Real and Financial Industry Booms and Busts

We examine how product market competition affects firm cash flows and stock returns in industry booms and busts. Our results show how real and financial factors interact in industry business cycles. In competitive industries, we find that high industry-level stock market valuation, investment, and financing are followed by sharply lower operating cash flows and abnormal stock returns. Analyst estimates are positively biased and returns comove more. In concentrated industries these relations are weak and generally insignificant. Our results are consistent with participants in competitive industries not fully internalizing the negative externality of industry competition on cash flows and stock returns. THROUGHOUT HISTORY, INDUSTRIES have gone through cycles in which firms have very high valuations and investment followed by lower subsequent valuations and investment. Periods associated with high valuations are commonly written about as the start of a “new era” in which productivity increases and new products justify very high stock prices and prompt massive investment.1 This phenomenon is present in many industries over time, and recent examples include the recent real estate boom and late 1990s internet and telecommunications boom.2 In this paper, we ask whether product market characteristics ∗University of Maryland and University of Maryland and National Bureau of Economic Research (NBER), respectively. Hoberg can be reached at ghoberg@rhsmith.umd. edu and Phillips can be reached at gphillips@rhsmith.umd. edu. We especially thank Matthew Rhodes-Kropf and David Robinson for many helpful comments. We also thank Malcolm Baker, Ron Giammarino, Bill Latham, Josh Lerner, Tim Loughran, L̆ubos̆ Pástor, Paul Povel, Paul Seguin, the editor (Campbell Harvey), an anonymous associate editor, an anonymous referee, and seminar participants at the AEA meetings, the 2007 Frontiers of Finance Conference, American University, Baruch, Delaware, George Mason, Georgia State, Insead, NBER, New York University, Oxford, University of British Columbia, Vanderbilt, University of Vienna, Washington University of St. Louis, the Western Finance Association, and Yale for helpful comments. All errors are the authors’ alone. 1See “Is there rationale for lofty prices? ” Wall Street Journal, March 23, 2000, and “IPOs are different in current era of net-stock mania,” Wall Street Journal, January 19, 1999. 2Our findings are robust to excluding the internet boom of 1998 to 2000. Other industries such as the Winchester disk drive industry and the early railroad industry have similar patterns. Sahlman and Stevenson (1987) note that in mid-1983, the Winchester disk drive industry had a market capitalization of $5.4 billion, but by year’s end the industry value fell to $1.4 billion as net income fell 98%. Turning to the railroads, extensive miles of track were laid (including spurs to future towns not yet built) by firms in the railroad industry only to be followed by extensive bankruptcies in the late 1870s. See: http://www.eslarp. uiuc.edu/ibex/archive/vignettes/rrboom.htm. The Chicago Sun Times wrote in 1872 that wealth from the railroads “will so overflow our coffers with gold that our paupers will be millionaires. ”