[Empirical Finance Research Blog] The Asset Growth Effect in Stock Returns: 9/10
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Wesley R. Gray
May 25, 2009, 7:54:54 PM5/25/09
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Investment Potential Rating: 9/10 (1 worst, 10 best)
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The Asset Growth Effect in Stock Returns
Michael J. Cooper
University of Utah
Huseyin Gulen
Purdue University
Michael J. Schill
University of Virginia
Working Paper, draft version: January 30, 2009 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1335524
Abstract:
We document a strong negative relationship between the growth of total firm assets and subsequent firm stock returns using a broad sample of U.S. stocks. Over the past 40 years, low asset growth stocks have maintained a return premium of 20% per year over high asset growth stocks. The asset growth return premium begins in January following the measurement year and persists for up to five years. The firm asset growth rate maintains an economically and statistically important ability to forecast returns in both large capitalization and small capitalization stocks. In the cross-section of stock returns, the asset growth rate maintains large explanatory power with respect to other previously documented determinants of the cross-section of returns (i.e., size, prior returns, book-to-market ratios). We conclude that risk-based explanations have some difficulty in explaining such a large and consistent return premium.
Data Source:
The authors exam all non-financial U.S stocks listed on NYSE/AMEX/NASDAQ from 1968 through 2007. To be included in the analysis companies must have stock return data from CRSP and total assets data from Compustat. The authors also require that firms be listed on Compustat for two years to be in the sample.
Data Specification:
Why would low asset growth firms reliably outperform high asset growth firms after adjusting for various risk factors?
My initial thoughts to this question were that high asset growth firms need capital to fund their growth, and firms that need capital quickly become friends with Wall Street investment bankers, who then market the firms they are working for and thus drive their prices to irrational levels. In this world the high asset growth firms (or firms that are most likely to be touted by Wall Street) become overvalued and low asset growth firms being undervalued.
Of course, not everyone is as skeptical of the efficient market hypothesis...
The risk-based arguments suggest that firms with growth options are riskier than firms that have converted their growth options into assets. In this framework it should be the case that firms which are exercising their growth options (i.e. firms that have growing asset bases) are less risky than the firms who are sitting on their growth options and refraining from investment.
The empirical evidence from the 1968-2007 sample suggests there are profit opportunities in low growth firms.
Investment Strategy:
To implement this strategy we recommend you first ditch all your index funds and then set up an automated system to trade this very easy strategy.
The authors form portfolios every June based on the asset growth of the firm in the previous calendar year (they use June to ensure all balance sheet data would have been publicly available). For example, the portfolio formed in June 1970 would be based on the asset growth from December 1969 to December 1970. The authors define asset growth as [Total Assets (t)-Total Assets(t-1)]/ Total Assets (t-1).
Once you have a sort of firms based on asset growth you go long the lowest asset growth firms and go short the highest asset growth firms (the authors break down groups by deciles).
The returns from this strategy are stunning and very Warren Buffetesque (see Table 3):
-Average annual return of 26% for low growth firms, and 4% for high growth firms.
-Plus, in only 4/39 years did the low growth portfolio underperform the high growth firm portfolio.
A "real money" track record like this would put an investor in the upper 1% of investors of all time...
Implementation Issues and Remarks:
The results from this paper are outstanding, however, they are not all that surprising. An analysis of the tables suggests that the returns here are likely driven by exposures to small stocks and value stocks, which we already know outperform over long periods (although to the authors credit in Table 4/6 they show evidence that returns to this strategy go above and beyond size/value/momentum exposures). Even so, the simplicity and remarkable consistency in annual outperformance for this strategy suggest it should be part of any quant's toolbox.
Investment Potential Rating: 9/10
--
Posted By Wesley R. Gray to Empirical Finance Research Blog at 5/25/2009 03:43:00 PM
============
The Asset Growth Effect in Stock Returns
Michael J. Cooper
University of Utah
Huseyin Gulen
Purdue University
Michael J. Schill
University of Virginia
Working Paper, draft version: January 30, 2009 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1335524
Abstract:
We document a strong negative relationship between the growth of total firm assets and subsequent firm stock returns using a broad sample of U.S. stocks. Over the past 40 years, low asset growth stocks have maintained a return premium of 20% per year over high asset growth stocks. The asset growth return premium begins in January following the measurement year and persists for up to five years. The firm asset growth rate maintains an economically and statistically important ability to forecast returns in both large capitalization and small capitalization stocks. In the cross-section of stock returns, the asset growth rate maintains large explanatory power with respect to other previously documented determinants of the cross-section of returns (i.e., size, prior returns, book-to-market ratios). We conclude that risk-based explanations have some difficulty in explaining such a large and consistent return premium.
Data Source:
The authors exam all non-financial U.S stocks listed on NYSE/AMEX/NASDAQ from 1968 through 2007. To be included in the analysis companies must have stock return data from CRSP and total assets data from Compustat. The authors also require that firms be listed on Compustat for two years to be in the sample.
Data Specification:
Why would low asset growth firms reliably outperform high asset growth firms after adjusting for various risk factors?
My initial thoughts to this question were that high asset growth firms need capital to fund their growth, and firms that need capital quickly become friends with Wall Street investment bankers, who then market the firms they are working for and thus drive their prices to irrational levels. In this world the high asset growth firms (or firms that are most likely to be touted by Wall Street) become overvalued and low asset growth firms being undervalued.
Of course, not everyone is as skeptical of the efficient market hypothesis...
The risk-based arguments suggest that firms with growth options are riskier than firms that have converted their growth options into assets. In this framework it should be the case that firms which are exercising their growth options (i.e. firms that have growing asset bases) are less risky than the firms who are sitting on their growth options and refraining from investment.
The empirical evidence from the 1968-2007 sample suggests there are profit opportunities in low growth firms.
Investment Strategy:
To implement this strategy we recommend you first ditch all your index funds and then set up an automated system to trade this very easy strategy.
The authors form portfolios every June based on the asset growth of the firm in the previous calendar year (they use June to ensure all balance sheet data would have been publicly available). For example, the portfolio formed in June 1970 would be based on the asset growth from December 1969 to December 1970. The authors define asset growth as [Total Assets (t)-Total Assets(t-1)]/ Total Assets (t-1).
Once you have a sort of firms based on asset growth you go long the lowest asset growth firms and go short the highest asset growth firms (the authors break down groups by deciles).
The returns from this strategy are stunning and very Warren Buffetesque (see Table 3):
-Average annual return of 26% for low growth firms, and 4% for high growth firms.
-Plus, in only 4/39 years did the low growth portfolio underperform the high growth firm portfolio.
A "real money" track record like this would put an investor in the upper 1% of investors of all time...
Implementation Issues and Remarks:
The results from this paper are outstanding, however, they are not all that surprising. An analysis of the tables suggests that the returns here are likely driven by exposures to small stocks and value stocks, which we already know outperform over long periods (although to the authors credit in Table 4/6 they show evidence that returns to this strategy go above and beyond size/value/momentum exposures). Even so, the simplicity and remarkable consistency in annual outperformance for this strategy suggest it should be part of any quant's toolbox.
Investment Potential Rating: 9/10
--
Posted By Wesley R. Gray to Empirical Finance Research Blog at 5/25/2009 03:43:00 PM
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