THE nexus between politics and commerce may conjure thoughts of whispered deals in smoke-filled corridors. But connections are not everything. A new NBER working paper*, by Lauren Cohen and Christopher Malloy of Harvard Business School and Karl Diether of Dartmouth College, shows how ordinary investors can also get in on the action by predicting the impact of new legislation on American firms.

The authors first assigned firms domiciled in a senator’s home state to one of 49 standard industry classifications. That allowed them to identify the industries of interest to each senator: if an industry ranked in the top three in terms of sales, it was labelled “important” to that state.

Next they looked at bills that were voted on by the Senate between 1989 and 2008 and screened them for industry-related keywords, such as “crude oil” or “military”. If a bill affected an industry that mattered in a specific state, the relevant senator was tagged as “interested”.

Armed with these data, the authors could start ploughing through voting records. If the proportion of interested senators voting “yes” exceeded the proportion of uninterested senators giving their assent, the bill was presumed to be positive for the industry in question. If the ratios of negative votes fitted the same pattern, then the law was bad for the industry. On this basis, the authors tested a simple investment strategy that bought or shorted industries accordingly when bills were passed, and found that the portfolio would have delivered steep annualised returns of 9-12%, independent of how the overall market had moved.

The more interested senators voted in favour of bills, the more positive it was for their industries’ shares. The biggest returns of all came from picking out individual firms that were likely to be particularly affected by a bill. Although specific firms are not mentioned in laws, the authors found success with a strategy of investing in companies headquartered in the states of interested senators.

The mystery is why the broader market is so slow to recognise the effect of legislation. You might expect gains or losses to materialise in the run-up to a vote or on the day of passage, but it actually takes a long time for the impact of a bill to show up in share prices. The prospect of wading through pages of legalese might be one explanation: returns increased if a bill went back and forth between the House and the Senate, a process that typically adds to laws’ complexity and unreadability. Whatever the explanation, a clever observer of Washington, DC, has 60 trading days to front-run the broader market. At least, he did until the paper was published.

* “Legislating Stock Prices”, August 2012