Exploring asset pricing anomalies.

• Author: Zhang, Lu
• Position: Research Summaries

One of the most important challenges in the field of asset pricing is understanding anomalies: empirical patterns that seem to defy explanation by standard asset pricing theories. he traditional approach to explaining these patterns focuses on the behavior of investors. Empirical evidence on anomalies has been cited widely in the academic literature on "behavioral finance" which challenges the efficient market hypothesis and admits the possibility of investor irrationality. I pursue a different approach in my work. Instead of focusing on the behavior of investors, I focus on the behavior of firms. In particular, I investigate whether recognizing the richness of firm investment decisions can help to explain some of the empirical patterns that are often labeled as anomalies.

My research explores the theoretical relation between firm attributes, investment decisions, and stock returns, and examines various empirical implications in this setting. Neoclassical investment theory implies that a firm invests until the net present value (NPV) of the last infinitesimally small project equals zero. For short-lived projects, this prediction means that the firm invests until its discount rate equals the benefits (for example, cash flows) of a marginal project divided by its costs. In turn, the discount rate is the weighted average cost of capital (WACC), which is the leverage-weighted average of the stock return and the bond return. Intuitively, a firm keeps investing until the costs of doing so, which rise with the level of investment, equal the benefits of investment discounted by the WACC.

Building on an early contribution by John Cochrane, (1) I recognize that expressing the expected stock return, which equals the levered WACC, as a function of firm characteristics provides a framework for interpreting anomalies in the data. I label this relation "the WACC equation." This framework does not depend on investor attributes. A key insight that emerges in this setting is that evidence that firm characteristics forecast stock returns does not necessarily imply that stocks are mispriced. (2)

The WACC equation predicts that, all else equal, stocks of firms that are investing heavily should earn lower average returns than stocks with low investment, and that stocks with high return-on-equity (ROE) should earn higher average returns than stocks with low ROE. When expected returns are time-varying (and, more importantly, vary in the cross section), then stock prices vary and they will be related to investment and ROE according to the WACC equation. In particular, stock prices will not adjust in a way that gives rise to a cross-sectionally constant discount rate, which is only true if all firms are equally risky and stock...