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8 October 2018 Financial Analysts Journal

The Predictive Power of Politics (Summary)

  1. Phil Davis

This In Practice piece gives a practitioner’s perspective on the article “Corporate Political Strategies and Return Predictability” by Chansog (Francis) Kim, Incheol Kim, Christos Pantzalis, and Jung Chul Park, published in the Fourth Quarter 2018 issue of the Financial Analysts Journal.

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What’s the Investment Issue?

Changes in the political landscape and in the law are a continuous source of uncertainty for companies. Political and legal changes can reshape companies’ investment opportunities, operating costs, regulatory environment, and value.

Assuming that the prices of companies with a strong focus on political events do react to political shocks, the authors seek to find out what this means for the share prices of similar companies.

It seems intuitive to the authors that, in response to a political event or policy, investors would initially assess the effect on companies that are adept at processing political information. Only afterwards would investors look at the impact on companies that do not focus on political developments.

That is, the authors seek to find out whether information contained in the share prices of politically connected companies eventually trickles down to the share prices of competitors and, if so, with what time lag.

How Do the Authors Tackle the Issue?

The authors evaluate the prices of US stocks from 1995—three years before information on corporate lobbying first became publicly available—to 2016.

They identify and examine three types of political strategies commonly used by companies: (1) hiring at least one ex-politician to the board of directors; (2) directing donations of money to politicians for their campaigns; or (3) lobbying directly or indirectly. To determine which companies hired ex-politicians, the authors use a tool to search the SEC database. Where the politician’s level of experience and influence is not publicly available, bespoke research is carried out. Donations data are sourced from the Federal Election Commission, and lobbying information is gathered from OpenSecrets, a non-partisan, not-for-profit research organization.

Depending on whether they used these political strategies or not, companies are split into two groups: politically connected firms and non-politically connected firms.

Portfolios for each of these groups are then produced based on combinations of (a) size, book-to-market ratio, and momentum and (b) industry and size. Creating portfolios of stocks is thought to be more reliable (and practical) than trying to find exact matches in each of the two groups. This process yields 125 and 144 portfolios, respectively. The authors base their findings on the 125 combinations of size, book-to-market ratio, and momentum, creating 125 pairs of politically connected firms and non-politically connected firms, which could then be compared.

In order to better understand political connectedness, the authors examine the relative change in stock prices within each pair of companies on a monthly basis. The authors seek to determine whether information trickles down from politically connected companies to less politically focused rivals and how long this process takes.

What Are the Findings?

The authors find that that a sizable proportion of US publicly listed companies have introduced a political strategy into their overall business model. Some 18.9% of the companies in the study carry out one or more of the three political strategies examined. And those companies that are politically active tend to simultaneously manage multiple political strategies.

The stock prices of companies with a strong political focus have a stronger short-term reaction than the prices of companies without political connections.

From that first finding, the authors are then able to show that the stock price performance of politically connected companies can predict the future direction of similar, but non-politically connected, companies. That is, political information is first reflected in the prices of politically connected firms and then, with a lag, in the prices of their non-connected competitors. This relationship is strong both within and across industrial sectors.

An investment strategy based on this finding can yield large returns. The authors find that a strategy that is positioned to take advantage of the political information trickling from politically connected firms to their less politically aware peers returns as much as 153 bps a month, before costs.

What Are the Implications for Investors and Investment Professionals?

The study indicates that investors should be able to predict future stock returns of companies without political strategies by looking to the stock prices of similar companies with a strong political focus and thereby devise outperforming investment strategies.

Gross returns should be large enough to exceed transaction costs that are endemic in a strategy of this type, which requires monthly rebalancing of portfolios. Investors wishing to exploit the strategy would need to gain timely access to information that the authors could gain only after a delay of a year or so. It is not clear whether this length of delay in obtaining the information would still allow for a profitable trading strategy.

It is likely that an investment firm with sufficient resources and skills could collate the relevant information more rapidly by relying on commercial database providers and bespoke research than by relying on publicly available information.

A further caveat is that the authors do not produce clear findings relating to industry and size. It is probable that larger companies with the resources and willingness to be politically connected are more politically driven than firms without these attributes. If true, the trickle-down effect of price action from a politically connected company to its (similarly-sized) non-connected peer may not occur.

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