New Research to Identify Which Stocks will “Crash”

Beware of companies that rapidly grow their assets on their balance sheets. The stocks of those companies are more likely to “crash” over the next three to five years, according to newly published research.

Before we look at the details of those findings, let’s review the asset pricing models and literature that underlie that research.

Over the long term, low-investment firms have outperformed high-investment firms. This finding has led to the investment factor (CMA, or conservative minus aggressive) being incorporated into the leading asset pricing models – the four-factor Q model (market beta, size, investment and profitability), the Fama-French five-factor model that adds value, and the Fama-French six-factor model that adds momentum.

As shown by Kewei Hou, Chen Xue and Lu Zhang in their paper “Digesting Anomalies,” firms with lower discount rates (lower costs of capital and thus lower expected returns) invest more. Firms with higher discount rates (higher costs of capital and thus higher expected returns) face higher hurdles for investment and thus invest less. In other words, investment predicts returns because, given expected profitability, high costs of capital imply low net present value of new capital and low investment, and low costs of capital imply high net present value of new capital and high investment. Thus, all else equal, firms with higher investment should earn lower expected returns than firms with lower investment.

In addition, valuation theory predicts that controlling for a firm’s market value and expected profitability, a company that must invest heavily to sustain its profits should have lower contemporaneous free cash flows to investors than a company with similar profits but lower investment. This is what Eugene Fama and Ken French found in their 2006 paper “Profitability, Investment and Average Returns.” They also found that while there is not a direct way to measure future investment, recent asset growth is a reliable proxy for expected investment, allowing them to measure the effect.