Does Q-Theory with Investment Frictions Explain Anomalies in the Cross-Section of Returns?

Abstract

Q-theory predicts that investment frictions steepen the relation between expected returns and firm investment. Using financing constraints to proxy for investment frictions, we document only weak evidence that the investment-to-assets and asset growth effects in the cross-section of returns are stronger in financially more constrained firms than in financially less constrained firms. There is no evidence that q-theory with investment frictions explains the investment growth, net stock issues, abnormal corporate investment, or net operating assets anomalies. Limits-to-arbitrage proxies dominate q-theory with investment frictions in explaining the magnitude of the investment-to-assets and asset growth anomalies in direct comparisons.

Keywords: q-theory, investment frictions, asset pricing anomalies, limits to arbitrage

JEL Classification: E22, E44, G12, G14, G31, G32