In a downturn, firms experience more than the estimated valuation losses on assets, according to the author, because of the presence of financially constrained peers in the industry, which drags down the industry’s prospects in the view of the investors. This result multiplies the effect of industry downturns.
The author demonstrates that the contagion effect during industry downturns can result in an increase in the value of loss—from 10% up to 15.8% for the average industry—because of the impact of maturing long-term debt of financially constrained peers within the group. Consequently, negative externalities can significantly affect the better-performing companies in the industry during a downturn. This effect is an important consideration in competitive industries with specialized assets and has implications for the choice of firm financial policies as well. The macroeconomic impact includes the extent to which it magnifies the level of shock for the entire economy.
How Is This Research Useful to Practitioners?
Although standalone analysis of target companies is important for investment professionals, the broader picture must also be taken into account. The author has highlighted the presence of both positive and negative contagions in every industry and considers their effects during industry downturns. Weaker entities can sometimes benefit a target company (i.e., positive contagion). The opposite may also be true, especially in cases where interdependencies might exist.
How Did the Author Conduct This Research?
The author has conducted a detailed analysis and expanded on previous research on the subject. Data are from Compustat’s North America Fundamentals Annual, Quarterly, and Rating Files and CRSP. Financial firms and regulated utilities are excluded. The period covered is 1970–2010, and the overall sample, after some filters are applied, is composed of 132,926 firm-wise yearly observations.
By analyzing cross-sectional differences in the debt maturity structures across industries experiencing downturns, the author predicts differences in their financial exposures to negative shocks occurring during the same year. He then considers the three-year periods before downturns.
The author provides evidence that negative contagion effects inside industries can lead to a quantitatively significant amplification of industry downturns. In addition, normal variation in firms’ ex ante financial policies can impose significant costs on their industry peers during industry downturns.