Irreversible Investment, Real Activity and the Value Premium

Abstract:     
We conduct an empirical investigation of the principal predictions of an emerging strand of models linking firms' real investment behavior under irreversibility and asset return dynamics. A string of recent papers (Berk, Green and Naik (1999), Gomes, Kogan and Zhang (2003), Zhang (2003), Carlson, Fisher and Giammarino (2003), Kogan (2003) and Cooper (2003) ties firms' characteristics, such as their book-to-market ratio, to their systematic risk within the framework of real options models. In these models systematic risk is conditional in nature. Book-to-market appears to explain the cross-section of average stock return and predicts return in the time series, because it is correlated with the systematic risk of the firm, namely the firm's conditional loadings with respect to risk factors. Empirical tests that do not adequately account for the conditional nature of pricing could therefore reject the (static) CAPM and find a book-to-market effect. We present a model that builds on the papers mentioned, that facilitates our empirical work. Our model yields a relationship among book-to-market, economically fundamental observable variables capturing the true, conditional, systematic risk of firms, and conditional moments of stock returns. We find substantial empirical support for the model's predictions and consequently for a link between book-to-market and risk. However, book-to-market retains some incremental information about expected returns which is not explained by our measure for systematic risk. Irreversibility of real investment plays a central role in the string of models discussed above. The irreversibility constraint occasionally binds, implying that at times firms will have excess capital capacity. The models predict that the conditional first and second moments of returns are positively correlated with excess capital capacity, and more so when the degree of investment irreversibility is high. The explanation for this in the different papers is rather distinct but they all share this feature. Since each model generates a value premium among firms that all use the same technology, it seems reasonable to sort stocks by industries. We therefore perform a battery of tests on industry portfolios. We begin by using the time series mean and volatility of capacity utilization (data on capacity utilization is given by the Federal Reserve) as a measure to rank industries by the degree to which investment is irreversible. We then continue to use capacity utilization as a measure for excess capital capacity. Our model yields an alternative measure of excess capital capacity, namely the capital-to-output ratio. We use both measures in our tests. We find that our economic variables explain return volatility, time variation in market beta and are strong predictors or returns in the time series. These findings provide strong support for the predictions stemming from the new literature.

Keywords: Irreversible investment, capacity utilization, value premium

JEL Classification: G12

working papers series