Investment and the Cross-Section of Equity Returns

Since the seminal contribution of Berk, Green, and Naik (Journal of Finance, 1999), we have witnessed a growing interest in rationalizing the observed cross-sectional relation between investment and stock returns. Unfortunately, however, the extant literature falls short of ensuring that the models in use are consistent with stylized facts on firm dynamics long established by the empirical I&O literature. The contribution of this paper is to study the cross-section of returns in a standard neoclassical model of firm dynamics parameterized to match those stylized facts. We start by characterizing the investment process among public firms in the United States, along the lines of what accomplished by Cooper & Haltiwanger (ReStud, 2006) for the universe of manufacturing establishments. Then, we write down a model of industry dynamics along the lines of Hopenhayn (Econometrica, 1992) augmented with aggregate shocks, capital accumulation, and a time-varying discount factor. The parameters are calibrated to ensure that the simulated investment behavior is consistent with our empirical findings. The goal is to quantify the role of investment as a determinant (and predictor) of the cross-sectoral variation in returns.