Winston Wei Dou

Competition Network, Distress Propagation, and Stock Returns

Joint with Mingming Ao, Shane Johnson, Wei Wu

January 2021


We build a competition network that links industries through common major players in horizontal competition of product markets. Using the network structure, we show that industries with higher competition centrality are more exposed to the cross-industry spillover of distress shocks, which can lead to aggregate fluctuations, thereby have higher expected stock returns. To test the core mechanism, we examine the causal effects of firms' distress risk on their product market behavior and the propagation of these firm-specific distress shocks through the competition network. The competition intensity on the network is endogenously determined by the capacity of (tacit) cooperation among peers. We identify idiosyncratic distress risk by exploiting the occurrence of local natural disasters and corporate fraud shocks. We find that firms hit by disasters exhibit increased distress and then compete more aggressively in product markets by cutting their profit margins. In response, their industry peers also engage in more aggressive competition and exhibit their own increased distress, especially in industries with high entry barriers and balanced market shares. Importantly, distress risk can propagate to other industries through common market leaders operating in multiple industries. These results cannot be explained by production network externality.