Ebook Do Investment Frictions Affect Anomalies in the Cross-Section of Returns?
We derive and test a novel implication of q-theory on cross-sectional returns: the expected return investment relation should be steeper in firms with high investment frictions than in firms with low investment frictions. Initiated by Cochrane (1991, 1996), investment-based asset pricing argues that real investment is important for determining expected returns. Intuitively, all else equal, low costs of capital imply high net present values of new projects and high investment, and high costs of capital imply low net present values of new projects and low investment.
The literature has so far applied the negative expected return-investment relation predicted by q-theory to explain a wide range of capital markets anomalies (empirical relations between average stock returns and firm characteristics that cannot be explained by traditional asset pricing models). By exploring the previously ignored interaction between the expected return-investment relation and investment frictions, our tests can address whether these anomalies can indeed be attributed to q-theory.
Our basic idea is simple. In a perfect world without frictions, investment is infinitely elastic to changes in the discount rate, meaning that a small change in the discount rate is associated with an infinite magnitude of change in investment. With frictions, investment entails investment costs, which cause investment to be less elastic to changes in the discount rate.
The crux is that the magnitude of this elasticity decreases with investment costs. The higher are the investment costs that a firm faces, the less elastic the firm’s investment will be in responding to changes in the discount rate. Equivalently, a given change in investment will correspond to a larger change in the discount rate, meaning that the expected return-investment relation is steeper for firms with high investment frictions than for firms with low investment frictions.
Our test design also is simple. We identify investment frictions with firm-level proxies of financing constraints. The premise is that if there are investment costs such as adjustment costs of capital, frictions in capital markets will induce additional financing costs at the margin. We use three financing constraints proxies: asset size, payout ratio, and bond ratings.
Firms with small asset, low payout ratios, and unrated public debt are more financially constrained than firms with big asset, high payout ratios, and rated public debt, respectively. We use six investment-related anomaly variables: Chen and Zhang’s (2009) investment-to-assets, Cooper, Gulen, and Schill’s (2008) asset growth, Xing’s (2008) investment growth, Fama and French’s (2008) net stock issues, Titman, Wei, and Xie’s (2004) abnormal corporate investment, and Hirshleifer, Hou, Teoh, and Zhang’s (2004) net operating assets. We run Fama-MacBeth (1973) cross-sectional regressions of returns on a given anomaly variable within extreme subsamples split by a given financing constraints proxy. Under the q-theory logic, the slope should be negative, and greater in magnitude in the more constrained subsample than in the less constrained subsample.
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