An empirical analysis of the investment and profitability effects

Asset pricing factors formed on the level of firm investment and profitability have significant ex post explanatory power in the cross-section of stock returns. Whilst asset pricing models incorporating these factors exhibit improved explanatory power in the cross-section of returns, conjecture exists as to what causes the investment and profitability effects. This thesis contains three empirical asset pricing studies that examine the investment and profitability effects, providing tests of the efficacy of these variables. The results presented consider the pervasiveness of these variables as well as examinations of two key theoretical explanations for these anomalies, namely shocks to the discount rate and state variables containing information of the future investment opportunity set. The first empirical chapter examines whether asset pricing models that incorporate investment and profitability factors should be considered ex ante predictors of stock returns. The focus is on the Australian stock market, which is characterised by small, high-investing, and low-profitability firms, a subset of the investment opportunity set that is problematic for US investment and profitability factors. The results in this chapter demonstrate that whilst the investment factor is persistently and pervasively related to Australian stock returns, the profitability factor is not. This result is robust to the asset pricing model chosen, and a battery of robustness tests. The second empirical chapter examines the relationship between discount rates, as proxied by monetary policy, and the returns attributable to portfolios formed on either investment or profitability. Theoretical explanations for the investment and profitability effects suggest that the level of discount rates relative to macroeconomic conditions drive the investment and profitability premia. The results in this chapter indicate that the underlying market state is a significant factor in the relationship between unexpected monetary policy shocks and the returns attributable to portfolios formed on investment and profitability, a result supportive of the theoretical explanations. The third empirical chapter examines whether the returns of regional and global investment and profitability hedge portfolios are explained by return dispersion. The results of this chapter support the assertion that return dispersion explains future investment and profitability hedge portfolio returns across all regional and the global portfolios. The results demonstrate that the explanatory power of return dispersion relates to hedge portfolio returns up to twelve months in the future, indicating that return dispersion may be a proxy for a state variable capturing the varying investment opportunity set.