Abstract

Expanding on rational Q theory, this study demonstrates that less exposure to systematic distress risk partially explains the phenomenon of investment growth anomalies, wherein equities of firms with greater growth in capital investment display lower stock returns. Using the default yield spread between BAA- and AAA-rated corporate bonds as a proxy for a systematic distress risk factor driving the pricing kernel, I show that firms with high (low) capital investment have lower (higher) exposure to systematic distress risk and thus lower (higher) expected returns. Depending on model settings, the factor used here to measure systematic distress risk explains 30–۴۰% of the investment growth effect. Overall, I conservatively conclude that a moderate part of investment growth anomaly can be viewed as compensation for systematic distress risk, even though many studies explain it as a result of behavioral mispricing.

Introduction

Titman, Wei, and Xie (2004) showed that firms with highly abnormal capital investments (ACI) earn significantly lower benchmark-adjusted returns—the so-called investment growth anomaly1. Existing literature offers two competing explanations for this anomaly: behavioral mispricing and rational Q theory.

Consistent with Jensen’s (1986) agency hypothesis, Titman et al. (2004) offered a mispricing-based explanation: investors underreact to managerial empire building through increased investment expenditures. Cooper et al. (2008) documented a significantly negative association betweenfirms’ asset growth and subsequent stock returns and found that investors overreact to past operating performance of firms with high asset growth. This finding coincides with the assertion that an asset’s growth effect is most consistent with a mispricing hypothesis. Using a stock’s price proximity to its 52-week high price as a measure of mispricing, George et al. (2014) interpreted their findings as corrections of mispricing, noting that stock returns on firms with high capital investment are not low when samples exclude stocks with prices farthest from their 52-week high prices.