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Asset Growth Reversals and Investment Anomalies
Abstract
The negative relation between asset growth or investment and future stock returns mainly comes from high- and low-growth firms that reverse their growth in the future. The negative relation does not exist among firms maintaining similar levels of growth. Controlling for past growth, future stock returns are positively related to realized (and unpredicted) future asset growth and profitability. By contrast, the relation between future returns and predicted future asset growth or profitability is somewhat mixed. Our evidence appears to be more consistent with the explanation of style investing with growth preference and extrapolation bias and the unconditional version of the dynamic q-theory and fails to support the overinvestment explanation, the real options explanation, or the conditional version of the dynamic q-theory.
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We derive and test q-theory implications for cross-sectional stock returns. Under constant returns to scale, stock returns equal levered investment returns, which are tied directly to firm characteristics. When we use generalized method of moments to match average levered investment returns to average observed stock returns, the model captures the average stock returns of portfolios sorted by earnings surprises, book-to-market equity, and capital investment. When we try to match expected returns and return variances simultaneously, the variances predicted in the model are largely comparable to those observed in the data. However, the resulting expected return errors are large. (c) 2009 by The University of Chicago. All rights reserved..
An investment factor, long in low-investment stocks and short in high-investment stocks, helps explain the new issues puzzle.
Adding the investment factor into standard factor regressions reduces the SEO underperformance by about 75%, the IPO underperformance
by 80%, the underperformance following convertible debt offerings by 50%, and Daniel and Titman's (2006) composite issuance effect by 40%. The reason is that issuers invest more than nonissuers, and the investment factor earns
a significantly positive average return of 0.57% per month.
This article develops and applies new measures of portfolio performance which use benchmarks based on the characteristics of stocks held by the portfolios that are evaluated. Specifically, the benchmarks are constructed from the returns of 125 passive portfolios that are matched with stocks held in the evaluated portfolio on the basis of the market capitalization, book‐to‐market, and prior‐year return characteristics of those stocks. Based on these benchmarks, “Characteristic Timing” and “Characteristic Selectivity” measures are developed that detect, respectively, whether portfolio managers successfully time their portfolio weightings on these characteristics and whether managers can select stocks that outperform the average stock having the same characteristics. We apply these measures to a new database of mutual fund holdings covering over 2500 equity funds from 1975 to 1994. Our results show that mutual funds, particularly aggressive‐growth funds, exhibit some selectivity ability, but that funds exhibit no characteristic timing ability.
This paper investigates whether stock prices reflect information about future earnings contained in the accrual and cash flow components of current earnings. The extent to which current earnings performance persists into the future is shown to depend on the relative magnitudes of the cash and accrual components of current earnings. However, stock prices are found to act as if investors "fixate" on earnings, failing to fully reflect information in the accrual and cash flow components of current earnings until it impacts future earnings.
Recent papers have debated whether the negative correlation between measures of firm asset growth and subsequent returns is of little importance since it applies only to small firms, justified as compensation for risk, or evidence of mispricing. We show that the asset growth effect is pervasive and evidence to the contrary arises due to specification choices; that one measure of asset growth, the change in total assets, largely subsumes the explanatory power of other measures; that the ability of asset growth to explain either the cross section of returns or the time series of factor loadings is linked to firm idiosyncratic volatility; that the return effect is concentrated around earnings announcements; and that analyst forecasts are systematically higher than realized earnings for faster growing firms. In general, there appears to be no asset growth effect in firms with low idiosyncratic volatility. Our findings are consistent with a mispricing-based explanation for the asset growth effect in which arbitrage costs allow the effect to persist.
As a consequence of optimal investment choices, a firm's assets and growth options change in predictable ways. Using a dynamic model, we show that this imparts predictability to changes in a firm's systematic risk, and its expected return. Simulations show that the model simultaneously reproduces: (i) the time-series relation between the book-to-market ratio and asset returns; (ii) the cross-sectional relation between book-to-market, market value, and return; (iii) contrarian effects at short horizons; (iv) momentum effects at longer horizons; and (v) the inverse relation between interest rates and the market risk premium.
We empirically evaluate the predictions of the mispricing hypothesis with limits-to-arbitrage suggested by Shleifer and Vishny (1997) and the q-theory with investment frictions proposed by Li and Zhang (2010) on the negative relation between asset growth and average stock returns. We conduct cross-sectional regressions of returns on asset growth on subsamples split by a given measure of limits-to-arbitrage or investment frictions. We show that: (i) proxies for limits-to-arbitrage and proxies for investment frictions are often highly correlated; (ii) the evidence based on equal-weighted returns shows significant support for both hypotheses, while the evidence from value-weighted returns is weaker; and (iii) in direct comparisons, each hypothesis is supported by a fair and similar amount of evidence.
Bradshaw, Richardson, and Sloan (BRS) find a negative relation between their comprehensive measure of corporate financing activities and future stock returns and future profitability. Noticing that accounting accruals are increases in net operating assets on a company's balance sheet, we question whether it is possible to distinguish between the ‘external financing anomaly’ documented by BRS and the ‘accrual anomaly’ first documented by Sloan [1996. Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289–315]. We show that once controlling for total accruals, the relation between external financing activities and future stock returns is attenuated and not statistically significant. These findings are consistent with Richardson and Sloan [2003. External financing, capital investment and future stock returns. Working Paper, University of Pennsylvania and University of Michigan].
When cumulative net operating income (accounting value-added) outstrips cumulative free cash flow (cash value-added), subsequent earnings growth is weak. If investors with limited attention focus on accounting profitability, and neglect information about cash profitability, then net operating assets, the cumulative difference between operating income and free cash flow, measures the extent to which reporting outcomes provoke over-optimism. During the 1964–2002 sample period, net operating assets scaled by total assets is a strong negative predictor of long-run stock returns. Predictability is robust with respect to an extensive set of controls and testing methods.
We ask to what extent the negative relation between investment and average stock returns is driven by risk. We show that: (i) the average return spread between low and high asset growth and investment portfolios is largely accounted for by their spread in systematic risk, as measured by the loadings on the Chen, Roll, and Ross (1986) factors; (ii) as predicted by q-theory and real options models, systematic risk falls during large investment periods; (iii) the returns of factors formed on the investment-to-assets, asset growth, and investment growth all forecast aggregate economic activities. Our evidence suggests that risk plays an important role in explaining the investment-return relation.
We develop a comprehensive and parsimonious measure of corporate financing activities and document a negative relation between this measure and both future stock returns and future profitability. The economic and statistical significance of our results is stronger than in previous research focusing on individual categories of corporate financing activities. To discriminate between risk versus misvaluation as explanations for this relation, we analyze the association between our measure of external financing and sell-side analysts’ forecasts. Consistent with the misvaluation explanation, our measure of external financing is positively related to overoptimism in analysts’ forecasts.
This paper extends the work of Sloan (1996. The Accounting Review 71, 289) by linking accrual reliability to earnings persistence. We construct a model showing that less reliable accruals lead to lower earnings persistence. We then develop a comprehensive balance sheet categorization of accruals and rate each category according to the reliability of the underlying accruals. Empirical tests generally confirm that less reliable accruals lead to lower earnings persistence and that investors do not fully anticipate the lower earnings persistence, leading to significant security mispricing. These results suggest that there are significant costs associated with incorporating less reliable accrual information in financial statements.
Q-theory predicts that investment frictions steepen the relation between expected returns and firm investment. Using financing constraints to proxy for investment frictions, we show only weak evidence that the investment-to-assets and asset growth effects in the cross section of returns are stronger in financially more constrained firms than in financially less constrained firms. There is no evidence that q-theory with investment frictions explains the investment growth, net stock issues, abnormal corporate investment, or net operating assets anomalies. Limits-to-arbitrage proxies dominate q-theory with investment frictions in explaining the magnitude of the investment-to-assets and asset growth anomalies in direct comparisons.
This paper identifies five common risk factors in the returns on stocks and bonds. There are three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity. There are two bond-market factors, related to maturity and default risks. Stock returns have shared variation due to the stock-market factors, and they are linked to bond returns through shared variation in the bond-market factors. Except for low-grade corporates, the bond-market factors capture the common variation in bond returns. Most important, the five factors seem to explain average returns on stocks and bonds.
Valuation theory says that expected stock returns are related to three variables: the book-to-market equity ratio (B-t/M-t), expected profitability, and expected investment. Given B-t/M-t and expected profitability, higher expected rates of investment imply lower expected returns. But controlling for the other two variables, more profitable firms have higher expected returns, as do firms with higher B-t/M-t. These predictions are confirmed in our tests. (c) 2006 Elsevier B.V. All rights reserved.
Firms that substantially increase capital investments subsequently achieve negative benchmark-adjusted returns. The negative abnormal capital investment/return relation is shown to be stronger for firms that have greater investment discretion, i.e., firms with higher cash flows and lower debt ratios, and is shown to be significant only in time periods when hostile takeovers were less prevalent. These observations are consistent with the hypothesis that investors tend to underreact to the empire building implications of increased investment expenditures. Although firms that increase capital investments tend to have high past returns and often issue equity, the negative abnormal capital investment/return relation is independent of the previously documented long-term return reversal and secondary equity issue anomalies.
We document that the firm level hiring rate predicts stock returns in the cross-section of US publicly traded firms even after controlling for investment, size, book-to-market and momentum as well as other known predictors of stock returns. The predictability shows up in both Fama-MacBeth cross sectional regressions and in portfolio sorts and it is robust to the exclusion of micro cap firms from the sample. We propose a production-based asset pricing model with adjustment costs in labor and capital that replicates the main empirical findings well. Labor adjustment costs makes hiring decisions forward looking in nature and thus informative about the firms’ expectations about future cash-flows and risk-adjusted discount rates. The model implies that the investment rate and the hiring rate predicts stock returns because these variables proxy for the firm’s time-varying conditional beta.
The author examines a factor pricing model for stock returns. The factors are returns on physical investment, inferred from investment data via a production function. The author examines the model's ability to explain variation in expected returns across assets and over time. The model is not rejected. It performs about as well as the CAPM and the Chen, Roll, and Ross (1986) factor model, and it performs substantially better than a simple consumption-based model. The author also provides an easy technique for estimating and testing dynamic, conditional asset pricing models--one simply includes factors and returns scaled by instruments in an unconditional estimate--and for comparing such models. Copyright 1996 by University of Chicago Press.
This article interprets the well-known value effect through the implications of standard Q-theory. An investment growth factor,
defined as the difference in returns between low-investment stocks and high-investment stocks, contains information similar
to the Fama and French (1993) value factor (HML), and can explain the value effect about as well as HML. In the cross-section, portfolios of firms with low investment growth rates (IGRs) or low investment-to-capital ratios have
significantly higher average returns than those with high IGRs or high investment-to-capital ratios. The value effect largely
disappears after controlling for investment, and the investment effect is robust against controls for the marginal product
of capital. These results are consistent with the predictions of a standard Q-theory model with a stochastic discount factor.
Japanese stock returns are even more closely related to their book-to-market ratios than are their U.S. counterparts, and thus provide a good setting for testing whether the return premia associated with these characteristics arise because the characteristics are proxies for covariance with priced factors. Our tests, which replicate the Daniel and Titman (1997) tests on a Japanese sample, reject the Fama and French (1993) three-factor model but fails to reject the characteristic model.
Studies relating accounting and price data often use the COMPUSTAT or related PDE data base as the source for the accounting data. This practice may introduce a look‐ahead bias and an ex‐post‐selection bias into the study. We examine this problem by comparing results from the standard COMPUSTAT data base with those from a data base which suffers from neither bias. We find that rates of return from portfolios chosen on the basis of accounting data from the two data bases differ significantly. Further, we find that these differences imply different conclusions when we test a specific hypothesis relating accounting and price data. Finally, we propose a number of remedies which may reduce the bias when the standard COMPUSTAT data base is used.
We show that corporate investment decisions can explain the conditional dynamics in expected asset returns. Our approach is similar in spirit to Berk, Green, and Naik (1999) , but we introduce to the investment problem operating leverage, reversible real options, fixed adjustment costs, and finite growth opportunities. Asset betas vary over time with historical investment decisions and the current product market demand. Book-to-market effects emerge and relate to operating leverage, while size captures the residual importance of growth options relative to assets in place. We estimate and test the model using simulation methods and reproduce portfolio excess returns comparable to the data. Copyright 2004 by The American Finance Association.
Firm sizes and book-to-market ratios are both highly correlated with the average returns of common stocks. Eugene F. Fama and Kenneth R. French (1993) argue that the association between these characteristics and returns arise because the characteristics are proxies for nondiversifiable factor risk. In contrast, the evidence in this article indicates that the return premia on small capitalization and high book-to-market stocks does not arise because of the comovements of these stocks with pervasive factors. It is the characteristics rather than the covariance structure of returns that appear to explain the cross-sectional variation in stock returns. Copyright 1997 by American Finance Association.
The anomalous returns associated with net stock issues, accruals, and momentum are pervasive; they show up in all size groups (micro, small, and big) in cross-section regressions, and they are also strong in sorts, at least in the extremes. The asset growth and profitability anomalies are less robust. There is an asset growth anomaly in average returns on microcaps and small stocks, but it is absent for big stocks. Among profitable firms, higher profitability tends to be associated with abnormally high returns, but there is little evidence that unprofitable firms have unusually low returns. Copyright (c) 2008 The American Finance Association.
We test for firm-level asset investment effects in returns by examining the cross-sectional relation between firm asset growth and subsequent stock returns. Asset growth rates are strong predictors of future abnormal returns. Asset growth retains its forecasting ability even on large capitalization stocks. When we compare asset growth rates with the previously documented determinants of the cross-section of returns (i.e., book-to-market ratios, firm capitalization, lagged returns, accruals, and other growth measures), we find that a firm's annual asset growth rate emerges as an economically and statistically significant predictor of the cross-section of U.S. stock returns. Copyright (c) 2008 The American Finance Association.
Post-1970, share issuance exhibits a strong cross-sectional ability to predict stock returns. This predictive ability is more statistically significant than the individual predictive ability of size, book-to-market, or momentum. Our finding is related to research that finds that long-run returns are associated with share repurchase announcements, seasoned equity offerings, and stock mergers, although our results remain strong even after exclusion of the data used in these studies. We estimate the issuance relation pre-1970 and find no statistically significant predictive ability for most holding periods. Copyright 2008 by The American Finance Association.
The book-to-market effect is often interpreted as evidence of high expected returns on stocks of "distressed" firms with poor past performance. We dispute this interpretation. We find that while a stock's future return is unrelated to the firm's past accounting-based performance, it is strongly negatively related to the "intangible" return, the component of its past return that is orthogonal to the firm's past performance. Indeed, the book-to-market ratio forecasts returns because it is a good proxy for the intangible return. Also, a composite equity issuance measure, which is related to intangible returns, independently forecasts returns. Copyright 2006 by The American Finance Association.
We present a rational theory of SEOs that explains a pre-issuance price run-up, a negative announcement effect, and long-run post-issuance underperformance. When SEOs finance investment in a real options framework, expected returns decrease endogenously because growth options are converted into assets in place. Regardless of their risk, the new assets are less risky than the options they replace. Although both size and book-to-market effects are present, standard matching procedures fail to fully capture the dynamics of risk and expected return. We calibrate the model and show that it closely matches the primary features of SEO return dynamics. Copyright 2006 by The American Finance Association.
Using a sample free of survivor bias, the author demonstrates that common factors in stock returns and investment expenses almost completely explain persistence in equity mutual funds' mean and risk-adjusted returns. Darryll Hendricks, Jayendu Patel, and Richard Zeckhauser's (1993) 'hot hands' result is mostly driven by the one-year momentum effect of Narasimham Jegadeesh and Sheridan Titman (1993), but individual funds do not earn higher returns from following the momentum strategy in stocks. The only significant persistence not explained is concentrated in strong underperformance by the worst-return mutual funds. The results do not support the existence of skilled or informed mutual fund portfolio managers. Copyright 1997 by American Finance Association.
For many years, scholars and investment professionals have argued that value strategies outperform the market. These value strategies call for buying stocks that have low prices relative to earnings, dividends, book assets, or other measures of fundamental value. While there is some agreement that value strategies produce higher returns, the interpretation of why they do so is more controversial. This article provides evidence that value strategies yield higher returns because these strategies exploit the suboptimal behavior of the typical investor and not because these strategies are fundamentally riskier. Copyright 1994 by American Finance Association.
Two easily measured variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with market "beta", size, leverage, book-to-market equity, and earnings-price ratios. Moreover, when the tests allow for variation in "beta" that is unrelated to size, t he relation between market "beta" and average return is flat, even when "beta" is the only explanatory variable. Copyright 1992 by American Finance Association.
This paper describes a production-based asset pricing model. It is analogous to the standard consumption-based model, but it uses producers and production functions in the place of consumers and utility functions. The model ties stock returns to investment returns (marginal rates of transformation), which are inferred from investment data via a production function. The production-based model is used to examine forecasts of stock returns by business-cycle related variables and the association of stock returns with subsequent economic activity. Copyright 1991 by American Finance Association.
Stock returns on portfolios sorted by previous ∆I/I quintiles and Growth ∆I/I t1,rank Growth N Size I/A t1 TAG t1 TAG t Ret ew Ret vw AdjRet ew AdjRet vw α ew α vw 1 (low) 1 (low)
- G Panel
Panel G: Stock returns on portfolios sorted by previous ∆I/I quintiles and Growth
∆I/I t1,rank
Growth
N
Size
I/A t1
TAG t1
TAG t
Ret ew
Ret vw
AdjRet ew
AdjRet vw
α ew
α vw
1 (low)
1 (low)
62