Why corporate political geography matters for stock returns

What are the drivers of the impressive performance derived from investment strategies designed to exploit firms' geographic proximity to political power (PAI)? High-Low PAI arbitrage portfolios yield between 3.4% and 3.9% per year, net of transaction costs. Consistent with the view that it is grounded on policy uncertainty, the PAI effect on returns only exists among firms lacking political connections. Abnormal stock returns of politically inactive firms from high PAI states reflect mispricing that seems to arise from flawed policy uncertainty resolution caused by the spillover of political optimism in local stock pricing and opportunistic managers’ propensity to exploit uncertainty.