Investment and The Cross-Section of Equity Returns
We confront the one-factor production-based asset pricing model with the evidence on firm-level investment, to uncover that it produces implications for the dynamics of capital that are seriously at odds with the evidence. The data shows that, upon being hit by adverse profitability shocks, large public firms have ample latitude to divest their least productive assets and downsize. In turn, this reduces the risk faced by their shareholders and the returns that they are likely to demand. It follows that when the frictions to capital adjustment are shaped to respect the evidence on investment, the model–generated cross–sectional dispersion of returns is only a small fraction of what documented in the data. Our conclusions hold true even when either operating or labor leverage are modeled in ways that were shown to be promising in the extant literature.
We thank the Editors, Kenneth Singleton and Stefan Nagel, one associate editor, and two anonymous referees for suggestions that greatly improved the paper. We are also grateful to Frederico Belo, Martin Boileau, Andrea Buffa, Ilan Cooper, João Gomes, Dirk Hackbart, Xiaoji Lin, Lars Lochstoer, Sydney Ludvigson, and Stijn Van Nieuwerburgh, as well as seminar attendants at NHH Bergen, Bank of Italy, Boston University, Federal Reserve Bank of St. Louis, NYU, University of Minnesota, University of Southern California, Wharton, University of Wisconsin, CAPR Workshop (Oslo), CIREQ Workshop (Montreal), Duke-UNC Asset Pricing Conference, “Firm Dynamics and the Aggregate Economy” at the Becker-Friedman Institute, ENSAI Economic Day (Rennes), EUI Macro Conference (Florence), Midwest Macro Meeting, NY/Philly Workshop on Quantitative Macroeconomics, and meetings of American Finance Association, European Finance Association, Canadian Macro Study Group, and Society for Economic Dynamics for their comments and insights. Marco Casiraghi and Peifan Wu provided excellent research assistance. Neither of us has relevant or material financial interests that relate to the research described in this paper. All remaining errors are our own responsibility. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
GIAN LUCA CLEMENTI & BERARDINO PALAZZO, 2019. "Investment and the Cross-Section of Equity Returns," The Journal of Finance, vol 74(1), pages 281-321.