Bridge over ocean
1 August 2015 CFA Institute Journal Review

Urban Vibrancy and Corporate Growth (Digest Summary)

  1. Derek Bilney, CFA

The investment activities of a firm are sensitive to the investments of other firms whose headquarters are nearby, irrespective of whether the firms are operating in the same industries.

What’s Inside?

The authors confirm earlier studies that show investment rates differ across US cities. They investigate the drivers of these differences and illustrate the sensitivity of investment rates to the investment activities of firms operating in different industries but in the same geographical area. The drivers can be split into external (exogenous) shocks that affect all firms in an area and endogenous drivers, whereby the activities of one firm generate investment opportunities for another.

How Is This Research Useful to Practitioners?

The authors show that the investment decisions of a firm are affected by the investment decisions of both other firms in its industry and firms that have headquarters in the same local area. For example, for regions dominated by a single industry, shocks to that industry have a flow-on effect on the investment activities of firms in other industries in the same area.

This region effect is the result of networking interactions and idea sharing between senior executives of firms located within the same area—for example, through participation in commercial, charitable, educational, medical, sporting, or business activities.

These findings may be useful for equity analysts. Typically, analysts focus on a group of firms in a particular industry and identify and compare common industry-specific factors that may affect those companies. The authors show that analysts should also consider the prospects of nearby firms operating in different industries because these firms may also provide useful insight into investment prospects. More broadly, the research may be useful for local and state governments investigating the positive ramifications of providing an economic and political environment conducive to investment opportunities.

How Did the Authors Conduct This Research?

The authors collect information for listed companies from 1970 to 2009. This information includes monthly stock returns from CRSP and annual fundamental data and industry codes from the CRSP/Compustat Merged Database. Firms are grouped by industry based on the Fama–French industry classifications. The location of a firm is determined by its headquarters rather than its operational base. Locations are assigned to one of 20 economic areas as defined by the US Bureau of Economic Analysis.

A series of regressions are then performed to isolate industry- and location-specific effects by looking at the investment rates of firms in the same area/same industry, same area/different industry, and different area/same industry. Control variables include firm, year, and area fixed effects and investment rates from recent periods. A second set of regressions model the investment activities of a firm as a function of such known determinants of investment activity as cash flows—again, split across the three area/industry combinations.

To better understand the drivers of the same area/different industry investment effect, tests are performed to assess the impact of an industry-specific exogenous shock (i.e., across the energy sector) on nonenergy firms. Other tests included assessing the different sensitivities to macro shocks and the impact of changing real estate values (as collateral for debt) on investment decisions.

Using robustness tests, the authors consider the differences between large and small firms, headquarter relocations, and the use of different industry classifications.

Abstractor’s Viewpoint

The migration of people from rural to urban settings has been an important factor in the intellectual development of humankind because it has allowed for increased sharing of knowledge and ideas through formal and informal networks. Vibrant cities, particularly those with a reputation in a particular industry, attract talented and motivated people, which can lead to investment opportunities across all industries in the area. This development, in turn, can attract new inhabitants. Crucially, cities need to encourage industry diversification to protect against the risk of shrinking industries affecting the dynamics of a city, evidenced by the travails of Detroit.

It would have been interesting if the authors had used the operational base of each firm as the basis for assigning location and replicated the regressions to assess whether the results differed as a final robustness check. For companies headquartered in a state for the sole purpose of receiving favorable taxation outcomes but with operations based elsewhere, different results could be produced.

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