Profitability and Investment-Based Factor Pricing Models

38 Pages Posted: 16 Feb 2015

See all articles by Brendan Elliot

Brendan Elliot

University of Newcastle (Australia)

Paul Docherty

The Brattle Group

Stephen Andrew Easton

University of Newcastle

Doowon Lee

Newcastle Business School

Date Written: February 2015

Abstract

The level of firm investment, along with firm profitability, has been shown to be empirically powerful asset pricing factors in the US and other markets. The q-factor model of Hou, Xue, and Zhang (2014), and the 5-factor model of Fama and French (2014a), both rely on factors capturing the interrelationship of firm investment and profitability. The models struggle in relation to small, high-investing and low-profitability stocks, a characteristic that is common to Australian firms. Using a sample of Australian stocks over the sample period of 1975-2013, we show that the profitability factor is virtually non-existent, despite numerous tests and iterations of the factor. The addition of a profitability factor provides trivial explanatory power when compared to firm size and investment. We interpret these results as evidence that the investment-profitability rationale that underpins both models is incomplete. Further, we confirm the results of Fama and French (2014a), who report that the explanatory power of the HML factor is subsumed when combined with investment and profitability. Finally, we provide the setting for a comparison of the q-factor and 5-factor models. Given our findings regarding the profitability and HML factors, we report no dominant model across a range of testing assets.

Keywords: Investment, profitability, asset pricing

JEL Classification: G11, G12

Suggested Citation

Elliot, Brendan and Docherty, Paul and Easton, Stephen Andrew and Lee, Doowon, Profitability and Investment-Based Factor Pricing Models (February 2015). Available at SSRN: https://ssrn.com/abstract=2565298 or http://dx.doi.org/10.2139/ssrn.2565298

Brendan Elliot (Contact Author)

University of Newcastle (Australia) ( email )

University Drive
Callaghan, NSW 2308
Australia

Paul Docherty

The Brattle Group ( email )

44 Brattle Street
3rd Floor
Cambridge, MA 02138-3736
United States

Stephen Andrew Easton

University of Newcastle ( email )

University Drive
Callaghan, nsw 2308
Australia

Doowon Lee

Newcastle Business School ( email )

1 University Drive
Callaghan
Newcastle, NSW
Australia
+61 2 4921 8620 (Phone)

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