Swedroe: Understanding The Investment Factor

February 06, 2019

Research demonstrates that the investment factor has explanatory power for the cross section of stock returns, with high-investment firms tending to underperform low-investment firms.

For example, Kewei Hou, Chen Xue and Lu Zhang, authors of the 2015 paper “Digesting Anomalies: An Investment Approach,” proposed replacing the Fama-French three-factor (market beta, size and value) model with a four-factor model that went a long way toward accounting for many of the anomalies that neither the Fama-French three-factor model nor the Carhart four-factor model (which added momentum as the fourth factor) could explain.

In their model, which Hou, Xue and Zhang call the “q-factor model,” an asset’s expected return in excess of the riskless rate is described by the sensitivity of its return to the returns of four factors: market beta, size, investment (the difference between the return on a portfolio of low-investment stocks and the return on a portfolio of high-investment stocks, or conservative minus aggressive) and profitability (the difference between the return on a portfolio of high return-on-equity stocks and the return on a portfolio of low return-on-equity stocks, or robust minus weak).

Eugene Fama and Kenneth French, in their paper “A Five-Factor Asset Pricing Model,” examined the q-factor model and agreed that a four-factor model that excludes the value factor (HML, or high minus low) captures average returns as well as any other four-factor model they considered, and that a five-factor model (adding HML) doesn’t improve the description of average returns over that of the four-factor models.

This occurs because the average HML return is captured by HML’s exposure to other factors. Thus, in the five-factor model, HML is redundant for explaining average returns.

Investment Premium Explained

As with the value premium, there’s a debate about whether the investment factor has a risk-based or behavioral-based explanation.

Rational theories suggest the investment premium reflects firms’ investment decisions—firms invest when they have low leverage, and expected stock returns are low (the discount rate is low, making the net present value of the investment higher), whereas firms do not invest when they have high leverage, and expected stock returns are high.

Behavioral theories argue that the investment premium reflects mispricing, as investors do not properly incorporate information on firms’ investment decisions into asset prices.

In his November 2018 paper, “Does Debt Explain the Investment Premium?”, Thomas Poulsen writes: “Investors extrapolate past performance too far into the future when they value stocks. If firms with high asset growth performed well in the past, investors expect them to continue to do so in the future. Investors overvalue stocks in these firms to the extent that they cannot live up to the high growth expectations going forward. When realized asset growth falls short of expectations, the market corrects the initial overvaluation and these stocks have low returns.”

Alternatively, investors fail to recognize that high asset growth may reflect overinvestment. The result is, according to Poulsen, that “investors tend to overvalue firms with high asset growth. The subsequent low stock returns to high asset-growth firms reflect that the market corrects the initial over-valuation.”

Bond Market Evidence

Benedikt Franke, Sebastian Muller and Sonja Muller contributed to the literature on the investment factor with their study “The Q-Factors and Expected Bond Returns,” published in the October 2017 issue of the Journal of Banking & Finance. They used a sample of U.S. corporate bonds from 1995 to 2011 to examine how exposure to the q-factor is priced by corporate bond investors.

They found there is not a robust relationship between exposure to the investment factor and the cost of debt. This held true regardless of the state of the economy. The conclusion that can be drawn is that, at least in terms of corporate debt, the investment factor is not a risk factor—it’s a behavioral one. This seems more likely than the other possible conclusion—that the institutional investors who dominate the corporate bond market are making persistent pricing mistakes that go uncorrected.

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