Market Power, Technology Shocks, and the Profitability Premium

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.