The expected investment growth premium

• Published date: 01 December 2021
• Author: Jun Li,Huijun Wang,Jianfeng Yu
• Date: 01 December 2021
• DOI: http://doi.org/10.1111/fima.12340

DOI: 10.1111/fima.12340

ORIGINAL ARTICLE

The expected investment growth premium

Jun Li1Huijun Wang2,3Jianfeng Yu4

1Department of Finance and Managerial

Economics, University of Texasat Dallas,

Richardson, Texas,USA

2Harbert College of Business, Auburn

University, Auburn, Alabama, USA

3Department of Finance, Faculty of Business

and Economics, University of Melbourne,

Melbourne, Australia

4PBCSF, TsinghuaUniversity, Haidian District,

Beijing, China

Correspondence

JianfengYu, PBCSF,Tsinghua University,

HaidianDistrict, Beijing, China, 100083.

Email:yujf@pbcsf.tsinghua.edu.cn

Abstract

We propose a novel measure of investment plans, namely

expected investmentgrowth (EIG), and find stocks with high

EIG outperform stocks with low EIG by 17% per annum. This

premium can be generated in a neoclassical model with the

investment plan friction, in which a firm’s expected returns

increases with its planned investment due to an embedded

leverage effect. We provideempirical evidence on the inter-

action of the cash flow effect and discount rate effect in driv-

ing this EIG premium. Our findings highlight the investment

plan friction as an important economic channel to under-

stand the cross-sectional risk premium.

1INTRODUCTION

Investment plans, that is, investment lags between the investment decision and the actual capital expenditure,have

been shown to be important in understanding economic fluctuations and the stock market.Cochrane (1991)andLam-

ont (2000) argue that the friction of investment plans can help to explain the weak empirical correlation between

aggregate investment and future stock returns, a finding that is inconsistent with the q-theory of investment. In the

presence of this friction, firms initiate larger investment plans following a negative shock to the discount rate,but the

actual capital expenditureonly materializes with a lag. Therefore, it should be the investment plan rather than the real-

ized investment that negativelypredicts market returns. While it is tempting to extend this discount rate argument to

the cross section and predict a lower expected return for firms with larger investment plans, this prediction fails to

take into account the important role of cash flow news at the firm level (e.g.,Vuolteenaho, 2002). In a firm’s optimiza-

tion problem, stock returns, investment decisions, and risk premium are all endogenous in response to firm-specific

cash flow news.

In this paper,we examine the relation between investment plans and stock returns in the cross section. Since firm-

level investmentplans are unobservable, we propose a novel measure, namely the expected investment growth (EIG),

byprojecting the firm-level investment growth onto prior stock returns, Tobin’sq, and cash flows that have been shown

© 2021 Financial Management Association International

Financial Management. 2021;50:905–933. wileyonlinelibrary.com/journal/fima 905

906 LI ET AL.

to predict future investment (e.g., Barro, 1990; Morck et al., 1990; Fazzari et al., 1988)1and constructing EIG as the

out-of-sample predicted investment growth. We compare EIG to the future realized investment growth to validate

it as a measure for investment plans. In the EIG decile portfolios, the difference in the average realized investment

growth between high and low EIG firms is quantitatively comparable to the spread of EIG itself, with EIG explaining

more than 80% of the cross-sectional variation in the future investment growth. Beyond the EIG deciles, our invest-

ment plan measure also captures the investment behavior of a much broader set of portfolios, including portfolios

sorted by size, book-to-marketratio, momentum, as well as industry classification.

Using this investment plan measure, we find that high EIG firms earn higher future returns than low EIG firms, in

contrast to the negative relation between investment plans and stock returns at the aggregate level.In the U.S. sam-

ple between August 1972 and December 2016, a long–short portfolio based on EIG generates an annualized return

of 17% that cannot be captured by leading asset pricing factor models, including the more recent Fama and French

(2015) five-factor model. The EIG premium persists in Fama–MacBeth regressions and alternative sample selections.

More importantly, the return predictive power of EIG is beyond that of the constituents of EIG. When we directly

project the EIG premium on the premiums associated with momentum, q, and cash flow, the abnormal return remains

highly significant. Further,when we construct the expected sales growth and expected gross profit growth following

the same procedure as we construct EIG, the corresponding expectedsales growth premium and expected gross profit

growth premium are substantially weaker than the EIG premium. These results together highlight the distinct role of

investment and suggest that the investment plan friction is an important economic channel for how variables such as

momentum, q, and cash flow are associated with the cross-sectional risk premium.

Tobetter understand the EIG premium, we develop a neoclassical model with the investment plan friction. In the

model, firms are endowed with one asset-in-place and an option to expandits production capacity. A key assumption is

thattheassetexpansion needs to be planned ahead and is costly to reverse, which is consistent with previous empirical

findings that firms rarely cancel planned projects.2We show that the existence of this investment friction creates a

leverage effect that makes the value of planned investment more sensitive to the economic condition than that of

existing assets. In the cross section, firms with positive idiosyncratic productivity shocks initiate larger investment

plans because of the positive cash flow effect. Meanwhile, the planned investment also raises the discount ratefrom

the embedded leverage. The interaction of the endogenous cash flow effect and discount rate effect gives rise to a

positive cross-sectional relation between investmentplans and the risk premium.

Weprovide empirical evidence for the economic mechanism in the neoclassical model. First, compared to firms with

low EIG, high EIG firms havehigher future sales growth and gross profits growth several years into the future, indicat-

ing a strong incentive for these firms to expand their production capacity.Second, in addition to this cash flow effect,

theplanned investment also increases the risk premium, and we find that higher EIG is associated with higher cash flow

sensitivity to the economic growth. Furthermore,investment is sizable compared with operating income, and the elas-

ticity of cash flow (operating income minus investment)to operating income increases monotonically with EIG. These

results suggest that the planned investment creates a leverage effect that makeshigh EIG firms riskier than low EIG

firms. Third, the cross-sectional heterogeneity in risk exposures across EIG portfolios also appears in stock returns.

A linear factor model with the market factor and economic growth (measured by industrial production growth, gross

domestic product growth, or aggregate consumption growth) as the risk factors can well explain the averagereturns

of EIG portfolios. Lastly, we find that the EIG premium is substantially larger in industries with greater investment

irreversibility and longer project durations, consistent with the important role of the investment plan friction in our

neoclassical model.

1Corporate investmentplans have many important aspects, such as the selection of investment projects, the determination of project locations, durations,

and starting time, the hiring decision, as well as the allocation of funds among different projects. Throughout this paper,we follow Lamont (2000)andfocus

onthe overall capital expenditure and define a firm’s investment plan as the planned growth rate of investment in the subsequent year.

2Thereis considerable evidence that investment is to a large extent irreversible at the plant and firm level;see, for example, Caballero et al. (1995), Doms and

Dunne(1998), and Ramey and Shapiro (2001).