Relative efficiency, industry concentration and average stock returns

Purpose: Previous research has found that industry concentration and firm efficiency affect stock returns. However, it is not clear if concentration is a byproduct of efficiency and hence its effect on stock returns is driven by efficiency. This paper aims to examine the relationships between industry concentration, firm efficiency and average stock returns. Mainly, it aims to answer if the effects of industry concentration and firm efficiency on stock returns are independent and significant. Design/methodology/approach: The stochastic frontier approach is used to estimate firm efficiency. The Herfindahl index is used to measure industry concentration. Regression and vector autoregressive analyses are performed to examine cross-sectional and lagged relationships between concentration, efficiency, profitability and stock returns. The characteristics-based benchmark approach is also used to investigate performance of test portfolios. Findings: Industry concentration and firm efficiency have independent and significant effects on average stock returns through profit margins and market shares, which are related to firms’ profitability. Industry concentration has a greater positive impact on market shares than on profit margins, whereas firm efficiency has a greater positive impact on profit margins than on market shares. In sum, highly efficient firms in highly concentrated markets have lower distress risks and hence provide lower average stock returns. Originality/value: The paper shows the linkages between industry concentration, firm efficiency, profitability and stock returns that have not been documented together in prior studies. Businesses can better understand the impact of concentration and efficiency on market shares and profit margins. Researchers may consider incorporating concentration and efficiency, both of which are meaningful microeconomic variables, into an asset pricing model. Investors can enhance their returns by having a zero-cost portfolio with long and short positions in stocks of firms with different levels of concentration and efficiency.