Production Networks and Stock Returns: The Role of Vertical Creative Destruction

70 Pages Posted: 6 Jun 2017 Last revised: 17 Jan 2018

Michael Gofman

Simon School of Business

Gill Segal

University of North Carolina (UNC) at Chapel Hill - Finance Area

Youchang Wu

University of Oregon - Lundquist College of Business

Date Written: January 16, 2018

Abstract

We study creative destruction in production networks and its implication for firms' risk profiles. Empirically, upstream firms with the longest distance to consumers earn an excess return of 105 basis points per month relative to downstream consumption producers. We explain this novel spread quantitatively using a general equilibrium model with multiple layers of production. The spread arises endogenously due to vertical creative destruction -- innovations by direct and indirect suppliers devalue the installed capital of customer firms. Consistent with our model predictions, the spread is smaller among firms that belong to supply chains with lower competition, and is larger among firms whose assets-in-place account for a larger fraction of firm value. We document other new facts that can be reconciled via vertical creative destruction: (1) a diminished value premium among downstream firms; (2) a positive relation between the return of downstream firms and the market power of their direct and indirect suppliers. Overall, we explore a novel channel of creative destruction and demonstrate its significant impact on firms' cost of capital.

Keywords: production networks, stock returns, creative destruction, monopolistic competition, technological innovations

Suggested Citation

Gofman, Michael and Segal, Gill and Wu, Youchang, Production Networks and Stock Returns: The Role of Vertical Creative Destruction (January 16, 2018). Available at SSRN: https://ssrn.com/abstract=2981447 or http://dx.doi.org/10.2139/ssrn.2981447

Michael Gofman (Contact Author)

Simon School of Business ( email )

Rochester, NY 14627
United States

HOME PAGE: http://gofman.info

Gill Segal

University of North Carolina (UNC) at Chapel Hill - Finance Area ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

Youchang Wu

University of Oregon - Lundquist College of Business ( email )

1280 University of Oregon
Eugene, OR 97403
United States

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