Investment and the Term Structure of Stock Returns

Sandra Mortal, Michael J. Schill
2013 Social Science Research Network  
In this paper we explore the momentum and reversal regularity in the term structure of stock returns. We show that these patterns in stock returns depend highly on leads and lags in firm investment such that there is no residual momentum or reversal effect in stock returns independent of that associated with firm investment. Our results also provide an explanation for the delay in momentum effects observed by Novy-Marx (2012). We propose new explanations consistent with our findings for the
more » ... e literature on the momentum and reversals regularities. We thank seminar participants at the University of Memphis and the University of Virginia for helpful comments. Schill acknowledges the financial support of the Darden Foundation. investors. The observation that abnormal investment is followed by return reversal is not completely new. An expanding body of research explores the asset pricing implications of changes in firm asset levels. 3 momentum and reversal pattern emerges in the following manner. Suppose a firm experiences a positive exogenous return shock. This shock facilitates asset expansion as the positive wealth effects facilitate an empire-building management to maximize their own utility. Investors respond to the asset expansion by initially bidding up firm stock as investments are undertaken but later bidding down the securities as the magnitude of nonvalue creating empire building is revealed. 8 The associated pattern is thus that high returns are followed by high returns (as managers invest) and later by low returns (as the empire-building nature of the investment is revealed). The same is true of poor returns as poor returns are associated with subsequent poor returns (as firm investment is constrained) and later followed by high returns (as investors correct their reaction to the underinvestment). An investment-based explanation provides some consistency with the more complex, Novy-Marx delayed structure of momentum due to the friction in time associated with firm investment. One ongoing question in the literature is whether both the momentum and reversal regularities are jointly determined and by what means they are determined. Our findings are consistent with a joint determination of the term structure. In our tests we use a cross-sectional regression framework to show a very strong relation between investment and past stock returns, as well as between stock returns and Variously referred to as an "investment effect" and tied to capital investment activity or an "asset growth effect" and tied more broadly to changes in total assets, the underlying empirical regularity is a negative correlation between growth in assets and subsequent returns. Representative papers include Fairfield,
doi:10.2139/ssrn.2348316 fatcat:b6cy4ip35vfrljn2brvfs435cq