05 Nov 2012  Research & Ideas

What Wall Street Doesn’t Understand About International Trade

Firms that correlate their international trading activity with the local ethnic community significantly outperform those that don't, according to new research by Lauren H. Cohen, Christopher J. Malloy, and Umit G. Gurun.

 

Making the best international trading decisions may be as easy as taking a stroll around the local neighborhood.

A recent research paper states that it's possible to predict whether a US firm will trade with any given country by studying the ethnic makeup of the nearby community, according to new research. What's more, firms that correlate their international trading activity with the local ethnic community significantly outperform those that don't—a fact that has escaped notice of financial analysts.

The findings could help Wall Street make better earnings performance forecasts, according to the authors of Channels of Influence, by Harvard Business School Associate Professors Lauren H. Cohen and Christopher J. Malloy, and Umit G. Gurun, an associate professor at the University of Texas at Dallas.

"When nearly half of anything a firm does is X, it's important to understand what's going on with X."

Global sales are critical to the success of most big businesses. In fact, for companies in the S&P 500, some 46 percent of sales came from outside the United States in 2011.

"When nearly half of anything a firm does is X, it's important to understand what's going on with X," says Cohen.

The research team reasoned that firms would most likely export products and services to countries where they had strong informational ties—and that people with personal knowledge of those countries could help firms to form those bonds.

"The hypothesis was that the surrounding ethnicity would help them to translate and transfer information about potential international trade decisions," Cohen explains. "We thought maybe the people who have ethnic links back to these countries—immigrants or other people who have a former relationship with the country—can help firms to decide whether it makes sense to do business with that country. What part of that country is the best trade partner? Who are the best contacts?"

Analyzing data

Of course, immigrants most likely to aid trading decisions are those who work at the firm. But because firms generally don't divulge information about their staff's ethnic makeup, the research team had to look at other related factors. For starters, Cohen, Malloy, and Gurun had access to ethnicity data of US metropolitan areas (from the Census Bureau and the American Communities Project at Brown University). They also were able to determine the nationality of firms' corporate board members, using data from a private research company specializing in biographical information on company officials. Looking at the data, the team found a large correlation between the ethnic makeup of a firm's board and the ethnic makeup of the surrounding neighborhood. "So if you have tons of Vietnamese people in the neighborhood, you also have a lot of Vietnamese people on the board," Cohen says.

To determine which companies were trading with which countries, the researchers looked at data from the Journal of Commerce's Port Import Export Reporting Service (PIERS), which collects and parses shipping information from US Customs and Border Protection. "From there we simply tested: If you have a lot of one country's ethnic makeup around you, are you more likely to import or export from that country?" Cohen explains.

The researchers found that the propensity of a firm to trade with any given country increased by more than 60 percent if the neighborhood surrounding headquarters had a high percentage of immigrants from that country. What's more, "the same effects happen with boards," Cohen says. "If you have a lot of Chinese board members, you import and export more from China. If you have a lot of board members who are Vietnamese, you trade a lot with Vietnam."

Correlation versus causation

The team knew, though, that the correlative data did not necessarily prove the causal impact of ethnic ties on international trade decisions. "You could imagine lots of reasons for this correlation," Cohen says. "In California, for instance, you may have more Japanese immigrants because it's the closest point of entry with Japan. And you may also do more trade with Japan because it's the closest place for you to ship. So it's possible for there to be cases in which there's a correlation, and yet one thing does not cause the other."

Establishing scientific proof required a situation in which the team could exogenously change the ethnic population of metropolitan areas near firms. The legality and feasibility of such an experiment seemed unlikely from a human rights perspective.

"We can link the causal effect from the immigrants to the firm trade decisions, even 60 years later."

However, the researchers decided to focus on a specific period in US history in 1942, following the Japanese attack on Pearl Harbor, when the United States forced more than a 100,000 Japanese Americans to relocate from their homes on the Pacific coast to internment camps in other parts of the country. Not knowing how long the internment would last, many of the internees hurriedly sold their houses and assets before leaving. And so, when they were freed a few years later, many no longer had homes. Others tried to return to the West Coast, only to find that they faced hostility and violence from their neighbors. As a result, after they were freed a few years later, many internees ended up resettling in the regions surrounding the internment camps—including Arizona, Arkansas, Idaho, Wyoming, and Utah. Thus, the Japanese American populations in these areas grew significantly and suddenly.

"The Japanese population in Arkansas in 1940 was literally 3 people," Cohen says. "With the internment camps, the government increased that population by almost 18,000. For sure, this was a huge exogenous shock."

The researchers then looked solely at the international trading activity of firms located near the internment camps that were exogenously shocked with the increased Japanese population. They found that these firms traded significantly more with Japan, thus establishing the causal link between the exogenous population change and trade decisions. When additionally examining only those firms formed before 1946 (when the internment camps were evacuated), they found similarly large impacts on trade with Japan. "We can link the causal effect from the immigrants to the firm trade decisions, even 60 years later," Cohen says.

Analysts take note

Having determined a causal effect, the team went on to look at the financial results of companies having trades correlated with the ethnic population, comparing them against firms that did not employ this trading strategy. They found that the former generally outperformed the latter in risk-adjusted returns by at least 5 to 7 percent. "The 'strategic traders'—those that trade in accordance with their ethnic population—have much higher sales, much higher profitability, and much higher stock returns than the 'non-strategic traders,' " Cohen says.

Historically, Wall Street has failed to consider the local ethnic population trading strategy when assessing the value of a firm. In fact, the researchers found that analysts are significantly less accurate in their earnings forecasts on "strategic" trading firms than on non-strategic firms.

"With nearly 50 percent of sales being driven by overseas sales—and the surrounding population being a big driver of that activity—understanding this is crucial to understanding the value of a firm," Cohen says.

About the author

Carmen Nobel is senior editor of Harvard Business School Working Knowledge.

Comments

    • Danny
    • Student, Awesomely Dutch

    When i read this text i have mixed feelings about it in a way. There are a couple of things you guys don't seem to take into account. Like for instance, even though the population originates from a certain country, are their ethnics still comparable with the population of the country itself? For intance, a lot of Dutch citizens moved to the US and Canada after the 2nd World War, but they aren't completely comparable with the current Dutch population as situations in a country change, especially in countries such as the Netherlands that is very dependable on surrounding countries when it comes down to our economy.

    In principle you are correct. When a company in the US trades with foreign countries they have to be aware of all sorts of things, especially the culture and if their products would be succesfull in this country and what the competition is like, besides the fact how the population in this country looks up to foreign products and what the risks involved are in various aspects. Like for instance, certain countries have a negative opinion about the US, therefore they would be less willing to buy US products, when you can't sell products to consumers you wont get any turnover out of these countries, thus wont be a succesfull partnership.

    And that all is besides the fact that some US concepts simply dont work in some foreign countries. Like for instance Euro Disney. The concept worked well in the US and was introduced in Europe, but where the big, bigger, biggest concept works well in the US, the XXL products wasnt a big hit in Europe as we have a different attitude towards these kind of concepts. So besides being aware of ethnics, also pay a lot of attention to trends and developements in foreign countries.

    When i read this article i get the impression that US companies think to much from their own perspective and too little from the consumers perspective, plus to often a top down managementstructere is applied when this isnt always that effective. Bottoms-Up management works just as effective as the imput of the workers in contact with the consumers are far better aware of possible oppertunities in the market.

    All that aside something irrelavent to this topic i have a question, why has Mitt Romney become so popular? When i read stuff about him i get the feeling that Romney represents the negative about the US economy. The more short term, profithunting businessmen that are in it for the quick gains instead of the longterm developement. I remember an internship i did at a Dutch bank a while ago, when i saw the way they work i wondered why they went for short term profits when chances they took cost possible long term profits that could have resulted in higher margins per spend capita per consumer. Anyways, this i felt like replying, its past midnight here and i had a long day, so as a native dutchman speaking dont mind the errors, if written in dutch grammar and spelling would be perfect! ha!

     
     
     
    • Dr. S A Visotsky
    • Chairman & CEO, Vitech Group LLC

    A pretty risky article, as it can easily be seen as racist.

    However, for arguments sake, lets humor those who where quoted, and see where they have led us, shall we?

    AP Cohen said:

    ""The hypothesis was that the surrounding ethnicity would help them to translate and transfer information about potential international trade decisions," Cohen explains. "We thought maybe the people who have ethnic links back to these countries--immigrants or other people who have a former relationship with the country--can help firms to decide whether it makes sense to do business with that country."

    I must ask then, what's the story with India?

    If your theory is true, why aren't ANY of the "ethnic population" of Harvard Graduates returning to India?

    Again, you said, "We thought maybe the people who have ethnic links back to these countries--immigrants or other people who have a former relationship with the country--can help firms to decide whether it makes sense to do business with that country."

    Are they (immigrants) deciding that India is indeed a lost cause, (along with the majority of Wall St. firms), due to it's complete lack of infrastructure and wildly out of control corruption at every level of business?

    I just received this from Desire Mohindra, Associate Director, World Economic Forum:

    National Capital Region, Gurgaon, India, 7 November 2012 - The exposure of corruption has reached a crucial turning point in India, according to the man responsible for uncovering some of the country's highest-level scams. Vinod Rai, Comptroller and Auditor General of India, said at the World Economic Forum on India today that for too long, politicians have believed they were entitled to govern without accountability."

    Please share any insight, AP Cohen.

    Kind Regards,

     
     
     
    • Anonymous

    yea i agree with In principle you are correct. When a company in the US trades with foreign countries they have to be aware of all sorts of things, especially the culture and if their products would be succesfull in this country and what the competition is like, besides the fact how the population in this country looks up to foreign products and what the risks involved are in various aspects. Like for instance, certain countries have a negative opinion about the US, therefore they would be less willing to buy US products, when you can't sell products to consumers you wont get any turnover out of these countries, thus wont be a succesfull partnership.

    http://superior-marketing-group.com

     
     
     
    • Nada S. AlMutawa
    • head of the reserch devision, kuwait university

    in my experience and research : Social networks of ethnic women entrepreneurs have positive effects on utilizing appropriate networks for businesses survival and growth. According to many researchers one of the main gains of ethnic entrepreneurial networking is business growth. This growth is related to the time entrepreneurs spend developing their network contacts with strategic groups such as customers, suppliers, investors and other business owners (Green et al, 2003). Studies proved that network size as well as acquiring new contacts have positive effects on business growth revenue (Hamouda, et al, 2003) (Klyver & Terjesen, 2007) Since lack of growth and expansion capital are some of the major barriers entrepreneurs face, it leads to the idea that networking is needed through all stages of a business venture (Green, et al 2003).