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Abnormal Stock Returns

Using Supply Chain Momentum


and Operational Financials

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ANTTI PAATELA, ELIAS NOSCHIS, AND ARI-PEKKA HAMERI

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A NTTI PAATELA supply chain or supply network abnormal returns have almost disappeared.

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is a visiting researcher in is a multicompany material-f low The latter finding is in line with the theory of
the Ecole des HEC at the

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ecosystem surrounding a pro- efficient markets. We explore further oppor-
University of Lausanne

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in Lausanne, Switzerland. duction company. Stock price tunities for customer-related information
and operational data of customer companies by switching to a completely different data

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antti.paatela@gmail.com

ELIAS NOSCHIS
provide an indication of supplier companies’
future operations and business performance.
A set: using financial reporting data instead of
stock market data to improve supplier com-
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is a visiting researcher at The delays and time lags between supply panies’ stock returns. Leaving the customer
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the University of Lausanne


in Lausanne, Switzerland.
chain operations may represent an oppor- companies’ stock prices out of the forecasting
noschise@hotmail.com tunity to forecast company performance method results implies that some important
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even before the company publishes its own qualitative market factors such as manage-
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A RI-P EKKA H AMERI financial reports. Understanding the inter- ment predictions for the future, competi-
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is a professor in the Ecole relationships between supply chain partners’ tive situation, new products in the business
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des HEC at the University


businesses intuitively provides an opportu- pipeline, and dividend policies are ignored.
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of Lausanne in Lausanne,
nity to gain abnormal investment returns in We, however, think that these very different
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Switzerland.
the stock market. perspectives should be kept separate at first
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ahameri@unil.ch
Although several studies have addressed and then integrated into a single forecasting
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supply chain implications for shareholder method in future research.


wealth, the majority of related research This article studies such supplier–
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focuses on single companies instead of supply customer supply chain pairs, in which the
chains, on company financial performance business link is strong and has existed for years.
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instead of stock market performance, and This ensures high-quality data and validity
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on special events analysis instead of contin- across business cycles but also limits the size
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uous operations. Further variations include of the sample. Because of the nature of supply
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emphasis on either upstream or downstream chains, most supplier companies are smaller
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sides of the supply chain, the size of the sector than their customer companies and can in
studied, and the variety of sampled compa- most cases be regarded as mid-cap or small-
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nies within the submarket. cap companies (by U.S. market perceptions).
One of the first supply chain stock price One of the key ideas of this study is to
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prediction studies claimed abnormal returns exploit company fundamental data, instead
on investment using customer companies’ of stock prices—that is, to use operational
market prices to predict the supplier compa- supply-chain-related financial data derived
nies’ stock returns. A later study claims these from 10-Q quarterly reports (for Q1–Q3)

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and annual 10-K reports (for Q4) in predicting supplier The lead–lag effect found was more pronounced for
stock prices. This approach opens a new perspective small suppliers and for supplier industries with dispersed
on supplier stock price prediction by omitting stock- sales and with higher relationship-specific investments
price-related speculation and under/overreactions and with their customers. Buying supplier industries with the
by altering market expectations for stock prices by (un) highest customer returns after a one-month time lag in

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sophisticated investors. the top quintile and selling short the industries with the

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Although investment practitioners already follow lowest customer returns in the bottom quintile yields up

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supply chains of large-cap companies, the same amount to 15% of abnormal return annually.

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of analyst manpower cannot be used with mid-cap or Investor inattention or the failure of many inves-

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small-cap companies cost-effectively. For smaller com- tors to include relevant information from a compa-
panies, availability of company-specific information also ny’s supply chain is advanced by Cohen and Frazzini

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becomes a challenge. This is why we propose a port- [2008] as a possible explanation for the stated abnormal

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folio rebalancing/trading solution with minimal sub- returns. Merton’s [1987] model offers some explana-

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jective inf luence applying publicly available company tion for investor inattention: Investors supposedly eval-

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reporting data. uate whether the gains of a new strategy are worth the
total cost of implementing and operating the strategy,

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SUPPLY CHAIN KNOWLEDGE ASSISTED including time and resources to market the strategy to

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STOCK TRADING SO FAR clients and legal compliance. If the perceived total cost

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is prohibitively high, its elimination by the market can
To date, many authors have investigated the links last for several years.

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between supply chains and the stock market, suggesting
the existence of trading strategies producing abnormal
A Six years after Cohen and Frazzini [2008]’s ini-
tial publication, another study by Wu and Birge [2014]
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returns. Cohen and Frazzini [2008] were among the claimed that customer momentum has almost completely
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first, claiming abnormal annual returns of 18.6% by disappeared and suggested two new approaches yielding
using the performance of customer companies as a pre- abnormal returns. One is supplier momentum—that is,
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dictor of supplier companies’ performance. They found inverting the roles of the customer and the supplier in
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a time lag between the market performance of a cus- the previously described trading strategy. The other
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tomer company and its suppliers. Using the previous approach, called centrality, consists of assessing the interac-
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month’s performance of all customer companies’ stocks, tion strength of a company within its network. According
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the authors organized the companies into five quintiles to this approach, abnormally low returns are expected for
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according to stock price increase. The stocks of the cor- highly networked manufacturing companies, whereas
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responding suppliers were purchased (shorted) in the abnormally high returns are typical for more central com-
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following month for all customer companies in the panies like in transportation, wholesale, and retail sectors.
top (bottom) quintile. This source of abnormal return Guan et al. [2015] maintain that the improvement in
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and predictability is referred to as customer momentum forecasting accuracy reached by customer momentum is
throughout this article. statistically as significant as that of following the industry
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The Cohen and Frazzini study spans from 1980 to peers of the supplier company analyzed.
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2004 and focuses on companies listed in the United States The effects of supply chain disruptions have also
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with share prices above $5 and is restricted to companies been studied. Hendricks and Singhal [2003] find that
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with a single customer generating 10% or more of total supply chain glitch announcements are associated with an
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sales. These findings of customer momentum for the abnormal decrease in shareholder value of 10% and that
U.S. market are confirmed by a second study, Shahrur larger firms or firms with lower growth prospects experi-
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et al. [2010], which investigates a sample of firms from ence a less negative market reaction. Olsen and Dietrich
22 developed markets from 1995 to 2007. Because the [1985] report that monthly sales announcements of firms
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probed markets do not necessarily require companies to in the retail industry seem to affect their suppliers’ stock
disclose their main customers, the authors ranked portfo- price and in a study focused on a single manufacturing
lios of supplier companies (e.g., car part suppliers) based company (1980–2005), Capkun et al. [2009] report a
on returns of customer companies (e.g., car makers). correlation between inventory performance and profit.

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Commodities with global market prices can also be quarterly reporting. After new quarterly reporting data
thought to have a “supplier” role for some companies. is received, the trading method performs comparisons
A decrease in the average oil price in one month indicates of the customer company’s SCF variables in the previous
a higher stock market return the following month. Back- quarter. Depending on the outcome of this comparison,
testing concludes that this strategy yields an abnormal the trading method issues a recommendation to buy the

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annual return of +4% after transaction costs over several stock of the corresponding supplier company and the

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years (Driesprong et al. [2008]). resulting return on investment is computed. A more tech-

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None of the publications to date directly link the nical description of the method is found in Appendix A.

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operational financials—for example, sales or invento- Because there are no standardized criteria to select

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ries—of a customer company to predict its supplier’s the best-suited input variables, we opted for a procedure
share price. The absence of such a published forecasting maximizing the method’s utility from an investor’s point

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procedure based on operational financials is what moti- of view under realistic trading conditions. We therefore

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vated our exploration of a new trading method. Unlike chose the Sortino ratio (Sortino and Price [1994]) as the

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many existing publications, this article considers com- output variable, because maximizing the Sortino ratio

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pany selection bias, survival bias, and true transaction ensures an optimal balance between risk and return. The
costs including broker fees and the spread. Sortino ratio seems better suited than the more widely

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As is the case for any trading method, the lack of a used Sharpe ratio because the former distinguishes

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publication is by no means proof that the method is not between upside and downside volatility in agreement

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used. However, it suggests that such a strategy is in its with most investors, who welcome large positive returns.
infancy or not published for competitive reasons. All studied customer–supplier company pairs were

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selected based on the methodology described in (Cohen
and Frazzini [2008]), which selected the pairs by con-
ANATOMY OF THE PROPOSED
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TRADING METHODOLOGY sidering only companies that disclose sales to a single
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customer of over 10% of the total sales. For meaningful


Both balance-sheet- and income-statement-related backtesting, we retained only company pairs that ful-
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variables were considered for the proposed trading filled this 10% sales threshold for at least seven years.
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method. The following variables—referred to as supply To facilitate possible practical implementation of the
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chain financials (SCF)—were all included as input data method, we only considered publicly available data. This
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candidates for our price prediction method, which issues restricted the pool of suitable companies to the U.S.
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trading recommendations: stock market. The U.S. Securities and Exchange Com-
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mission (SEC) has required listed companies to disclose


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• net sales such information since 1998. The share prices used in
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• cost of goods sold the calculation are the daily adjusted closing prices.
• inventories Based on our analysis, which is described in the
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• inventory turnover (sales/inventories) next section, we assumed an effective transaction cost


• accounts payable of 0.55% (55 bps) of the traded assets for every trade
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• accounts receivable consisting of buying and selling a share. The impact of


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total transaction costs on the results is discussed later.


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We assessed each variable’s suitability to predict Information was retrieved solely from the Morningstar
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share price movements by testing each variable individu- website because the reports are available there on the day
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ally as an input for a trading method issuing buying and they are officially published. For practical purposes, this
selling recommendations for supplier companies’ shares. constraint sets the beginning of the backtesting period
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The principal logic of the trading method is the same as to January 2002 for the majority of the selected compa-
that used in earlier work (Cohen and Frazzini [2008]), nies. Prior to 2002, only a minority of financial reports
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except that the input variables were changed and the can be retrieved electronically from this service. At the
timing parameters (when to buy and sell) were opti- other end, data were collected until December 2013, the
mized anew. Naturally, the sampling frequency cannot latest full year considered for this study. This 12-year
be optimized; it is fixed to four times a year because of timeframe is long enough to test the methodology over

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various regimes of economic growth and abrupt con- for data quality for the entire study period. The sales
traction in 2008–2009 for the U.S. economy. percentages in Exhibit 1 represent the average share of
Company selection began with a set of over 200 total sales attributable to the corresponding customer
randomly chosen small and mid-size market capitaliza- company over the studied period. One of the supplier
tion companies within the U.S. market from different companies shown, Spirit Aerosystems, is of particular

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industries with broadly varying product lifecycles and interest and referred to as the high-dependence supplier.

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manufacturing lead times. In these selected supply chain

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company pairs, the supplier companies are typically THE PREDICTIVE POWER

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smaller than the customer companies. Small supplier OF SUPPLY CHAIN FUNDAMENTALS

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companies are more likely to form longer-lasting bonds
with a customer fulfilling the 10% sales threshold. The The first part of the analysis consisted of selecting

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focus was set on companies mainly producing tangible SCF variables and optimizing the timing parameters of

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products. Companies from the financial and insurance the trading method. Exhibit 2 lists the Sortino ratios

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sectors, for example, were not considered. computed based on the trading recommendation for each

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After applying these various constraints, we SCF. The Sortino ratios for applying each variable are
narrowed the original company set to 20 companies compared against returns of two indexes, the S&P 500

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forming 10 company pairs. An initially balanced port- and Russell 2000, plus the passive buy- and-hold strategy

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folio consisting of shares for these 10 supplier companies using the subset of companies listed in Exhibit 1. Passive

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grew at a pace compatible with the Russell 2000 index returns result from buying shares of the supplier com-
over the studied 12-year time period, making this com- pany at the earliest possible date (January 2002 or the day

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pany set a representative sample of U.S.-based goods-
manufacturing suppliers to test our trading method.
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the supplier company was publicly listed) and holding
them until the end of the period (December 2013). The
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The 20 companies involved are listed in Exhibit 1. The passive portfolio is included in the analysis to assess the
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proposed investment strategy was validated by studying potential sampling bias. We computed the quoted Sor-
the returns of a heterogeneous portfolio of 10 compa- tino ratios for the various SCF variables of the high-
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nies. Although the companies were dissimilar in the dependence supplier stock because this allowed us to test
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business sense, they shared the strictest requirements the predictive power of the method under nearly ideal,
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strong customer–supplier link conditions.


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EXHIBIT 1
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The 10 Supplier–Customer Company Pairs and the EXHIBIT 2


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Share of Sales Attributable to the Customer Company


Sortino Ratios for Various Input SCF Variables
with Respect to Total Supplier Company Sales
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of the Trading Methodology


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Note: Sortino ratios of two market indexes and a passive buy-and-hold


strategy are also displayed for comparison purposes.

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The sales variable of the customer company is the 2000 companies. The spreads of this sample are plotted
best-suited input SCF for the trading method because its in Exhibit 4. Based on these spreads, we define the
Sortino ratio has the highest score. The tests show that average transaction cost as 75% × 0.6% (average spread) +
the COGS variable provides only slightly lower returns. 0.1% (realistic trading fee of a discount broker) = 0.55%.
This is also intuitively understandable because sales and We therefore assume that half of all trades are executed

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COGS are closely related in efficiently managed com- at the market price (at the average spread cost of 0.6%)

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panies. Somewhat unintuitively, using downstream and the remaining trades were completed using limit

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inventory data would not show strong improvements orders at the midquote price between bid and ask prices

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in the Sortino ratio. Having identified the optimal (thus adding an average spread cost of 0.3%). Unless

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SCF, we extended backtesting to include a portfolio of stated otherwise, all returns in the following are com-
the supplier companies listed in Exhibit 1. The back- puted assuming this average transaction cost of 0.55%.

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tested individual compound annual growth rates for The active portfolio beats the S&P 500 and Russell

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the 10 companies and for an initially equally weighted 2000 indexes annually by 12.2% and 8.7%, respectively.

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portfolio of these companies obtained from active and More importantly for some investors, the risk-adjusted

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passive trading are displayed in Exhibit 3. Sortino ratios are roughly four times better than for the
Estimating the realistic transaction costs used in Russell 2000 reference index (see Exhibit 3). For 8 out

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backtesting is not a trivial task because of the variation of 10 companies, the active portfolio beats the passive

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in spreads between individual stock prices and trading portfolio. For two company stocks, Scotts Miracle-Gro

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practices. Because there is no standardized method to (SMG) and Oil-Dri Corporation of America (ODC),
the best of our knowledge, we defined the average the passive investment yields better returns. This result

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transaction cost for trading shares of the companies in
Exhibit 1 by analyzing a representative sample of Russell
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is discussed later in the text. The Sortino ratio of the
passive portfolio is comparable to the market indexes,
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meaning that after adjusting for risk, there is no signifi-
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cant selection bias in the company sample.


EXHIBIT 3 An appealing feature of the active portfolio is that
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Computed Compound Annual Growth Rates it is materially uncorrelated with the broader market:
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of the 10 Individual Stocks Based on Passive Correlations are −0.13 for the Russell 2000 and −0.16 for
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and Active Trading the S&P 500. The standard deviation of the active port-
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folio monthly returns (see Exhibit 5) is comparable to


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the S&P 500 market index, while the average monthly


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return of the active portfolio is significantly higher than


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any of the other three benchmarks. This is an indication


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that the abnormal returns of the active portfolio are not


the result of a few particularly successful single trades.
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The key metrics—correlation, monthly returns, and


compound annual growth rate—of the passive portfolio
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and the Russell 2000 index over the studied period lie
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within the same range. If the passive portfolio is consid-


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ered as a proxy for the market index, the difference in


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the average monthly returns of +0.3% between the active


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(+1.3%) and passive (+1.0%) portfolios quantifies the


abnormal return provided by including information from
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the supply chain in the stock trading of these companies.


For the studied sample, there is no significant
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correlation between the amount of supplier dependence


Notes: The key outcomes are the significantly improved compound annual on its main customer and abnormal returns; see Exhibit 6.
growth rates (CAGRs) and Sortino ratios in the active portfolio. The CAGRs
and Sortino ratios of a portfolio for the 10 companies with initial equal weight This means that exceptionally large single-
and two market indexes are also displayed for comparison purposes. customer sales are not a prerequisite for high returns.

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EXHIBIT 4
Distribution of the Spreads for a Representative Sample of the Russell 2000 Index

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EXHIBIT 5 VALIDITY OF ABNORMAL RETURNS

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Correlations and Characteristics of the Monthly
Returns of the S&P 500, Russell 2000, Passive,
A The calculated abnormal annual returns in excess
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and Active Portfolios of +8% show that opportunities for exploiting customer
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momentum still exist, which differs from the finding of


Wu and Birge [2014], but achieving them requires the
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use of new data sets. The results are also in line with
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single-company research, in which low inventories also


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presuppose improved business performance. However,


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the return potential is smaller than shown in the earlier


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customer momentum research. One obvious reason for


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this is the smaller number of yearly runs of the method


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because there are only 4 quarterly predictions per year


against 12 predictions in monthly runs.
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Given the various backgrounds of the probed com-


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panies, there can be no single straightforward cause to


explain the abnormal returns. A simple supply chain
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Notes: (Top) Correlations between the monthly returns of the S&P 500, explanation is that in a long-term partnership, increasing
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Russell 2000, passive, and active portfolios. The near-zero correlation a customer company’s outbound material f lows will lead
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values between the active portfolio and the three other strategies may also be
appealing to investors from a pure diversification point of view. (Bottom)
to increased material f lows from the suppliers. This will
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Characteristics of the monthly returns of both indexes and both portfolios. later ignite supplier top-line growth, economies of scale,
and, in the majority of cases, increased future cash f lows,
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and finally, higher supplier valuation.


Because it is more likely to find a supplier company with
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Because of the selection criteria of the men-


a 10% rather than, for example, a 30% sales dependence tioned supplier–customer company pairs, the reported
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on a single customer, this lack of correlation is a useful abnormal returns are likely to apply to most of the subset
finding when implementing the trading method in a composed of U.S. small capitalizations’ manufacturing
real environment. It broadens the group of companies goods with at least one large customer. As noted in past
for which the stock may be traded. studies (Thomas and Zhang [2002]), quarterly sales and

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EXHIBIT 6 sectors. In any case, both methods return bias values in
Scatter Plot between Customer Sales and Active/ the low-single percent digit range (1.2% and 2%).
Passive Strategies As noted before, the trading method fails to beat
the passive strategy for two companies: SMG, which
produces branded consumer lawn and garden products

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of superior quality, and ODC, which develops and

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manufactures products used to absorb liquids and gases.

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A thorough company-specific investigation of this

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underperformance goes beyond the scope of this article.

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Beyond obvious seasonality issues, reasonable explana-
tions for this behavior include the fact that SMG has three

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large customers that together account for 60% –70% of

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its sales: Home Depot, Lowe’s, and Walmart. It could be

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that the method works less reliably when several, instead

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of one, customers cross the 10% threshold of total sales.
The underperformance of ODC is marginal and turns

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Notes: Abnormal annual returns defined as the difference in CAGR into a small overperformance for a transaction cost of
between the active and passive investment strategies of the 10 supplier

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companies’ stocks as a function of the percentage of total sales to these 0.4% instead of 0.55%.

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companies’ main customers. Companies with small capitalizations typically have
weak or even no analyst coverage. The abnormal returns

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inventory figures may be subject to manipulation by A
may be explained at least partially by a lack of awareness
on the part of many investors concerning these links
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company executives. Although such distortions surely in the supply chain. Although executing the proposed
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cannot be excluded, the 12-year analysis period mitigates stock trading is neither time consuming nor difficult,
the total effect of temporary anomalies. In most past the methodology required for implementation creates a
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publications, transaction costs are not at all considered. certain entry barrier.
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The role of luck in generating abnormal returns for


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the company pair with the strongest bond was ruled out
BENEFITING FROM PRACTICAL
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by Monte Carlo simulations, in which results of random


IMPLEMENTATION OF SUPPLY
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buy-and-sell recommendations were compared against


CHAIN KNOWLEDGE
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the backtested returns. The simulation results rule out


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luck with a comfortable safety margin for practitioners. Supply chain analysis of a company as a part of
The details of these calculations are presented in the
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asset management has unexplored benefits. The benefits


Appendix B. are twofold. First, supply chain analysis in addition to
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By design, the selection procedure of the traded single-company analysis increases investment returns.
shares excludes the majority of all listed companies. Second, the diversification of a portfolio will improve
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To assess the relevance of the abnormal returns due to as shown. However, successfully applying the proposed
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supply chain dynamics, stock-picking bias must be quan- active portfolio requires investing in an informed selec-
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tified. One simple method consists of subtracting the tion of companies and thereafter efficiently executing
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CAGR of the passive portfolio from that of the Russell the transactions.
2000 index (see Exhibit 3), yielding a stock-picking bias
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In the quarterly analysis design, the active port-


in the CAGR of +2% (9.4% − 7.4%). A more thorough folio involves a relatively high asset turnover ranging
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method described in Appendix C consists of splitting the typically between 200% and 300% annually. For this
Russell 2000 index into industrial sectors and comparing reason, the transaction costs play a decisive role in return
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the performance of a subset of sectors against the index. performance. All results presented so far assume fixed
This method yields a stock-picking bias in the CAGR transaction costs, but it is also revealing to do sensitivity
of +1.2%, which is used here to eliminate the selection analyses regarding those costs. Transaction costs may be
bias and the impact of excluding non-goods-producing explicit costs, such as commissions and fees, but also may

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EXHIBIT 7
Effect of Transaction Cost on Cumulative Annual Growth Rate

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Notes: (Left) Compound annual growth rate (01/2002–12/2013) of the active and customer momentum portfolios and two market indexes as a function

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of the effective transaction cost consisting of buying and selling a particular company share as a percentage of the invested funds. The active portfolio performs

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much better than the momentum portfolio in a real-world context. (Right) Breakdown of the abnormal return into three constituents as a function of the
transaction cost of one trade (i.e., first buying and then selling shares of a given company) in basis points (1 bp = 0.01%) of the traded assets.
A
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be implicit costs such as unusually large bid/ask spreads Some investment funds restrict the investable assets
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(Fabozzi et al. [2010]). Whereas explicit costs tend to be in a given stock to a maximum of 10% of the average
independent of the stock, implicit costs typically increase daily traded volume in order to limit the implicit trans-
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for less traded stock, which is mainly the case for smaller action costs (Fabozzi et al. [2010]). This rule would limit
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companies. the size of a hypothetical fund based on the described


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The annual returns of the active and customer trading methodology.


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momentum portfolios are plotted in Exhibit 7 (left) for On the other hand, any company pair satisfying
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effective transaction costs up to 0.9%. Exhibit 7 (left) the 10% single customer sales threshold is a poten-
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shows that the returns drop by 0.3% for every 0.1% tial candidate for the analyzed portfolios, implying a
increase in effective transaction cost for the active port- potential of some hundreds of different shares. Stan-
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folio. This drop is significantly steeper for the customer dard diversification and risk management needs would
momentum strategies presented in earlier publications. also require multiplying the number of companies
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The active portfolio can survive real-world transaction included. Although reaching a fund size of $100 million
costs, whereas the performance of previously published is a realistic target, we consider the active supply chain
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momentum strategies with likely 3–4 times higher turn-


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portfolio a niche fund, in which the main purpose


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over are at risk. The new proposed method is much less may be to improve the diversification of larger, more
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sensitive for true transaction costs. traditional funds.


To assess the relevance of the proposed trading From the risk management perspective, the active
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method, the abnormal annual returns are broken down portfolio presented reduces the market risk because of
into three components: trading costs, stock picking, and its low correlation with the market indexes. Although
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actual abnormal returns of the SCF methodology as a the methodology is not likely to recommend buying
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function of the transaction cost (see Exhibit 7, right). The companies with diminishing earnings, we recommend
abnormal annual return of the SCF methodology, though regular qualitative reviews by a financial analyst to
reduced to +5.9%, is still significant in a real-world envi- remove such companies from the portfolio of a hypo-
ronment, assuming pessimistic transaction costs of 0.8% thetical fund, which may encounter risks not visible in
and a relatively high stock-picking bias of +2%. financial reports.

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CONCLUSIONS one set of data. Supply chains present varying operational
dynamics and investment characteristics. We suggest
We present a new method to improve investment focusing on submarkets, industrial sectors, and similar
returns based on the knowledge of supply chain structure supply chain samples instead of targeting the broadest
and downstream financial performance. This method possible markets.

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has an operations or material-f low approach, in con- Service and financial companies were excluded

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trast to the market-based work on customer momentum from this study because of expected irrelevance in terms

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presented by previous authors. The investment system of “material f lows.” However, this is not necessarily the

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proposed yields annual abnormal returns of 8.7% com- case, and further research could reveal similar behavior

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pared to the Russell 2000 index, assuming transaction in the excluded sectors as in the more physical supply
costs of 0.55%. The abnormal annual returns may be chains. Finally, this study was restricted to U.S. markets;

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further increased by 1% –2% by selecting companies it could be expanded not only to other stock exchanges

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with a spread less than 0.6%. but also to include multinational supply chains with

A
The proposed method uses customer companies’ multiple data sources and currencies.

IN
quarterly reporting information. Quarterly sales of the
customer company proved to be the most statistically sig-

LE
nificant driver of performance for the supplier. To opti- APPENDIX A
mize the parameters of the trading method, we introduced

C
PARAMETERS OF THE TRADING METHOD
the risk-adjusted Sortino ratio, instead of market prices,

TI
for improved balance between risk and return. As with The trading method can be reformulated as If [SCFq >

R
earlier methods, timing of transactions is critical and needs SCFq−1] → buy on tstart and sell after Δtown , where SCF is any
to be optimized for successful trading recommendations.
A
of the variables listed, including, for example, sales or inven-
IS
By design, the method issues four sets of buy/sell tories. In this representation, q refers to a given quarter and
q−1 to the previous quarter (1 ≤ q ≤ N), where N is the total
TH

recommendations annually for the shares of a given com-


pany, in contrast to the monthly recommendations of the amount of trading quarters. Financial data were available
from 2002 until 2013 for most companies corresponding to
E

customer price momentum system. This quarterly trading


N = 60 (= 12 × 4) quarters. The parameter tstart is the number
C

frequency reduces the number of yearly opportunities


of trading days starting from the day on which the customer
U

for profitable transactions; however, it is much less sensi-


company publishes its quarterly sales and Δtown is the time span
D

tive to true transaction costs including the spreads—a


of the share ownership.
O

major challenge for the earlier customer price momentum The optimal parameters tstart and Δtown were determined
R

methods. Another important practical implication is the by testing all combinations of time periods less than a quarter
EP

very low correlation of the proposed investing strategy of a year and dividing the total available data into two subsets
with relevant benchmark indexes. Introducing the pro- of the total available time period. The parameter set maxi-
R

posed trading recommendations would thus not only mizing the Sortino ratio of the earlier time period was used to
TO

increase the returns of a fund but also decrease the vola- compute the Sortino ratio for the later time period subset. The
tility. Some practical limitations of the system include the median values of these two parameters for these 10 companies
L

small number of supply chain partners with identifiable, are 12 and 41 trading days, respectively.
A

strong long-term links and the typically small trading To avoid producing spurious results, we divided the
G

volumes of supplier companies’ shares compared to their data set into two subgroups and calibrated the trading method
LE

with one earlier subset and tested with another, later subset.
often much bigger customers. The biggest beneficiaries of
the proposed methods may thus be either smaller specialty
IL

funds or larger funds looking to improve their diversifica- APPENDIX B


IS

tion and to lower the funds’ volatility.


There are several opportunities to develop the MONTE-CARLO SIMULATION
IT

current trading method before establishing an opera- OF RANDOM TRADING


tional supply chain fund. It is likely that integrating the
We assessed the robustness of the backtested compound
methods and data sets in a multivariable multiperiod
annual growth rate for the high-dependence supplier com-
algorithm would provide better results than using just pany pair by issuing random buy-and-sell recommendations

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EXHIBIT B1 EXHIBIT C1
Distribution of the Compound Annual Growth Synthetic Index and Synthetic Portfolio for the
Rates Computed from Random Buy/Sell Trading Assessment of Stock-Picking Bias
Recommendations of the High-Dependence Supplier
Company Pair

T
A
M
R
FO
Y
N
A
IN
LE
for these companies. Over 400 such randomly computed

C
CAGR values are plotted in Exhibit B1. sectors as they occur in the portfolio of the companies listed

TI
The active portfolio beats the majority of random in Exhibit 1 (because there are, for example, 4 out of 10

R
trades. The confidence interval of the results is 92%, which companies producing consumer goods, 40% of the synthetic
is not sufficient from a theoretical point of view to exclude a A
portfolio has a CAGR of 10.6%). According to this method,
the stock-picking bias is +1.2% (= 13.9% capped synthetic
IS
statistical artifact but is significant enough for practitioners.
portfolio – 12.7% capped synthetic index).
TH

APPENDIX C
REFERENCES
E
C

NEUTRALIZING STOCK SELECTION


Capkun, V., A.-P. Hameri, and L.A. Weiss. “On the Rela-
U

AND SECTOR BIAS


tionship between Inventory and Financial Performance in
D

Manufacturing Companies.” International Journal of Operations


O

Reconstructing the accurate composition of the Russell


2000 index over the time period 01/2002–12/2013 is beyond & Production Management, Vol. 29, No. 8 (2009), pp. 789-806.
R

the scope of this publication. We therefore start with the list


EP

of the Russell 2000 companies available at the moment of this Cohen, L., and A. Frazzini. “Economic Links And Pre-
dictable Returns.” Journal of Finance, Vol. 63, No. 4 (2008),
R

writing. From this list, we select only the companies avail-


able for trading from January 2002 until December 2013. We pp. 1977-2011.
TO

define the CAGR of these companies as the uncapped syn-


thetic index with a computed CAGR of 14.9%; see Exhibit C1. Driesprong, G., B. Jacobsen, and B. Maat. “Striking Oil:
L

This selection method introduces a bias because compa- Another Puzzle?” Journal of Financial Economics, Vol. 89, No. 2
A

nies excluded from the index before the end of the period are (2008), pp. 307-327.
G

not considered. Such companies could have gone bankrupt,


LE

merged, or relocated the headquarters’ country, among other Fabozzi, F., S. Focardi, and P. Kolm. Quantitative Equity
reasons for exiting the Russell 2000 index prematurely. Investing. John Wiley & Sons, 2010.
IL

In the next step, we applied a cap of $1 billion market


capitalization for the companies of the uncapped synthetic index Guan, Y., M.F. Wong, and Y. Zhang. “Analyst Following
IS

in order to reduce the bias due to sufficient company growth for along the Supply Chain.” Review of Accounting Studies, Vol. 20,
No. 1 (2015), pp. 210-241.
IT

them to leave the Russell 2000 index. This capped synthetic index
has a computed CAGR of 12.7%. The CAGR for the different
sectors of the capped synthetic index are displayed in the plot. Hendricks, K.B., and V.R. Singhal. “The Effect of Supply
Finally, to assess the stock-picking bias, we constructed Chain Glitches on Shareholder Wealth.” Journal of Operations
a capped synthetic portfolio by weighting the CAGR of the Management, Vol. 21, No. 5 (2003), pp. 501-522.

WINTER 2017 THE JOURNAL OF PORTFOLIO M ANAGEMENT 59

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Merton, R. “A Simple Model of Capital Market Equilibrium
with Incomplete Information.” Journal of Finance, Vol. 42,
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Olsen, C., and J.R. Dietrich. “Vertical Information Trans-

T
fers: The Association between Retailers’ Sales Announce-

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pp. 144-166.

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FO
Shahrur, H., Y.L. Becker, and D. Rosenfeld. “Return Predict-
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Financial Analysts Journal, Vol. 66, No. 3 (2010), pp. 60-77.

Y
N
Sortino, F.A., and L.N. Price. “Performance Measurement in

A
a Downside Risk Framework.” The Journal of Investing, Vol. 3,

IN
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LE
Thomas, J.T., and H. Zhang. “Inventory Changes and Future
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pp. 163-187.

TI
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Wu, J., and J. Birge. “Supply Chain Network Structure and
Firm Returns.” Working paper, 2014, SSRN 2385217. A
IS
TH

To order reprints of this article, please contact Dewey Palmieri


at dpalmieri@ iijournals.com or 212-224-3675.
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C
U
D
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EP
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A
G
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