Optimal Investment, Growth Options, and Security Returns

As a consequence of optimal investment choices, a firm’s assets and growth options change in predictable ways. Using a dynamic model, we show that this imparts predictability to changes in a firm’s systematic risk, and its expected return. Simulations show that the model simultaneously reproduces: ~i! the time-series relation between the book-to-market ratio and asset returns; ~ii! the cross-sectional relation between book-to-market, market value, and return; ~iii! contrarian effects at short horizons; ~iv! momentum effects at longer horizons; and ~v! the inverse relation between interest rates and the market risk premium. RECENT EMPIRICAL RESEARCH IN FINANCE has focused on regularities in the cross section of expected returns that appear anomalous relative to traditional models. Stock returns are related to book-to-market, and market value.1 Past returns have also been shown to predict relative performance, through the documented success of contrarian and momentum strategies.2 Existing explanations for these results are that they are due to behavioral biases or risk premia for omitted state variables.3 These competing explanations are difficult to evaluate without models that explicitly tie the characteristics of interest to risks and risk premia. For example, with respect to book-to-market, Lakonishok et al. ~1994! argue: “The point here is simple: although the returns to the B0M strategy are impressive, B0M is not a ‘clean’ variable uniquely associated with eco* Berk is at the University of California, Berkeley, and NBER; Green is at Carnegie Mellon University; and Naik is with the University of British Columbia. We acknowledge the research assistance of Robert Mitchell and Dave Peterson. We have benefited from and are grateful for comments by seminar participants at Berkeley, British Columbia, Carnegie Mellon, Dartmouth, Duke, Michigan, Minnesota, North Carolina, Northwestern, Rochester, Utah, Washington at St. Louis, Washington, Wharton, Wisconsin, Yale, the 1996 meetings of the Western Finance Association, and the 1997 Utah Winter Finance Conference and the suggestions from an anonymous referee and from the editor, René Stulz. We also acknowledge financial support for this research from the Social Sciences and Humanities Research Council of Canada and the Bureau of Asset Management at University of British Columbia. The computer programs used in this paper are available on this journal’s web page: http:00www.afajof.org 1 See Fama and French ~1992! for summary evidence. 2 See Conrad and Kaul ~1998! for a recent summary of evidence on this subject. 3 See Lakonishok, Shleifer, and Vishny ~1994! for arguments in favor of behavioral biases and Fama and French ~1993! for an interpretation in terms of state variable risks. THE JOURNAL OF FINANCE • VOL. LIV, NO. 5 • OCTOBER 1999