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  How a company's financial structure affects its stock returns 

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How are stocks trading now? Amid a shock like the COVID-19 crisis, are new patterns emerging?

The 2021 paper "Stock Comovement and Financial Flexibility" shows that the more similar in financial flexibility two firms are, the more their market returns are correlated. Here's a brief look at how coauthors Teng Huang, Anil Kumar, Stefano Sacchetto and Carles Vergara came to that conclusion and what the main implications are.

Market moves
For all that financial experts know about asset pricing, there's certainly more to be discovered, as this research indicates. Here is the key visual in the paper:


What is going on here? Under fairly typical trading conditions (between the labeled peaks in the chart), pairs of stocks have some residual correlations -- that is to say, comovement after controlling for size (small cap v. large cap), risk, price-to-book ratios (value v. growth), profitability, and investment, which are the five factors named in the famous Fama-French five-factor model (FF5, 2015). That comovement is exaggerated when there's a shock, like the bankruptcy of Lehman Brothers in 2008, China's stock market turbulence in 2015, or the global COVID-19 outbreak in 2020. These external shocks suddenly (and unexpectedly) affect the value of key collateralizable assets, namely real estate, and thus affect firms' financial flexibility. Controlling for other factors, the abrupt changes in financial flexibility provide an empirical test for the coauthors' dynamic model.

Why is this relevant? Coauthors Sacchetto and Vergara weigh in:
  • While we are hearing a lot about which stocks climbed in the pandemic (Zoom, pharma companies) and which fell (hotels, airlines), no one seems to be talking about the markets getting more correlated. This correlation has significant implications for asset managers and executives at financial institutions who want to diversify their holdings -- or improve their market predictions.
  • Investors in general should take note: Our paper shows that this comovement is related to financial flexibility (intended as the firm's ability to raise financing when needed): when two firms have more similar levels of financial flexibility, their stocks comove more.
  • CEOs and other senior managers should be aware that their decisions regarding their company's financial structure (for example, the amount of debt, cash and collateralizable assets held) have an effect on the comovement of their stock with other firms' stocks, and so, on the amount of risk that the firm's shareholders cannot diversify away.
  • Finally, it's relevant that any regulations that affect financial flexibility may have unintended consequences on comovement in the stock markets. This should matter to regulators because it may impact the extent to which investors can diversify their equity portfolios in order to mitigate risk.

Sacchetto acknowledges financial support from the AXA Research Fund, AGAUR (Ref: 2017-SGR-1244), and AEI (ECO2017-84016-P AEI/FEDER, EU) from the Spanish Ministry of Science, Innovation and Universities. Vergara acknowledges the financial support of the State Research Agency of the Spanish Ministry of Science, Innovation and Universities (Ref.PGC2018-097335-A-I00 MCIU/AEI/FEDER, EU), the Ministry of Economy and Competitiveness (Ref. ECO2015-63711-P), and AGAUR (Ref: 2014-SGR-1496).
This article is based on:  Stock comovement and financial flexibility
Year:  2021
Language:  English