Market Power, Technology Shocks, and the Profitability Premium

34 Pages Posted: 18 Feb 2024

See all articles by Yao Deng

Yao Deng

University of Connecticut

Ding Luo

City University of Hong Kong

Jincheng Tong

University of Toronto

Date Written: January 31, 2024

Abstract

This paper studies how market power affects the well-documented positive relation between firms' profitability and future stock returns in the cross-section. We find that this relation is significantly more pronounced among firms with high markup. A long-short portfolio sorted on profitability earns an average monthly return of 0.57% among firms with high markup, and only 0.05% among firms with low markup. Firms' differential exposure to investment-specific technology shocks explains this gap. To understand these results, we introduce market power into a standard investment-based asset pricing model to study its impact on firms' endogenous investment and risk exposures. Market power exacerbates the displacement risk faced by highly profitable firms.

Suggested Citation

Deng, Yao and Luo, Ding and Tong, Jincheng, Market Power, Technology Shocks, and the Profitability Premium (January 31, 2024). Available at SSRN: https://ssrn.com/abstract=4714159 or http://dx.doi.org/10.2139/ssrn.4714159

Yao Deng (Contact Author)

University of Connecticut ( email )

Ding Luo

City University of Hong Kong ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

Jincheng Tong

University of Toronto ( email )

Toronto, Ontario M5S1L1
Canada

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