Intangible capital, volatility shock, and the value premium

• DOI: http://doi.org/10.1111/fire.12193
• Date: 01 November 2019
• Published date: 01 November 2019
• Author: Yongkil Ahn

DOI: 10.1111/fire.12193

ORIGINAL ARTICLE

Intangible capital, volatility shock, and the

value premium

Yongkil Ahn

College of Management, National TaiwanNormal

University, TaipeiCity, Taiwan

Correspondence

YongkilAhn, No. 31, Shida Road, Daan District,

TaipeiCity,Taiwan,10645.

Email:yongkil.ahn@gmail.com

Abstract

This paper extends the canonical, neoclassical investment-based

asset-pricing model through the incorporation of intangible capital

and the formulation of a joint productivity distribution with eco-

nomic uncertainty shocks at the firm level. The distinctiveevolution-

ary dynamics of intangible capital as opposed to that of physical cap-

ital mitigate the negative impact of temporary uncertainty shock on

production and serve well to explain the value premium with mod-

est assumptions. The value premium is unconditionally positive, but

the realized value spread plummets to negative after major transient

second-moment shocks, for example, the Loma Prieta Earthquake

and the 9/11 terrorist attack.

KEYWORDS

economic uncertainty, intangible capital, value premium

JEL CLASSIFICATIONS

E22, E23, G11, G12

1INTRODUCTION

Investment-basedasset-pricing models, for example, Zhang (2005), argue that the value premium exists in a production

economy with rational expectations. Though this argument draws huge attention, the investment-basedexplanation

begets a dilemma. On one hand, value firms are riskier than glamour firms because highly asymmetric capital adjust-

ment cost, together with countercyclical price of risk, leads physical capital to be harder to adjust especially in reces-

sions. On the other hand, the same argument implies that assets in place are necessarily riskier than growth options in

such an economy,completely opposite to the conventional wisdom in the literature.1

This paper proposes a remedy that reconciles the predicament. I postulate an economy with two types of assets

in places and time-varying economic uncertainty. In particular,I extend the canonical, neoclassical growth model to

include intangible capital and conditional uncertainty shock.2I use the augmented investment-based asset-pricing

model to conclude that complementarity in an intangible capital accumulation process together with time-varying

1Referto Berk, Green, and Naik (1999), Gomes, Kogan, and Zhang (2003), and Hillier, Grinblatt, and Titman (2011).

2Zhang's(2005) economy is characterized by one type of capital and no time variation in economic uncertainty.

Financial Review.2019;54:739–762. wileyonlinelibrary.com/journal/fire c

2019 The Eastern Finance Association 739

740 AHN

volatility can generatea notably positive value spread in a production economy with rational expectations. The magni-

tude of the observed value premium in this new production economy with intangible capital is free from the abnor-

mally asymmetric capital adjustment cost assumption that appears to create a quandary on the investment-based

explanation.

Recent studies have found that the production side of the real economy appears to be heavilydependent on intan-

gible capital. McGrattan and Prescott (2005) estimate that the value of intangible capital in U.S.corporations exceeds

60% of gross domestic product (GDP). Corrado, Hulten, and Sichel (2005) argue that the stock of intangible capital is

as large as that of physical capital. Aside from the exact magnitude of the intangible capital stock, it is safe to saythat

intangible capital is a crucial component of the market price of a firm to the extent that the market price of the firm

measures the value of all its different forms of productive capital (e.g., plants, structures, know-how, employeeexper-

tise, organization capital, etc.). Data also suggest that U.S. firms have steadily increased the stock of intangible capital

over the past 60 years,for example, Hall (2001) and Falato, Kadyrzhanova, and Sim (2013).

Recent literature on fluctuating economic uncertainty emphasizes that the impact of temporary volatility shock

appears to be salient in the production side of the real economy, for example, Bloom (2009) and Arellano, Bai, and

Kehoe(2012). In particular, Bloom (2009) shows that an increase in aggregate volatility is associated with an increase in

the dispersion of firm profit growth, firm stock return, total factor productivity,and GDP forecast. Optimal investment

decision under conditions of fluctuating economic uncertainty, for example, Lucas and Prescott (1971) and Bloom,

Bond, and Van Reenen (2007), is a key driverof the correlation reported in the literature. It turns out that account-

ing for the causal link to asset returns has nonetheless proven far from simple. On both empirical side and theoretical

side, canonical investment-basedasset-pricing models, for example, Cochrane (1991) and Zhang (2005), have difficulty

reconciling the empirical phenomena that economic uncertainty fluctuation and joint uncertainty–cash flow relations

determine stock return properties. Caballero (1991) also argues that the presence of asymmetric adjustment costs

is not sufficient to render a negative relationship between investment and mean-preserving changes in uncertainty.

A jointly dynamic uncertainty-investment structure has therefore become an important objective in the production-

based asset-pricing literature.

The proposed jointly optimal investment dynamics for physical capital and intangible capital under time-varying

volatility serve well to explain the cross-section of stock returns, providing a fresh insight into why physical capital-

intensive value firms require more risk premium than intangible capital-intensive growth firms.3It is costly to adjust

the stock of physical capital at each plant. When the real economy is bad and economic uncertainty is high, firms sit

tight until economic conditions become clearer to avoidreducing the stock of physical capital.4Moreover, idiosyncratic

volatility is higher than aggregate volatility,for example, Campbell, Lettau, Malkiel, and Xu (2001). Hence, a significant

increase in idiosyncratic volatility at each level of disaggregation (i.e., from the macroeconomy to each plant) exacer-

bates the inaction on physical investment at each plant. On the contrary,it is not the case for intangible capital. The

complementarity between already-acquired intangible capital and new intangible investment implies that firms have

an incentive to sustain their intangible investment at a certain levelin order to be productive.5Consequently, the real

option effect is more salient for physical capital investment, leading physicalcapital-intensive value firms to have cash

flows that are more sensitive to the state of the real economy.

I incorporatethis idea into the canonical, investment-based asset-pricing model by assuming the usual law of motion

for physical capital stock but assuming that the stock of intangible capital evolves nonlinearly in a complementary

Cobb–Douglas manner. The standard production-based asset-pricing framework deals with the evolutionof intangi-

ble capital in the same way that physical capital develops over time. Griliches (1979), Hall and Hayashi (1989), and

3In linking the book-to-market ratio and intangible capital, I adopt standard empirical evidenceas given. Lev and Sougiannis (1999, p. 420) show that “low

BM[book-to-market] companies have a large R&D capital, while high BM companies have low R&D investment.” Ai and Kiku (2016, p. 742) also point out that

“highR&D spending and high Tobin's Q, low leverage, and low dividend yields …are characteristicof growth firms.”

4SeeBernanke (1983), McDonald and Siegel (1986), Eberly (1994), and Bloom (2009), for example.

5Intangible capital is embodied into a firm in the form of research and development(R&D), organization capital (Eisfeldt & Papanikolaou, 2013), brandcap-

ital (Belo, Lin, & Vitorino, 2014), customer capital (Gourio & Rudanko, 2014), etc. I find that R&D spending is less noisy than other measures of intangible

investment.I thus use the term R&D as a concrete and representative example for intangible investment.