Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks

We provide a unified explanation for several apparent anomalies in the cross-section of asset returns, namely the failure of the CAPM to account for the cross-sectional relation between average stock returns and firm valuation ratios, past investment, profitability, market beta, or idiosyncratic volatility. Using a calibrated structural model, we argue that these characteristics are imperfect proxies for the share of growth opportunities to firm value, which determines firms’ exposures to capital-embodied shocks, and risk premia. Return differences among firms sorted on the above characteristics are largely driven by the same systematic factor related to embodied technology shocks. ∗MIT Sloan School of Management and NBER, [email protected] †Kellogg School of Management and NBER, [email protected]