The neoclassical q-theory is a good start to understand the cross section of returns. Under constant return to scale, stock returns equal levered investment returns that are tied directly with characteristics. This equation generates the relations of average returns with book-to-market, investment, and earnings surprises. We estimate the model by minimizing the differences between average stock returns and average levered investment returns via GMM. Our model captures well the average returns of portfolios sorted on capital investment and on size and book-to-market, including the small-stock value premium. Our model is also partially successful in capturing the post-earnings-announcement drift and its higher magnitude in small firms.
We thank Nick Barberis, David Brown, V. V. Chari, Rick Green, Burton Hollifield, Patrick Kehoe, Narayana Kocherlakota, Leonid Kogan, Owen Lamont, Sydney Ludvigson, Ellen McGrattan, Antonio Mello, Mark Ready, Bryan Routledge, Martin Schneider, Masako Ueda, and seminar participants at the Federal Reserve Bank of Minneapolis, Yale School of Management, University of Wisconsin--Madison, Carnegie-Mellon University, New York University, Society of Economic Dynamics Annual Meetings in 2006, the UBC Summer Finance Conference in 2006, and the American Finance Association Annual Meetings in 2007 for helpful comments. Some of the theoretical results have previously been circulated in NBER working paper #11322 titled "Anomalies.'' All remaining errors are our own. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.