Investment And The Cross Section Of Equity Returns

When the neoclassical model of investment is serious about investment, it fails to replicate elementary cross-sectional features of equity returns. Without leverage, the model produces a value discount -- i.e. value firms earn lower returns than growth firms. With large enough operating leverage, a value premium emerges, but its magnitude is always smaller than the size premium's. Furthermore, when parameters are set to match key moments of the cross-sectional distribution of investment and the average book-to-market ratio, the value premium is minuscule -- about one order of magnitude smaller than found in the data. This result holds true for different specifications of the stochastic discount factor and does not depend upon the magnitude of capital adjustment costs.