Product Market Threats: Implications for Future Profitability and its Use by Market Participants

Abstract

This study establishes the informational value of a firm’s product market competition, a measure derived from narrative disclosures in 10-K filings. Consistent with economic theory predicting faster mean reversion in earnings, we find that product market fluidity has large explanatory power for future profitability: higher fluidity (i.e., more competitive product market threats) is negatively associated with future earnings. However, capital market participants do not fully use this information leading to predictable future stock returns and sell-side analyst forecast errors. A trading strategy exploiting this information is associated with abnormal future returns and remains profitable after combining with other prominent size and book-to-market strategies. The findings are more consistent with mispricing than risk-based explanations: the results remain after adjusting for risk factors and cluster around subsequent earnings announcements. In addition, future analyst forecast errors and stock returns are directionally consistent with delayed information processing (mispricing). Overall, our findings suggest that qualitative disclosures can convey valuable information to capital market participants and play a meaningful role in fundamental analysis.