Summary
The Covid-19 pandemic had a substantial negative impact on the aggregate economy, with the world’s gross domestic product falling by 3.3% in 2020. However, at the firm level, the impact of this global health crisis varied considerably, with some companies even experiencing an increase in their market valuation. For example, a few months into the crisis, Zoom Video Communications Inc. reached a market valuation larger than the combined value of the world’s seven largest airlines. As this example illustrates, the impact of the pandemic on firm value depended in large part on the industry in which the firm operates. However, the impact of the pandemic varied considerably even for firms within the same industry, depending on each firm’s characteristics at the onset of the crisis. The main objective of our project is to answer the following question: Which firm characteristics can best predict the impact of the pandemic on stock returns?
Main results
In the paper “Stock Comovement and Financial Flexibility”, joint with IESE professor Carles Vergara and IESE PhD graduates Anil Kumar and Teng Huang, we show how one specific firm characteristic, financial flexibility, predicts stock comovement between firms, using the COVID-19 outbreak as an event study.
Stock comovement measures the extent to which the stock returns of two firms move together (i.e., are correlated) over time. Comovement is a core issue in asset pricing and portfolio management, as it determines the ability of investors to diversify risk across stocks. Our contribution is to relate comovement to financial flexibility, which denotes a firm’s ability to raise capital to finance investment when needed. This ability depends, crucially, on the firm’s debt capacity, which reflects the value of the assets that the firm can use as collateral.
To study the link between financial flexibility and stock comovement, we first develop a theoretical model, and then test its empirical predictions in the data. The model features firms that, in each period, choose how much to invest to increase their size, and can finance their operations by choosing whether to use internally generated funds, equity, or debt. When making corporate decisions, firms need to account for uncertainty, as profits are affected by both aggregate and firm-specific shocks. Moreover, we introduce in the model shocks to the value of collateralizable assets and, therefore, to firms’ debt capacity and financial flexibility. Positive shocks to the value of collateralizable assets allow firms to increase leverage to finance their investment needs. The resulting higher rates of investment are reflected in firms’ cash flows and stock returns. Due to this collateral channel, stock return comovement arises among firms with similar values of pledgeable assets. Overall, our model’s main prediction is that comovement in stock returns across firms arises from similarity in financial flexibility as well as in other firms’ characteristics, such as size, market-to-book, and leverage.
To test the model predictions, we implement two main empirical strategies. For our first test, we use data on U.S. firms from 1993 to 2018 and rely on the value of corporate real estate (CRE) assets to measure the degree of firms’ financial flexibility. CRE assets are an important component of firms’ collateralizable assets: in 2018, U.S. non-financial corporations owned $13.1 trillion in real estate, which represented 31% of total firm assets. We find that the average within-year pairwise correlation in monthly stock return residuals among firms in the same percentile of lagged financial flexibility is 0.5% higher than firms with a difference of 50 percentiles. Thus, the effect of financial flexibility is sizable, as this estimate represents 62% of the average correlation in return residuals (0.8%) for the portfolio of firms with a 50-percentile difference. Our finding of a positive relationship between similarity in financial flexibility and stock comovement is robust to multivariate analyses that control for several dimensions of similarity across firms.
As a second empirical test, we perform an event study of stock comovement around the start of the COVID-19 crisis. The outbreak of the COVID-19 pandemic in early 2020 had a significant impact on the revenues of many firms and affected their ability to raise financing. To quantify the effect of this shock on stock comovement through firms’ financial flexibility, we analyze the change in pairwise stock-return-residual correlation in the weeks around the outbreak of the COVID-19 pandemic. Our results show that stock comovement increased significantly in the post-outbreak period. However, we find that this increase was driven by the subsample of firms with the highest degree of similarity in financial flexibility. In particular, these firms had 1.02% higher correlation in stock return residuals before the COVID-19 outbreak than other firms. After the outbreak, this difference in comovement doubled to 2.08%. Overall, the post-outbreak level of stock comovement for firms with the highest degree of similarity in financial flexibility was ten times larger than the average stock comovement of other firms in the pre-outbreak period (0.21%).
Importance for society
Our findings provide new insights for regulators and policymakers. For instance, an implication of our results is that, to the extent that monetary policy and banking macroprudential regulations affect firms’ financial flexibility, they may have unintended consequences on comovement in the stock markets and, therefore, affect the extent to which investors can diversify the risk of their equity portfolios. Moreover, our results on the link between financial flexibility and stock comovement have important implications for investors. For example, our insights can be used to design new investment strategies that exploit the information in the collateral value of corporate assets and its effect on stock correlation to generate portfolio excess returns.
Overall project development
The project led to a publication in one of the top international academic journals in finance: the article “Stock Comovement and Financial flexibility” is forthcoming in the Journal of Financial and Quantitative Analysis.
To complete the paper, we:
1: Obtained data for estimation.We gathered financial data on firms from various financial databases, such as CRSP, Compustat, and Capital IQ, and performed the econometric analysis to calibrate the parameters of the model and perform the empirical tests.
2: Formulated and solved the economic model. We formulated, solved, and calibrated a dynamic structural model of corporate decisions, and performed counterfactual experiments to study the effects of financial flexibility and stock comovement. To do so, we developed and tested numerical codes in Matlab and Julia, and performed the calibration of the model’s parameters using the data mentioned above.
3: conducted an empirical analysis. As described above, we implemented two main empirical strategies to test the model predictions. First, we used data on U.S. firms from 1993 to 2018 and relied on the value of corporate real estate (CRE) assets to measure the degree of firms’ financial flexibility. Second, we performed an event study of stock comovement around the start of the COVID-19 crisis. Moreover, we ran several robustness tests to verify the validity of our empirical results. For example, we performed a second event study around the 2008 global financial crisis, and we extended the analysis to several countries (Great Britain, Japan, France, Germany, Italy, and Spain, among others).
4: Presented the results of the project and completed the paper. We presented the paper in several international conferences, and at seminars in different academic institutions (see list below). We then incorporated the feedback received into the final version of the paper, which we submitted for publication.
Finally, working on this project led us to develop new research ideas. While, so far, we have focused on stock returns, in current work my IESE colleague Valentina Raponi and I are using the model and data from this project to study the effects of the COVID pandemic on important firm decisions such as corporate investment and financial structure.
Impact and outputs
The results of the project are of interest not only for academics, but also for managers, policymakers, and investors:
- The model generates predictions about the optimal response of firms to aggregate and idiosyncratic economic shocks: how much firms should invest in physical capital; and how the means of financing (debt, equity, precautionary cash holdings) should be adapted due to the new economic environment. These insights will be of great interest for managers to guide their business decisions following negative economic shocks.
- Our dynamic model allows to generate counterfactual experiments to gauge the effects of different government policies on firm behavior. For example, the model could be used to understand the effect of monetary policies on firms’ financial flexibility. These results will be useful for regulators and policymakers to understand the impact of different types of government interventions, and to improve their design to achieve the desired outcome.
- Finally, our empirical tests provide evidence on the effects of the Covid pandemic on the cross-section of stock returns. These insights will be helpful for retail investors and portfolio managers to understand the effects of the crisis on their equity portfolios, and to optimize their holdings to maximize the risk-return trade-off.
Publications
“Stock Comovement and Financial Flexibility”, Teng Huang, Anil Kumar, Stefano Sacchetto, Carles Vergara-Alert, forthcoming in the Journal of Financial and Quantitative Analysis.
Conference presentations
37th International Conference of the French Finance Association (AFFI), 49th Financial Management Association (FMA) conference, 7th Paris Financial Management Conference, 2nd Danish Finance Institute conference, 27th Spanish Finance Forum, 2019 American Real Estate and Urban Economics Association (AREUEA) International conference, 35th American Real Estate Society meeting, 15th Corporate Finance Day at the University of Antwerp, 25th European Real Estate Society meeting.
Seminar presentations
CUNEF (Spain), IILM University (India), and Swansea University (UK).
