The Underperformance of High-Investment Firms

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. That is what Eugene Fama and Ken French found in their 2006 paper, “Profitability, Investment and Average Returns.” They also found that while there is no direct way to measure future investment, recent asset growth is a reliable proxy for expected investment, allowing them to measure the effect.

The cross-section of investment and profitability

Mete Kilic, Louis Yang and Miao Ben Zhang contributed to the investment factor literature with their study, “The Cross-section of Investment and Profitability: Implications for Asset Pricing,” published in the September 2022 issue of the Journal of Financial Economics. They began by noting: “Expected returns are decreasing in investment holding profitability constant and increasing in profitability holding investment constant. These conditional predictions suggest that unconditional sorts may not be capable of detecting investment and profitability premiums. In particular, when investment and profitability are highly positively correlated, the cross-sectional variation in investment is primarily driven by the variation in expected profitability instead of discount rates.” Thus, the direct relation between investment and returns (and the direct relation between expected profitability and returns) will be weaker when the investment-profitability correlation is high: “As a result, even though investment negatively predicts returns within the profitability buckets, unconditional sorts on investment may not identify this predictability. In sum, the investment CAPM suggests an economic reason for weak unconditional investment and profitability premiums when the cross-sectional investment-profitability correlation is high.”

To test their predictions, they constructed two samples of U.S. firms with significantly positive and negative cross-sectional relations between investment (I/A) and profitability (return on equity, ROE). They classified industries featuring high I/A-ROE correlation as the high-correlation sample and industries featuring low I/A-ROE correlation as the low-correlation sample. They found that the investment premium in the high-correlation sample was insignificant and less than one-fifth of that for the benchmark factors, and the profitability premium (robust minus weak, RMW) was statistically significant and about three-fifths of that for the benchmark factors. In contrast, in the low-correlation sample, both premiums were statistically significant and indistinguishable from their benchmark factors. Their findings led Kilic, Yang and Ben Zhang to conclude: “This is consistent with our prediction that triple sorts help detect premiums by properly addressing the correlation between investment and profitability.”

Externally or internally financed growth

In their July 2023 study, “Dissecting the Expected Investment Growth Premium,” Shan Chen and Xujun Liu examined the impact on returns based on how investment was financed. They decomposed asset growth into external growth (equity and debt financing) and internal growth (financed from profits) and constructed expected investment growth measures based on different components. Logically, if a firm can increase its total assets by utilizing retained earnings (instead of issuing debt or equity), a firm with high asset growth is likely to be more profitable, implying a higher expected return. Their findings confirmed their theory: Externally financed investment growth persistently negatively predicted returns over time, and its significance remained after five years. On the other hand, the coefficient for internally financed investment growth was indifferent from zero and even became negative after one year, suggesting a weak ability to predict long-term returns.

The authors ran a regression of the change in asset growth on three variables: the log of Tobin’s q, cash-based operating profitability, and the change in return on equity, used to forecast growth of investment. They found that their regression provided a good approximation of actual realized growth and confirmed that the expected investment growth premium was positive and robust under various controls – firms with high (low) expected growth in investment had high (low) returns. The expected investment premium was positive rather than negative as in the realized investment case (Fama and French).

Chen and Liu’s findings are consistent with those of Hongtao Li, author of the 2017 study, “External Growth and the Cross Section of Stock Returns,” who found:

• External growth, measured as asset growth raised from capital markets, had stronger power than total asset growth in predicting the cross-section of average returns.

• External growth subsumed the total asset growth effect and outperformed other measures of firm investments in predicting returns.

• The profitability of external growth strategies was not explained by well-documented factors (i.e., market, size, value, profitability, investment and momentum).

• An external growth factor helped explain a wide range of anomalies – especially, it accounted for nearly half of momentum profits.

Chen and Liu’s findings are also consistent with those of the research team at Dimensional in its 2020 paper, “Investment and Expected Stock Returns.” It found that in large caps, spreads in annualized compound returns between the top and bottom quartiles of the asset growth portfolios were negative. But the return spreads were not reliably different from zero – the results were weak. In small caps the difference in average monthly returns between the bottom and top quartiles was 50 basis points and reliably different from zero – the performance of the investment factor was driven by the significant underperformance of small-cap firms with high asset growth. It also found that the underperformance of the top-decile firms persisted on average for about two years. Importantly, it found that equity issuance was the most prominent individual driver of high asset growth among U.S. small caps, followed by debt issuance. And it found that high asset growth firms had poor historical returns regardless of whether firms with merger and acquisition (M&A) activity were included or excluded, suggesting M&A activity was not the only driver of the investment effect.

Finally, Chen and Liu’s finding that firms with high expected growth earned higher expected returns than firms with low expected growth (holding investment and expected profitability constant) is consistent with those of the authors of the study, “q5,” in which they added expected growth to the q-factor model.

Investor takeaways

Valuation theory predicts that investment is negatively related to expected returns, all else fixed. Using current asset growth as a proxy for expected investment, high asset growth/high investment growth firms tended to underperform the market. And, as has been found to be the case with other factors (such as value, momentum and profitability), small-cap firms were the primary drivers of the underperformance.

Another key takeaway is that while realized asset growth was a negative predictor of returns, expected investment growth was a positive predictor.

Investors should also ensure that the investment factor is not considered in isolation when building portfolios, as the empirical findings demonstrate that profitability and how asset growth is financed (internally or externally) matters. Not all high investment firms (those with high asset growth) have low expected returns; those with high profitability and asset growth financed internally have high expected returns.

A final takeaway is that an efficient way to improve the expected performance of an equity strategy is to systematically exclude small-cap firms with high externally financed asset growth and low profitability.

Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.

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