Capital to Labor Growth Ratio and the Cross-Section of Stock Returns
2016 Northern Finance Association Annual Meetings, Mont Tremblant, Quebec, Canada
The 11th Conference on Asia-Pacific Financial Markets (CAFM), Seoul, Korea
2014 Jerusalem Finance Conference - In honor of Professor Dan Galai and Professor Itzhak Venezia
59 Pages Posted: 6 Oct 2015 Last revised: 28 Nov 2016
Date Written: November 28, 2016
Abstract
We examine the cross-sectional relation between the ratio of log growth in physical capital to log growth in labor and subsequent stock returns. The ratio is a negative predictor of abnormal returns and the relation strengthens with measures of financing constraint while remaining robust to previously provided determinants of returns. A ratio-based 2-factor model outperforms common asset pricing models explaining various anomalies indicating that anomalies reflect cross-sectional variation in growth ratio. We interpret the findings as outcomes reflecting displacements on the production isoquant, and show the pattern in returns is consistent with an investment-based model in which firms face financing constraints.
Keywords: Cross-section of stock returns, asset pricing, corporate investments, growth options, production technology, substitutability of labor for physical capital, factors of production, operating risk, stock return and risk, financial constraints, production flexibility
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