Does Debt Explain The Investment Premium?
Poulsen provides the latest contribution to the literature in his November 2018 paper. His data sample covers the period July 1970 through June 2016, and almost 15,000 firms. Following is a summary of his findings:
- The investment premium decreases from 0.36% per month (statistically significant at the 1% confidence level with a t-stat of 3.8) with levered returns to 0.17% per month (and fell short of conventional statistical significance with a t-stat of 1.90) once leveraged is controlled for.
- Average excess returns decrease with asset growth, and the effect is more pronounced for small firms.
- The investment premium does not exist among zero-leverage firms—the return differential between zero-leverage firms with low and high asset growth is -0.11% per month and is statistically insignificant (t-stat of -0.7). Thus, the premium reflects leverage.
- There is a strong relationship between asset growth and leverage. Within each size quintile, the average leverage ratio decreases monotonically with asset growth. The differences between average leverage ratios in the low- and high-asset-growth portfolios are highly statistically significant—firms’ investment and financing decisions are related. Because behavioral theories do not distinguish between zero-leverage and levered firms, this finding is inconsistent with behavioral explanations.
- The investment premium increases with firms’ refinancing intensities. Measuring refinancing intensity by the ratio of debt maturing within one year to total debt, the return differential increases monotonically from 0.12% per month for firms with low refinancing intensities to 0.64% for firms with high refinancing intensities—the difference is statistically significant (t-stat = 2.6) and remains almost the same, measured in risk-adjusted returns when controlled for exposures to common risk factors (market, size, value, momentum, profitability and even investment).
- When leverage is controlled for, the unlevered return differential between low and high asset-growth firms increases with refinancing intensities by 0.33%. Leverage therefore explains some of the cross-sectional return differential, though refinancing intensities remain informative about the investment premium. Rational financial theory suggests that both the riskiness of debt and the expected stock return increase with leverage and its intensity.
Poulsen found his results are “inconsistent with prominent theories using firms’ investment decisions to explain the investment premium”—otherwise, there would be an investment premium in the stocks of low investment firms without debt.
He added: “The investment premium reflects both leverage and refinancing intensities [reflecting rollover risk]. These two factors explain 36% of the time-series variation in the investment factor.”
Poulsen added that rational financial theory suggests that both the riskiness of debt and the expected stock return increase with leverage and its intensity. The model predicts that firms with low asset growth will have higher leverage and higher expected stock returns relative to firms with high asset growth, which the author writes are consistent with his empirical findings.
Poulsen concluded: “Taken together, my results offer a novel perspective on the economic interpretation of the investment premium and shed new light on the asset pricing implications of firms’ investment and financing decisions. I focus on the effects of leverage and refinancing intensities but the investment premium may also be related to other financing decisions such as the choice of debt covenants.”
Summarizing, Poulsen’s findings provide valuable insights into how the investment premium adds explanatory power to the cross section of expected returns—the investment premium is related to leverage and refinancing intensity (two risk factors) and is not present in zero leverage firms.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.