Star firms and finance.

Why are star firms important in the market?

15 November 2023

The article at a glance

This blog post discusses the significant role of ‘star firms’ in the financial markets, a concept introduced by Gutiérrez and Philippon (2019). These firms are not only large in their sectors but also profoundly impact market dynamics in the US.

By Dr Mehrshad Motahari, CERF Former Research Associate, Cambridge Judge Business School, University of Cambridge

What are star firms?

Mehrshad Motahari.
Dr Mehrshad Motahari

Large, dominant ‘star’ firms play a pivotal role in financial markets. Star firms, a term conceptualised by Gutiérrez and Philippon (2019), are not just large entities in their sectors;  they significantly impact macroeconomic outcomes in the US, especially in areas like exports, foreign direct investment, and research and development, leading to increased profits and industry concentration (Autor et al, 2017; Grullon et al, 2019; De Loecker et al, 2020). Their growing influence is further amplified by advancements in artificial intelligence (Babina et al, 2024). AI-powered growth in sales, employment, and market valuations concentrates among larger superstar firms and leads to their greater influence through product innovation.

The rise of star firms is attributed to factors such as economies of scale, significance of proprietary information technology (Bessen, 2020), accumulation of intangible digital capital (Tambe et al, 2020), better access to human capital (Choi, Lou and Mukherjee, 2017), and weakened anti-trust enforcement (Döttling, Gutiérrez and Philippon, 2017). Their market power enables them to create entry barriers, affecting the performance and future earnings of other firms in their industry. The lack of full consideration of these dynamics by market participants like sell-side equity analysts could lead to predictable patterns in the earnings and returns of star and non-star firms.

Information externalities: what do star firms reveal about their peers?

In the article entitled ‘Star Firms, Information Externalities, and Predictability’, CERF/CCFin postdoctoral alumnus Mehrshad Motahari (Bayes Business School, formerly Cass) and co-authors Vidhi Chhaochharia, Alok Kumar, and Ville Rantala (Miami Herbert Business School) shed light on this phenomenon, exploring the multifaceted ways star firms influence the financial ecosystem. The paper delves into the financial information externalities of these star firms within industries. It seeks to understand how shifts in the performance of star firms can predict future earnings, growth opportunities, and the returns of non-star industry peers. Moreover, it probes into whether market participants, like sell-side equity analysts, have fully integrated this information into their earnings forecasts.

The paper’s empirical analysis measures the relative earnings growth difference between star and nonstar firms. This measure is not just a static snapshot; it is dynamic, capturing the variations in earnings growth across quarters. The findings indicate that changes in the earnings performance of star firms are closely mirrored by the earnings growth of nonstar firms in the same industry. This lead-lag relationship is a testament to the gravitational pull exerted by star firms on their industry peers.

Furthermore, the research suggests that security analysts might not be fully cognizant of the information externalities of star firms. This lack of complete integration leads to predictable patterns in earnings surprises and returns of related non-star firms. Essentially, the market dynamics surrounding star firms are complex, and the full scope of their influence is not always immediately apparent to market observers.

Another significant finding of the study pertains to the influence of these firms on stock market returns. It appears that the relative earnings performance of star firms harbours information that is not wholly incorporated in market prices. This insight is crucial for understanding future stock returns, indicating that the market might not be fully efficient in pricing the performance data of these influential entities.

Lastly, the study explores the connection between market anomalies and biased earnings expectations. It posits that the anomalies observed in star firms can be indicative of future returns of connected nonstar firms. This finding suggests that market anomalies contain critical information about peer firms not immediately recognised by the market.

Why do star firms lead their industries?    

The impact of star firms is notably more pronounced in less competitive industries. This suggests that market power is a considerable source of their influence. In industries where competition is less fierce, the dominance of star firms becomes more marked, allowing them to exert greater influence on market dynamics and the performance of other firms.

The labour market implications of the study are equally compelling. The research draws a connection between changes in the economic performance of star firms and labour market effects, such as variations in job postings for non-star firms. This aspect underscores the broad spectrum of influence these firms have, extending beyond mere financial metrics to the very fabric of employment and career opportunities in the industries they dominate.

What are the important takeaways?

In a broader context, the research contributes to our understanding of lead-lag effects in stock returns. It identifies a pattern where the performance of star firms – both in terms of earnings and stock returns – can be predictive of the outcomes for other connected firms. This insight is an addition to the literature on market dynamics, offering a new lens to view the influence of dominant industry players.

The study offers a nuanced and detailed exploration of the role of star firms in the economy. It reveals that the performance of these firms has far-reaching implications, influencing not just their own trajectory but also creating a ripple effect across the broader economy and the stock market. This research underscores the importance of considering the interconnectedness of firms within industries and highlights the subtle yet significant ways in which star firms shape economic and market dynamics.

For investors, policymakers, and anyone keenly observing the economic landscape, these insights may be helpful. They emphasise the need for a more nuanced approach in analysing market trends and economic patterns, taking into account the often subtle yet powerful influence of these dominant players in the market. As the global economy continues to evolve and as technologies like artificial intelligence further entrench the position of these star firms, understanding their role becomes not just an academic exercise but a necessity for navigating the complex world of modern financial markets.