance and less uncertainty about future earnings, as they

can transfer potential negative shocks to consumers rather than absorb them (Hou and

Robinson, 2006;Gaspar and Massa, 2006;Irvine and Pontiff, 2009;Peress, 2010). This

leads us to predict that strong market power induced from industry concentration

enhances investors’ ability to anticipate future earnings.

Intra-industry information transfer serves as another channel that expedites the

incorporation of future earnings information into current stock returns. When a rm

makes public disclosures, investors make inferences about the impact of the news on the

rm values of both the announcing rm and its industry peers. In forecasting a specic

rm’s future earnings, market participants incorporate information (such as earnings

and sales announcements, dividend payouts and share repurchases) from other rms in

the same industry (Foster, 1981;Ramnath, 2002;Massa et al., 2007). Furthermore,

industry-wide news (such as industry output) provides common information about the

future earnings of all industry members (Ayers and Freeman, 2003;Piotroski and

Roulstone, 2004;Crawford et al., 2012). Peer rms in concentrated industries are likely to

be involved in a greater extent of strategic interaction (Piotroski and Roulstone, 2004;

Chen et al., 2005;Massa et al., 2007). As a result, intra-industry information transfer is

more pronounced in concentrated industries, where investors can easily extract the

value-relevant information about industry peers from one rm’s disclosure. In sum,

industry concentration is likely to make a rm’s public disclosure and industry-common

information more useful to investors in predicting the future earnings of its peers, which

contributes positively to the informativeness of current returns about future earnings[4].

Following the prior literature, we measure industry concentration by the Herndahl–

Hirschman index, which is the sum of the squared market shares of the rms competing

in each industry-country sample. We disaggregate industry concentration into two

components: one related to product market power and the other to industry information

transfer. Operationally, we dene the product market power component as the portion of

industry concentration that can be explained by industry protability and earnings

volatility. The residual portion of industry concentration is expected primarily to

capture the effects of information transfer within industry[5].

We examine a cross-country sample to take advantage of a wide variation in

competition across countries as well as within each country. While the accounting

literature focuses attention on US samples to test the relation between industry

concentration and rm-level information environments, US rms face a substantially

higher level of competition than similar non-US rms. US anti-trust law prevents

extreme industry concentration and explicit collusion among competitors (as evidenced,

for instance, by the breakup of AT&T and the birth of the “Baby Bells”). The increasing

market shares of imported goods also make the US product market more competitive

445

Ability to

anticipate

future

earnings