Local Information Advantage Provides Investors an Edge
Abstract:Investors in the stock market are in a perpetual state of needing information about the firms in which they invest. Value-relevant information about firms is often geographically dispersed. Finance professor Johan Sulaeman of SMU Cox and co-authors parse the impact of geography on information and performance in their new research. The authors suggest that local information advantages do matter, and institutional investors that play the local advantage angle realize higher returns on their stock portfolio holdings.
The authors offer a novel metric of firms’ geography, in comparison
to previous research that focuses on headquarters of firms. They consider the
effect of the economic interests of a firm rather than just the firm's
headquarters (HQ). For example, Irving, Texas-based Fluor Corp. is an infrastructure
firm, with projects in many countries around the globe. However, relative to the
U.S., they have a number of major projects in various states. In the Gulf of
Mexico, where a large portion of the U.S.'s refining capacity exists, Fluor worked
on the Garyville, Louisiana Marathon Oil refinery expansion, a major project
with significant local economic impact. In this case, Louisiana- or Houston-based
institutional investors with potential local information advantages about the
project could have earned excess returns if they knew that the refinery project
was positively impacting the financial bottom lines of Fluor and Marathon Oil.
Sulaeman says, "We think there is more to being local than just having a corporate headquarter in a locale. If I live in Seattle, Boeing has significant operations there but is not headquartered in Seattle. There can be an information advantage gained from soft information from local sources as opposed to hard data alone." These findings make important contributions to the emerging literature in finance that recognizes the importance of geography. While other studies have examined the local bias of institutional investors, their study is the first to show that the institutional local bias phenomenon is not exclusive to firms’ HQ locations. Rather it is typical of locations where the firm's economic interests exist.
In this research, the authors also disentangle the local information advantage versus the 'familiarity'-based investing that may not be due to informational advantage. For example, you may see a number of new Wal Marts cropping up in a region and conclude that they must be profitable. In this case, you may feel comfortable with investing in Wal Mart from being familiar with the firm.
"We should also think about diversification," notes Sulaeman. "If a portfolio is overweighted with local stocks (along with information advantages deemed acceptable) and they perform well, then the portfolio's performance reflects this. This concentration of local stocks may have higher risk, but the rewards may also be higher. The investors believe the local information is good enough to bet this way." Think of hedge funds in Houston concentrating in oil and gas stocks, given the proximity to energy firms, distribution networks, and sources of oil supply.
About the research
To determine if firm-level information affects investor portfolio decisions, the authors mapped the geographical distribution of firms' economic interests and measured the relative importance of each location for the firm. They therefore needed information about the geographical dispersion of plants, operations, R&D facilities, retail outlets, and other value-relevant activities and events. This information was not readily available or neatly compiled in any database. They devised a way to measure the relevance of each U.S. state relative to the firm's operations, considered an economically-relevant (ER) state or location. In particular, a specific state is designated to be more relevant to a particular firm as that state was mentioned more often in the firm's annual 10-K report. This measure identified by the authors offers a more comprehensive instrument to determine how the local factor can work in a portfolio, rather than just the HQ location.
The authors' rationale is that "firms sharing ER locations would face common local shocks and/or have systemic relations, which would generate a common local component in their stock returns as well as their operating performance and capital investments." Said another way, by including a local market factor, asset-pricing models provide more explanatory power. The more times a specific state was mentioned in the firm's annual 10-K report, a proxy for local exposure, the more sensitive the stock return was to the local factor. Sulaeman believes their methodology translates to the global arena, which they will pursue in another research cycle.
Additionally, the local information edge matters for stocks of firms that are hard to value. The authors found that for younger and smaller firms and more volatile or less liquid stocks, the institutional ownership of these stocks in their economically-relevant locations or states was important. "The performance of institutional investors’ local (ER) portfolios depends directly on the potential availability of local information, both at the level of the individual holding and of the local portfolio as a whole," the authors write. Technology stocks and other types of growth stocks are likely to fall into the hard-to-value category, where specialized knowledge is needed to evaluate the firm's prospects.
Economic relevance is a metric that has meaning. "This is also the game of market participants," says Sulaeman. "If I observe an Austin firm trading in Austin-based Dell stock, and doing well, I will watch and follow these investors. However, the market may not be paying attention to the local ER investors, like when an important Louisiana investor trades British Petroleum stocks for which there may be a longer term information advantage." (British Petroleum has significant economic exposure to to the Gulf Coast and Louisiana.)
The evidence presented by the authors "suggests that an investor may be able to exploit local information about some local firms in her portfolio to trade profitably on other local stocks," as well. Importantly, large investors may leverage information that is geographically dispersed, and the returns in their portfolios will reflect the information advantages.
The paper "Home Away From Home: Geography of Information and Local Investors" by Johan Sulaeman, of Southern Methodist University's Cox School of Business, Gennaro Bernile, Singapore Management University, and Alok Kumar, University of Miami, is under review.
Written by Jennifer Warren.