Investment and The Cross-Section of Equity Returns
By Gian Luca Clementi and Dino Palazzo
Forthcoming
on the Journal of Finance
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.