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Investment and The Cross-Section of Equity Returns

By Gian Luca Clementi and Dino Palazzo

Forthcoming on the Journal of Finance

Paper (PDF Format)

Abstract


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.