The Investment Factor and Expected Returns

Editor’s note: Earlier this week, Lu Zhang discussed his thoughts on the investment factor and expected returns. In this piece, Larry discusses a recent research piece that tells a different side of the story. We recommend that blog readers review both pieces. As is the case with many ideas in finance, there are no “correct” answers.

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It is well documented in the literature that over the long term, low-investment firms have outperformed high-investment firms.⁽¹⁾ This finding has led to the investment factor (CMA, or conservative minus aggressive) being incorporated into the leading asset pricing models—the four-factor Q model (market beta, size, investment and profitability), the Fama-French five-factor model that adds value, and the Fama-French six-factor model that adds momentum.⁽²⁾

Importantly, as shown by Kewei Hou, Chen Xue, and Lu Zhang in their paper, “Digesting Anomalies” firms with lower discount rates (lower costs of capital and thus lower expected returns) invest more. Firms with higher discount rates (higher costs of capital and thus higher expected returns) face higher hurdles for investment and thus invest less. In other words, investment predicts returns because, given expected profitability, high costs of capital imply low net present value of new capital and low investment, and low costs of capital imply high net present value of new capital and high investment. Thus, all else equal, firms with higher investment should earn lower expected returns than firms with lower investment.

In addition, valuation theory predicts that controlling for a firm’s market value and expected profitability, a company that must invest heavily to sustain its profits should have lower contemporaneous free cash flows to investors than a company with similar profits but lower investment. This is what Eugene Fama and Ken French found in their 2006 paper “Profitability, Investment and Average Returns.” They also found that while there is not a direct way to measure future investment, recent asset growth is a reliable proxy for expected investment, allowing them to measure the effect.

The research team at Dimensional contributes to the literature on the investment factor with their October 2019 paper “Investment and Expected Stock Returns.” Their data sample covers the period July 1974 through December 2018 in the U.S., January 1990 through December 2018 in developed ex-U.S. markets, and January 1994 through December 2018 in emerging markets. Following is a summary of their findings:

• The top asset growth quartile tends to have higher asset growth relative to the rest of the market one, three and five years into the future within small and large caps, and in U.S., developed ex-U.S. and emerging markets.
• In general, small caps exhibit a larger dispersion of asset growth than large caps. This is driven mainly by differences between the top investment quartiles. For example, U.S. large-cap firms in the top investment quartile grow their assets by 47 percent on average, while for small-cap firms in the top investment quartile, the average growth rate is 73 percent. The more extreme asset growth for small caps is consistent with small-cap firms having a lower asset base on average. As a result, it is more feasible for small-cap firms to grow their assets substantially through the raising of capital.
• As predicted by valuation theory, in large caps spreads in annualized compound returns between the top and bottom quartiles are negative in all three markets. However, the return spreads are not reliably different from zero—the results are weak.
• In the case of small caps, in the U.S., while there was similar performance for the bottom three quartiles (annualized compound returns of 14.3 percent to 16.5 percent), the annualized compound return for the top quartile is substantially lower (7.2 percent). And the difference in average monthly returns between the bottom and top quartiles is 50 basis points and is reliably different from zero. The results for developed ex-U.S. and emerging markets are similar. In all three regions, there is a reliably positive investment premium that is driven primarily by the significant underperformance of small-cap firms with high asset growth.
• The results are not only pervasive around the globe but also persistent. For example, the top asset growth decile underperforms the rest of the small-cap market 84 percent of the years in the U.S. market, 72 percent of the years in developed ex-U.S. markets, and 76 percent of the years in emerging markets.
• The underperformance of the top decile firms persists, on average, for about two years after sorting.
• The historical investment premium is positive across different sectors in the U.S., developed ex-U.S., and emerging markets.
• There are three ways in which firms can raise capital to grow their assets: issue equity, issue debt, or retain earnings. All three contribute to the investment factor. Equity issuance is the most prominent individual driver of high asset growth among U.S. small caps, followed by debt issuance.
• The growth in both physical and intangible capital contributes to the investment effect.
• U.S. high asset growth firms have poor historical returns regardless of whether firms with merger and acquisition (M&A) activity are included or excluded, suggesting M&A activity is not the only driver of the investment effect.

The authors concluded:

“The persistent and pervasive nature of the underperformance suggests that investors might benefit from incorporating investment in their equity strategies.”

Rizova and Saito , “Investment and Expected Stock Returns,” Dimensional Fund Advisors, 2019

Summary

Valuation theory predicts that expected investment is negatively related to expected returns, holding all else fixed. Using current asset growth as a proxy for expected investment, high asset growth/high investment growth firms tend to underperform the market. Providing confidence that the findings are not the result of data mining, the evidence is persistent across time and pervasive across the globe and sectors. And, as has been found to be the case with other factors (such as value, momentum, and profitability), small-cap firms are the primary driver of this underperformance. In addition, it is present across the relative price and profitability segments.

The conclusion that can be drawn is that an efficient way to improve the expected performance of an equity strategy investing in small caps might be to systematically exclude small-cap firms with high asset growth.