Expected Investment Growth and the Cross Section of Stock Returns

Abstract

Expected investment growth (EIG) is a strong predictor for cross-sectional stock returns. Between July 1953 and December 2015 in the US, an investment strategy that takes a long position in firms with high EIG and a short position in firms with low EIG generates an average annual return of more than 20%, with a Sharpe ratio of 1.01. This return predictability holds both in subperiods and in different subsamples of firms, as well as in all other G7 countries. Leading empirical factor models including CAPM, Fama-French three-factor model, Carhart four-factor model, and the recent Hou, Xue, and Zhang four-factor model and Fama and French five-factor model all fail to fully capture the profitability of this investment strategy. Further analyses suggest that EIG is closely related to financial distress risk, especially at a short horizon up to one year, and is a better predictor of stock returns than failure probability from Campbell, Hilscher, and Szilagyi (2008). We provide supporting evidence for both risk-based explanation and behavioral explanation for this large EIG premium.