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Is profitability driven by industry - or firm-specific factors? A new look at the evidence

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In this study the authors revisit the question of whether firms' profitability (usually measured as return on assets or ROA) is driven primarily by industry- or firm-specific factors. Recent studies that examine the relative impact of industry and firm factors on ROA provide evidence of a dominant firm-specific effect. They re-examine the question from a number of perspectives. Firstly, they test for alternative measures of performance such as economic profit per dollar of capital employed and market-to-book value. Secondly, they use a new and richer data set. Thirdly, they implement a different statistical approach for testing the significance of independent effects, in contrast to the fixed effects ANOVA of previous studies. They show that alternative measures of performance, a new data set and a finer statistical approach do not alter the conclusion of the majority of recent studies which found that firm-specific factors were more dominant than industry effects in explaining firms' profitability. But our study uncovers an important phenomenon that is in large part responsible for the reported strong firm-effect. The authors show that a significant proportion of the absolute estimates of the variance of firm-specific factors in our study is due to the presence of a few exceptional firms in an industry: the two firms that outperform their industry and the two that under-perform in comparison to the rest. In other words, only for a few dominant value creators (leaders) and destroyers (losers) do firm-specific assets matter more than industry factors. For most firms, i.e. for those that are not notable leaders or losers in their industry, the industry effect turns out to be more important for performance than firm-specific factors. A possible explanation of this phenomenon is that superior (or poor) management leads to superior (or poor) firm performance irrespective of industry structure, which matters only for firms "stuck in the middle", i.e. for firms with average managerial capabilities and performance.

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