Labor Intensity , Risk , and Return ∗

I analyze the relationship between labor intensity – the wages to revenue ratio – and a firm’s risk and book-to-market ratio in a production model. Under plausible parameters, labor intensive firms are riskier and exhibit higher book-to-market ratios than capital intensive firms. Covariance with the stochastic discount factor grows with labor intensity so the return spread between labor and capital intensive firms should explain the cross-section of stock returns. I provide evidence that labor intensive firms do appear riskier than capital intensive firms and that the spread between labor and capital intensive firms helps explain the cross-section of stock returns. ∗The financial support of The Dean Witter Foundation and the White Foundation is gratefully acknowledged. I would like to thank Jonathan Berk, Pierre Collin-Dufrense, Greg Duffee, Thomas Gilbert, Jacob Sagi, Adam Szeidl and seminar participants at Vanderbilt University for insightful conversations and suggestions. Any errors remain my own. †Owen Graduate School of Management, Vanderbilt University. Email: [email protected]. Phone: +1(615)322-8059. Address: 401 21 Avenue South, Nashville, TN, 37203 (USA). http://owen.vanderbilt.edu/palacios