Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks

Abstract

Average return differences among firms sorted on valuation ratios, past investment, prof- itability, market beta, or idiosyncratic volatility are largely driven by differences in exposures of firms to the same systematic factor related to embodied technology shocks. Using a calibrated structural model, we show that these firm characteristics are correlated with the ratio of growth opportunities to firm value, which affects firms’ exposures to capital-embodied productivity shocks and risk premia. We thus provide a unified explanation for several apparent anomalies in the cross-section of stock returns---namely, predictability of returns by these firm characteristics and return comovement among firms with similar characteristics.

Keywords: stock returns, investment, firm characteristics, predictability, value premium

JEL Classification: E20, E22, G10, G12