"Relationship Between Return and Market Value of Common Stocks"
The empirical relationship between firm level investments, stock return, systematic risk, and the book-to-market effect Måns Kjellsson [email@example.com] Department of Business Administration, Lund University Box 7080 220 07 Lund Abstract The paper tests the relationship between firm level investments (fixed capital and intangible assets), stock return, systematic risk (levered and unlevered equity beta), and the book-to-market effect in a sample of European firms. Results tba. 2/6 Introduction The purpose of this study is to investigate the relationship between growth in firm level investments (fixed capital and intangible assets) and security returns, changes in the systematic risk and the Book-to-market (value) effect. The study draws on previous findings from US data by Anderson & Garcia-Feijoo (2006) and Xing (2006) that firm investments in fixed capital predict stock return and replace the Book-to-market factor, and findings by Lev & Souigiannis (1999) and Nelson (2006) that investments in R&D and advertising spending predict cross sectional stock returns and explain part of the value effect and extends the tests to European markets and test with individual securities. The empirical findings by Fama & French (1992) that Book-to-market and Size have significance in explaining cross sectional stock returns while the CAPM beta was insignificant gave rise to a discussion on the “death of beta”. Besides the methodological discussion on Fama & French’s tests, see for instance Berk (2000) and Conrad, Cooper, and Kaul, (2003), have a number of suggestions been put forward on what the Fama & French factors are proxying for. Three main categories of explanations can be identified; the first is that the factors are catching a security mispricing and irrational investment behaviour; this is for instance supported by Daniel & Titman (1997) and Daniel, Titman & Wei (2001). The second explanation is that the factors are risk factors or proxies for omitted state variables, such as default risk or changes in the investment opportunity set, see for instance Fama & French (1993) and Petkova (2006). Finally, has a recent line of articles emerged arguing that the Fama & French factors are correlated with changes in systematic risk due to firms’ investments, see for instance Berk, Green & Naik (1999), Gomes, Kogan & Zhang (2003), Carlson, Fisher & Gimmarino (2004) and Cooper (2006), thereby giving the CAPM-beta a chance to resurrect. Berk et al (1999) and Gomes et al (2003) use different analytical models with different assumptions but they show that a firm’s systematic risk is conditioned on the investment behaviour of the firm. This is a possible explanation to the significance of the Book-to-market factor in predicting stock returns since previous test do not take the time varying risk into consideration instead static betas are used. The theoretical literature is complemented with Anderson & Garcia-Feijóo (2006) that perform empirical tests of the relationship between exercise of growth options (proxied as growth in capital expenditure), the Fama & French effect and stock returns. With a US dataset Anderson & Garcia (2006) conclude that growth in capital expenditure can explain the BM ratio and cross sectional stock returns. Increased (decreased) investments are negatively (positively) associated with subsequent stock returns. The theoretical rationale for this is that the exercise of growth options decrease the systematic risk of the firm and hence is the subsequent required return also 3/6 lower. They further show that the sorting of securities in Book-to.-market portfolios is conditioned on investment spending the years before sorting and that firm specific growth in investment can explain (alongside with the book-to-market ratio) stock return. In a parallel study on a US dataset, Xing (2006) show that a factor mimicking portfolio formed on growth rates in investments can explain the value effect, and that investment growth is negatively related to subsequent stock return. Xing (2006) explain the observed relationship in Q-theory framework. Besides investments in fixed assets has the relationship between security return and firm level investments in intangible assets such as R&D and marketing been investigated by Lev & Sougiannis (1999) and Nelson (2006). Lev & Sougiannis (1999) show that investments in intangible assets (R&D) can explain the Book-to-market ratio and also replace the Book-to- market factor in tests of the three factor model. Nelson (2006) shows that factor mimicking portfolios for the intangible assets R&D and advertising spending, replace the BM factor in time series regressions, and that a four factor model incorporating the two intangibles factors is more efficient than the original three-factor model. The empirical findings support the idea that the Book-to-market ratio proxies for value creation (investments in positive NPV-projects), they do however not answer the question if the BM-ratio and the correlated investment variables are proxies for underlying risk factors (omitted risk factors) or if the changes in investment rates are correlated with changes in systematic risks that are not detected by the static betas previously used to test the models. Therefore there is a need to empirically analyze the effects that investment growth have on systematic risk. As is shown by Callahan & Mohr (1989) is the systematic equity risk a function of both the financial and operational leverage of the firm. Cooper (2006) show that investments will have an effect on the systematic risk since the operational leverage change as a result of the firm’s capital investments. The change in systematic risk can however be obscured or offset by contemporaneous changes in financial leverage, that can arise both through increased lending to finance the projects and trough the increase in market value of equity that is a result of the firm investing in projects with positive NPV. Therefore, should the tests of systematic risk take the D/E ratio into explicit consideration. In this study that is done by adjusting observed betas with leverage into equity betas (unlevered betas). The purpose of this paper is firstly to use a European dataset to test the relationship between stock return and investments, both in fixed capital and in intangible assets. The purpose is secondly to investigate the relationship between investments and the book-to-market factor and the CAPM-beta (both levered and unlevered) to bring an empirical contribution to the discussion 4/6 on the effect that investments have on systematic risk. Since the portfolio approach originally applied by Fama & French (1992) has been criticized will the tests be executed with individual stocks as well as with portfolios. The study brings a contribution the existing literature by testing the investment effect on a European sample thereby (possibly) corroborating the results form the US data. The study also brings a contribution by analyzing the combination of investments in both intangible and tangible assets, previously the two types of investments have only been investigated in separate datasets. Finally, the study brings a contribution to the discussion on “the death of beta” by explicitly testing the effect of investments on individual equity betas, both levered and unlevered. The leverage adjustment of betas makes the betas time varying thereby mitigating the effect that static betas can have on the predictive power of the Book.-to-market factor. If the betas are adjusted as a result of the changes in investment growth is it also possible that the betas can predict returns as good as the Book-to-market factor that by definition incorporates the change in required return that can take place as a result of the investments. 5/6 References Anderson, C.W., Garcia-Feijóo, L. 2006. Empirical Evidence on Capital Investment. Growth Options, and Security Returns, Journal of Finance, 61:171-194 Berk, J.D. 2000. Sorting Out Sorts. Journal of Finance, 55: 407-427 Berk, J.B., Green, R.C., & Naik. V. 1999. Optimal investment, Growth Options, and Security Returns. Journal of Finance 54(5):1553-1607 Callahan, C.M. & Mohr, R.M.1989. The Determinants of Systematic Risk: A Synthesis. The Financial Review, 24(2):157-181 Carlson, M., Fisher, A., Gimmarino, R., 2003. Corporate Investment and Asset Pricing Dynamics: Implications for the Cross section of returns, Journal of Finance, 59(6) Conrad, J., Cooper, M., & Kaul, G. 2003. Value versus Glamour. Journal of Finance, 58(5):1969- 1995 Cooper, I., 2006. Asset pricing implications of nonconvex adjustment costs and irreversibility of investment. Journal of Finance, 61(1), 139-170 Daniel, K., Titman, S., 1997. Evidence in the characteristics of cross-sectional variation in stock returns. Journal of Finance, 52 (1), 1-33 Daniel, K., Titman, S.s., Wei, J. K. C., 2001. Explaining the Cross-Section of Stock Returns in Japan: Factors or Characteristics?, Journal of Finance, 56 (2), 743-766 Fama, E.F,, & French, K.R. 1992. The Cross-Section of Expected Stock Returns. Journal of Finance, 47(2):427-465 Fama, E.F., & French, K.R. 1993. Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33: 3-56 Gomes, J., Kogan, L., & Zhang, L. 2003. Equilibrium Cross Section of Returns. Journal of Political Economy, 11(4):693-732 Lev. B. & Sougiannis, T. 1999. Penetrating the Book-to-Market Black Box: The R&D Effect. Journal of Business Finance and Accounting, 26(3) & (4) Nelson, J. M., 2006. Intangible assets, book-to-market, and common stock returns, Journal of Financial Research, 29(1), 21-41 Petkova, R., 2006. Do the Fama–French factors proxy for innovations in predictive variables?, Journal of Finance, 61:581-612 Xing, Y., 2006. Interpreting the Value Effect Trough the Q-theory: An Empirical Investigation, Working paper, Rice university 6/6