Investors failing to look into a company’s supply chain could be opening themselves up to excess risk—and missing potential alpha, research has shown.
Analysis by Deutsche Bank of Factset data has shown there is a strong case for looking at a company’s suppliers and purchasers to gain the edge in stock selection.
“We find that stock selection signals based on supply chain data contain significant alpha.”“A single shock at one company may be transmitted to other connected firms,” Deutsche Bank’s analysts said in a recent paper. “When a subject company raises its target earnings guidance (or increases dividends or beats earnings expectations), its suppliers also tend to benefit.”
The bank found that the performance of companies up and down the supply chain was therefore linked and predictive of an investor’s target firm’s own stock returns and fundamentals.
“We also find that stock selection signals based on supply chain data contain significant alpha,” the analysts said.
The bank analysed firms up and down the chains to create a network that highlighted systemically important companies and key suppliers in certain sectors.
“Our analysis shows that key companies within the supply chain network contain strong alpha on the long side, after controlling for other factors and risk measures,” the bank said.
However, accessing this data is not straightforward, the bank said. Even using the best source for this kind of information meant gathering data for just 50% of listed US companies. Additionally, supply chain data has a bias towards larger companies, as they come under the most scrutiny from analysts and investors.
Despite the difficulty, the bank urged investors to consider it in their analysis as unlike financial hedging and diversification, it is difficult or even impossible for large companies to hedge their operational risk.
Using Apple as an example, Deutsche Bank looked at Foxconn, a significant supplier in the US tech company’s chain. Most of Foxconn’s factories are based in China and it may be the only company on earth with the manufacturing capability or capacity for Apple’s popular products. Therefore any shock to Foxconn is systemic to Apple.
Additionally, looking at who else suppliers work with is an important consideration for stock selection, the analysts said.
“A good example is the auto industry bailout during the 2008 crisis,” the bank said. “Ford Motor Company asked the US government to bail out its major competitor, GM Corp, because GM’s shutdown would have pushed their common suppliers to bankruptcy, adversely affecting Ford.”
Deutsche Bank said portfolio managers could utilize “unstructured customer-supplier data” to generate alpha.
“Companies do not exist in isolation but are connected to their customers, suppliers, competitors, and joint ventures,” the bank concluded.