Profitability and Investment-Based Factor Pricing Models

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