What Does High Asset Growth Say About a Company’s Expected Return?
For nearly 40 years, research at Dimensional has focused on advancing our understanding of what drives differences in expected returns among securities. A recent study by our Research team into the behavior of firms with high investment suggests new ways to potentially enhance expected returns for equity investors.
Our research is motivated by valuation theory, which provides a useful framework for analyzing the drivers of expected returns. It says that expected returns are driven by the prices investors pay and the cash flows they expect to receive. Expected future cash flows are related to the expected future profits of a company. However, not all profits are returned to shareholders because companies may make investments. Therefore, expected investment lowers expected future cash flows to shareholders, all else equal.
How can we measure and quantify firm investment? There are three ways a firm can raise capital to invest: equity issuance, debt issuance, and growth in retained earnings. Asset growth aggregates financing from all three methods. Equity issuance and growth in retained earnings both lead to an increase in the book equity of a firm and, as a result, to an increase in total assets. Debt issuance leads to an increase in the liabilities of a firm and consequently also to an increase in its total assets. Thus, we can focus on asset growth as a broad measure of investment to examine the relation between investment and expected returns.
Consistent with academic studies, such as Fama and French (2006 and 2015), when sorting all stocks on asset growth, we see large differences in returns between stocks with high asset growth and stocks with low asset growth. We see this pattern in returns among stocks within the US, developed markets ex US, and emerging markets. Moreover, in all three regions, we find that the return spreads are mainly driven by the strong and reliable underperformance of small cap stocks with high investment. The return spreads in large cap stocks, while directionally consistent with valuation theory, are generally not reliable. This is consistent with the smaller cross-sectional differences in asset growth among large caps.
We also find that the investment effect helps explain the poor performance of firms with high stock issuance, high debt issuance, high merger and acquisition activity, high growth in physical capital, and high growth in intangible capital.1 Therefore, incorporating investment into an implementation process may help address a broad set of return patterns in the data in a comprehensive and systematic manner.
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Investment and Expected Stock Returns
Valuation theory predicts that, all else equal, expected investment should be negatively related to expected returns. We study the relation between expected investment and expected stock returns globally. We show that recent asset growth is a systematic proxy for future investment not only in the US, but also in developed ex US and emerging markets. Using this proxy, we find a negative investment effect across developed and emerging markets as well as across sectors in those regions, consistent with the prediction of valuation theory. Globally, the effect is much stronger among small caps than large caps and is mainly driven by the underperformance of high investment firms. Examining the different components of asset growth related to raising of capital as well as those related to use of capital, we find that all components contribute to the investment effect.
1Intangible capital refers to non-physical assets, such as patents, trademarks, copyrights, computer software, branding, and reputation.
Fama, Eugene F., and Kenneth R. French. “Profitability, investment and average returns.” Journal of Financial Economics 82.3 (2006): 491–518.
Fama, Eugene F., and Kenneth R. French. “A five-factor asset pricing model.” Journal of Financial Economics 116.1 (2015): 1–22.
Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP.
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