The Cross-Section of Investment and Profitability: Implications for Asset Pricing

Abstract

Asset pricing predictions from the investment CAPM depend on the cross-sectional relation between investment and profitability. In samples of U.S. stocks featuring high cross-sectional investment-profitability correlation, both investment and profitability premiums are weak. Consistent with the conditional predictions from the investment CAPM, triple sorts on size, investment, and profitability as in Hou, Xue, and Zhang (2015)'s q-factors mitigate this impact and resurrect premiums in the high-correlation samples. We find similar results using cash-based profitability, consistent with the investment CAPM in a dynamic setting. Our work has important implications for constructing asset pricing factors and offers guidance on interpreting out-of-sample asset pricing test results.

Keywords: Investment CAPM; Cross-Section of Stock Returns; q-Factors; Investment Premium; Profitability Premium; Out-of-Sample Test.

JEL Classification: G10, G12, G31, D92