The objective of this paper is to shed new light on the importance of
industry membership in profitability forecasting.
A substantial body of research stresses the importance of industry effects
on firm profitability and performance. It has also shown that stock returns are
closely connected to industry membership.
Yet the view that industry membership is important to understanding firm
performance does not go unchallenged. A recent study focused on a large sample
of US firms shows that industry-specific models do not improve firm
profitability forecasts relative to economy-wide models. It concludes that
there is no industry effect in profitability forecasting.
Recognising that these conflicting perspectives exist, this study introduces
two novel aspects to the analysis which have been previously unexplored.
Firstly, it considers that many firms are diversified into various
industries, with activities generally organised in separate business segments.
When segments belong to different industries, no single industry can accurately
represent the whole firm. A firm-level industry-specific forecasting model is
therefore unable to capture the industry effects in profitability forecasting
in these cases. Put differently, the lack of industry effects can be explained
by the aggregated reporting of multiple-segment firms at the firm level.
However, industry effects in profitability forecasting should reappear when
confining the analysis to single-segment firms.
Second, the researchers follow the insights of the forecasting literature to
determine a better trade-off between the advantage of economy-wide models (high
estimation reliability) and industry-specific models (less estimation bias). To
reliably extract industry patterns from the data, the industry classifications
have to be sufficiently broad - otherwise industry-specific profitability
forecasts are too noisy to accurately predict future profitability.
This paper examines the incremental advantage of industry-specific models.
It finds considerable industry effects in profitability forecasting. However,
the effects are only visible for focused firms. For diversified firms,
aggregated reporting at the firm level prevents the effects from being
observed. Furthermore, to reliably extract industry patterns from the data,
industry classifications have to be sufficiently broad - otherwise
industry-specific profitability forecasts are too noisy to improve forecast
The results have a number of implications for academics and
- Industry effects in profitability forecasting can be exploited by market
participants. A long/short trading strategy based on the firms'
industry-specific profitability forecasts can yield significant returns.
- The research findings, such as that information contained in segment-level
data can help to improve a firm's profitability forecasts, are relevant to the
accounting disclosure literature.
A pre-published version of the research paper is available for download