Investment and the Cross-Section of Equity Returns

49 Pages Posted: 6 Apr 2015 Last revised: 10 Apr 2015

See all articles by Gian Luca Clementi

Gian Luca Clementi

New York University - Leonard N. Stern School of Business; National Bureau of Economic Research (NBER); University of Bologna - Rimini Center for Economic Analysis (RCEA)

Berardino Palazzo

Board of Governors of the Federal Reserve System

Date Written: April 2015

Abstract

We confront the one-factor production-based asset pricing model with the evidence on firm-level investment, to uncover that it produces implications for the dynamics of capital that are seriously at odds with the evidence. The data shows that, upon being hit by adverse profitability shocks, large public firms have ample latitude to divest their least productive assets and downsize. In turn, this reduces the risk faced by their shareholders and the returns that they are likely to demand. It follows that when the frictions to capital adjustment are shaped to respect the evidence on investment, the model–generated cross–sectional dispersion of returns is only a small fraction of what documented in the data. Our conclusions hold true even when either operating or labor leverage are modeled in ways that were shown to be promising in the extant literature.

Suggested Citation

Clementi, Gian Luca and Palazzo, Berardino, Investment and the Cross-Section of Equity Returns (April 2015). NBER Working Paper No. w21064, Available at SSRN: https://ssrn.com/abstract=2590227

Gian Luca Clementi (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

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National Bureau of Economic Research (NBER) ( email )

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University of Bologna - Rimini Center for Economic Analysis (RCEA) ( email )

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Berardino Palazzo

Board of Governors of the Federal Reserve System ( email )

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Washington, DC 20551
United States

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