Corporate Investment and Asset Price Dynamics: Implications for the Cross‐section of Returns

Abstract

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. CORPORATE INVESTMENT DECISIONS are often evaluated in a real options context, 1 and option exercise can change the riskiness of a firm in various ways. For example, if growth opportunities are finite, the decision to invest changes the ratio of growth options to assets in place. Additionally, the resulting increase in physical capital may generate operating leverage through long-term obligations, including the fixed operating costs of a larger plant, wage contracts, and commitments to suppliers. It is natural to conclude that expected returns might be related to current and historical investment decisions of the firm.The empirical literature has long recognized a need to account for the dynamic structure of risk when testing asset pricing models. 2 A small but growing literature that endogenizes expected returns through firm-level

Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks

“…The introduction of operating leverage alters this relation, but the results are highly sensitive to the nature of capital adjustment costs (e.g. Carlson et al, 2004;Zhang, 2005;Hackbarth and Johnson, 2012). More problematic for our purposes, these models imply that returns have a conditional one-factor structure, hence the market portfolio should absorb the comovement associated with characteristics.…”

“…This connection is particularly valuable in our case, since the theoretical link between certain characteristics and growth opportunities can be subtle. For instance, in the model of Carlson et al (2004), firm investment is negatively related to the share of growth opportunities in firm value.…”

Durability of Output and Expected Stock Returns

“…One branch of the literature shows that the size and book-to-market effects arise naturally from optimal production and investment decisions (e.g., Berk, Green, and Naik 1999;Kogan 2001Kogan , 2004Gomes, Kogan, and Zhang 2003;Carlson, Fisher, and Giammarino 2004). A limitation of these earlier studies is that the underlying determinants of stock returns are often difficult to durability of output 945 measure, and perhaps more important, they rely on differences between firms that are not true primitives of the economic environment.…”

Nominal Rigidities and Asset Pricing

“…Fama and French (1992) offer a concise treatment of the size effect of Banz (1981), the value premium of Rosenberg, Reid, and Lanstein (1985), and other cross-sectional relationships in a unified setting. Berk, Green, and Naik (1999), Carlson, Fisher, and Giammarino (2004), Zhang (2003), andKogan (2004) document that these premia naturally arise from firms' optimal production and investment behavior. Hou and Robinson (2006), Bustamante and Donangelo (2012), and Donangelo (2013) relate industry concentration, product market competition, and labor mobility across industries to expected returns in the cross section.…”