Woranga Abdul Ghani

Mariam Jawad

THE ASSET GROWTH EFFECT: INSIGHTS FROM

INTERNATIONAL EQUITY MARKET

ARGUMENT:
It has been stated that firms with higher asset growth tend to experience lower stock
returns in international equity market. The effect of asset growth is located in developed
capital markets and where stocks are efficiently priced but is irrelevant to those markets
where there are limits on arbitrage, investor protection and accounting quality. And we
will be later proving that its more due to optimal investor than different forms of
mispricing, which are: over investment, firms market timing behavior in financing
decisions, investors extrapolation bias and corporate earnings management.

AUTHORS:
The following authors present this article:

Akiko Watanabe
Yan Xu
Tong Yao
Tong Yu

Akiko Watanabe: Akiko received her PhD in economics from University of Yale in 2004
and currently working in finance and statistical analysis department of University of
Alberta School of Business. Her research interest is in empirical asset pricing,
international finance and market microstructure.

Yan Xu: He received his PhD from University of South Carolina in 2007. In present, he
is associate professor of finance in University of Hong Kong. His expertise are in
empirical asset pricing, international financial market, financial development and
economic growth.
Tong Yao: Yao received his PhD from Boston College and currently associate of finance
from University of Iowa. His research interests are in mutual funds, investment
management and stock price predictability.
Tong Yu: He also received his PhD from University of South Carolina in 2001. Working
as associate professor of finance in University of Rhode Island. His expertise are in
empirical asset pricing, corporate finance and risk management.

INTRODUCTION:
This article investigates the asset growth effect in international stock market. Article is
divided into two parts: first we inspect the negative relationship between asset growth
and future stock return in financial market of international countries except US. In second
part we use international data to assess the economic causes of asset growth effect. By
evaluating different countries we present two ideas that relate countries asset growth to
their characteristics. First, if asset growth effect is due to mispricing, we expect this effect
to be stronger in countries where stocks are less efficiently priced and in countries where
mispricing is difficult to arbitrage away. Further, if managerial empire-building, capital
structure market timing, or accounting manipulation is behind the asset growth
irregularity, one would expect this effect to be weaker in countries with stronger
corporate governance, better investor protection, and less room for accounting
manipulation. Second, if the asset growth effect is motivated by optimal corporate

investment decisions, we expect stronger effectin countries where stocks are more
efficiently priced. Based on these thoughts, we present three hypotheses and examine
them.

OPTIMAL INVESTMENT EFFECTS:

We explain the optimal investment effect with the help of the model of Li and Zhang
called Q-theory. With the help of which we can find a firms cash flow, which is:
Ri =

+1

/ 1 + i(I/Ki0)

is the capital depreciation rate.

is the marginal productivity of capital.
i indicates a higher degree of investment friction.

Ii0/Ki0 is the observed investment of a firm.

Where Ri is the discount rate or the expected return.

In the above equation the left-hand-side is the cost of capital, whereas the right-hand-side
is the marginal investment return. Based on this equation it is stated that the optimal level
of investment is reached when the cost of capital equals the marginal return on
investment.

TWO INVESTMENT EFFECT MOTIVATED BY Q-THEORY:

DISCOUNT RATE CHANNEL:
Though we are not talking about the profitability of a firm, discount rate channel says that
if we take profitability () and depreciation rate () constant, in a result of which firms
with larger observed investments (Ii0/Ki0) have lower discount rates Ri. Henceforth, a

negative cross-sectional relation between investment and stock return arises.

CASHFLOW CHANNEL:
Cash flow channel suggests a situation when our asset is grows but the profitability
becomes a decreasing function of investment. So, if the profitability decreases in the lefthand-side, the right-hand-side expected return also decreases with it.
In conclusion, expected return has direct relationship with profitability and depreciation
rate but inverse relationship with the factors in denominator.

MISPRICING BASED EXPLANATION:

OVER-INVESTMENT:
Due to less information about the agency problems of over investment corporate
managers invest in projects of negative net present value. Which in a result reduces the
value of a firm and over-value a firm with large investment (large potential cash flow).
Thus, the low return due to large investment reflects a negative relationship of asset
growth with future stock returns.
FIRMS MARKET TIMING BEHAVIOR IN FINANCING DECISION:
As firms have wellinformation of their values, theytake advantage of situations
andpromotetheir equity when their stocks are over-priced and buy back shares when their
stocks are under-valued. If investors become careless when they value their stocks, result
in negative relation between corporate financing and subsequent stock returns.
CORPORATE EARNINGS MANAGEMENT:

With the act of rising external financing, firms sometimes manipulate reported corporate
earnings upward in order to get satisfactory market valuation. Even though asset growth
has no causal effect on future returns, earnings management creates a coexistent
association between asset growth and over-valuation, resulting in negative relation
between asset growth and stock returns.
INVESTORS EXTRAPOLATION BIAS:
Sometimes investors extremely estimate from firms past growth when they value stocks.
Such excessive extrapolation gives rise to overvaluation of firms with high past growth
and their low future returns.

TESTABLE HYPOTHESES:
Following hypotheses are to empirically validate every aspect of the above-mentioned
explanations. Now we attempt few predictions that can be test using international level
data.
Hypothesis 1:
The first hypothesis talks about the relation between market efficiency and the asset
growth effect.Under the optimal investment explanation, the asset growth effect is
stronger in stock markets that are more informational efficient. Under the mispricingbased explanation, the asset growth effect is weaker in markets that are more
informational efficient.
Hypothesis 2:

The second hypothesis is about the effect of limits to arbitrage. Under the mispricingbased explanation, the asset growth effect is stronger in markets with severer limits to
arbitrage.
Hypothesis 3:
The third hypothesis we investigate is directly related to the potential causes of the asset
growth effect under the mispricing explanation. Under the mispricing-based explanation,
the asset growth effect is stronger in markets with less investor protection, weaker
corporate governance mechanism, poorer accounting quality, and more prevalence of
earnings management.

International Evidence on the Asset Growth Effect:

According to the article the international evidence shows 54 countries markets which
provides the summary statistics including the U.S. The sample covers many countries
from different regions. But in this table we only chose the countries that have the highest
observations and market capitalization. Which U.S represents the largest part of overall
sample which have 41% of the total market capitalization and 24% of the total firm year
observation. Japan and the United Kingdom have the second and third largest market
capitalization and firm year observation. The last two columns of table are the Median
and Standard deviation of the asset growth rates.

Table 1:

Countries
United State
Japan
UK
France
Germany
Brazil
Canada
China

Firm
Year Obs
69307
42333
24557
10775
9216
4658
11666
10818

Total of other 47
Countries
108395
All
291725
All
Excluding
U.S.
222418

No.
of
% of total Firms
Obs
per year
23.75
2475
14.51
1512
8.41
877
3.69
385
3.16
329
1.6
291
4
417
3.71
601

%of
total
Firm
21.58
13.18
7.65
3.36
2.87
2.54
3.63
5.24

Total
mkt
Value
6234398
212823
1092150
680754
499159
304985
362691
408681

%
of
total
mkt
value
40.85
13.95
7.16
4.46
3.27
2
2.38
2.68

Asset
Growth
MD
(%)
7.8
2.36
8.22
7.27
4.47
8.76
8.46
9.36

Asset
Growth
SD (%)
51.73
16.91
57.9
47.27
62.73
123.58
62.38
39.22

37.17
100

4583
11470

39.95
100

5467095
15262736

23.25
100

-48.76
7.94

415.32
46.4

76.24

8990

78.42

9028338

59.15

7.94

46.3

Asset Growth and Stock Returns:

According to the article there are two measures that are used to quantify the magnitude of
the asset growth effect into each country.
1- The return spread of sorted portfolios
2- Derived from univariate predictive regressions and to ensure this we measure
SPREAD and SLOPE based on two things which is Equal-Weighting and ValueWeighting.
SPREAD: spread is the difference between the bid and ask price of a security or asset.
SLOPE: slope is negative one times the coefficient of regressing USD-denominated
annual stock returns onto asset growth rates across all stocks.
In this table according to the article positive value of slope means a negative relation

between asset growth and stock returns and in this table all the slope value is a positive
number. So it proves that in all over the world asset growth and stock returns have
negative relationship. The weights for the value-weighting spread and slope are based on
the market capitalization of individual stock.

Table 2:
Equal-Weighted
SPREA tSLOP
D
Stat E
(3.8
2)

Restricted
Sample

43 Countries
6.1

Whole Sample

Global
Global
Excluding
U.S.
Country
Neutral
C NE ex
U.S.
54 Countries
Global
Global
U.S.

6.18

6.43
3.55
3.5

ex
6.07

(3.7
9)
(3.9
4)
(3.5
0)
(4.1
2)
(3.7
9)

3.95
4.44
3.38
3.42

3.94
4.38

tStat

Value-Weighted
SPREA tSLOP
D
Stat E

tStat

(2.3
2)

4.17

(1.9
0)

(2.74
)

(3.1
7)
(2.8
2)
(2.8
5)
(2.4
6)
(3.1
3)

4.04
3.77
3.81

4.07
4.32

(1.7
1)
(2.2
2)
(2.2
4)
(1.8
6)
(1.7
4)

4.11
4.39
5.34
5.53

6.23
5.74

(2.31
)
(1.84
)
(1.78
)
(2.83
)
(2.21
)

Note: This table shows the asset growth effect at the global level using a global-pooling
approach and a country-neutral approach.

Asset Growth Effect in China:

In this case we chose China which is also one of the nine stock markets in the Asian
Pacific-Basin region (PACAP) and China is one of the most rapid growing economies.
According to the evidence from the Pacific-Basin Markets article the annualized stock

return spreads between the top and bottom stock deciles sorted on total asset growth
rateis -8.64%. The Average stock price is 3.95$ which has the highest turnover of 375%
over the period of 1994 until 2004. Based on the international evidence of the article,
China has the total observation of 3.71% and market capitalization of 2.68%. This article
also argues about the asset growth affect stock returns which shows that they have
negative relationship in China.

Conclusion:
We proved that there is a negative relation between Asset Growth and Future Stock
Returns. As Cooper, Gulen and Schill (2008) proved that,U.S. firms with lower asset
Growth rates tend to have higher subsequent stock returns. We also proved it based on
Market Mispricing and Optimal Investment.

References:
I.

Watanabe, Akiko, Yan Xu, Tong Yao and Tong Yu, 2013, The asset growth effect:
Insights from international equity markets, Journal of Financial Economics 108,
529563.

II.

Chen, Shaw, Tong Yao, Tong Yu, Ting Zhang, 2008, Asset growth and stock
returns: evidence from the Pacific-Basin Markets.