What Explains the Investment Growth Anomaly?

An Empirical Evidence from PSX

SUBMITTED BY:
Muhammad Amin
(1735237)

Supervised by:
Sir Imran Omer Chapra

Submitted to:
Shaheed Zulfikar Ali Bhutto Institute of Science and
Technology

Fall 2018
 1.0 INTRODUCTION

In capital markets it is understood that different asset classes provide different returns to

investors, but this principal question always exist that why is it so? The answer to this

question lies in many of the concepts in finance and investment and one of the reason

among them is “asset pricing”. Asset pricing models helps us to find that why the average

returns of different assets or securities vary. At the same time, all these assets pricing

models based on the rule that the return is a compensation of a systematic risk which

investors take by investing in securities, for instance, Sharpe (1964), Markowitz’s mean

variance analysis (1952) and “Capital Asset Pricing Model (CAPM)” proposed by Lintner

(1965). All these models assume that market (systematic) risk is the only factor which has

an impact on expected returns. The basic motive of investors is to get the high average

return and for that purpose they try to find the factors and reasons in the firms which can

give them a strengthened link or proves that the firm will give higher average returns. For

this purpose, they develop different asset pricing models and valuations through which

those factors or variables can be identified.

In continuation to fair valuations and asset pricing models, technically, investors capitalize

the transactions been done by the firm into valuation like acquiring and dispose of assets.

Many researchers have been working on this and trying to link the company’s

characteristics in the form of factors with various finance based valuation techniques and

ratios like cross sectional returns, market to book ratio, discounted cash flows, price

earnings etc. At the same time, when empirical studies showed and proved that the CAPM
cannot define the average cross sectional returns completely, many researchers started

finding different patterns in cross sectional average returns and called them “Anomalies”.

For this particular anomaly which focuses on the average expected returns, researchers call

it “Investment growth or asset growth anomaly”.

The more simplest way of understanding this is, risk-return trade off or asset pricing theory

which says that, higher the risk higher the returns. Those companies which are expanding

rapidly through raising funds or making investments are taking higher uncertainty for

future depicting higher risk, means they should make higher returns. But empirical studies

provided and still providing contrary results, which is known as “Investment or Asset

growth anomaly”

1.1 What is Investment Growth Anomaly?

As per Xing (2008), “Investment or Asset growth anomaly” are the difference and changes

in stock returns of the companies which have high investment and companies which have

low investment as attributed by Fama and French (1993)’s one of the three factors i.e “value

factor (HML)”. He stated in his study that the portfolio of companies which have less

investment growth provide higher returns and portfolio of companies which have high

investment growth tend to give lower returns in comparison. Equation as per Xing (2008)

of IGR is stated as:

𝐼𝐺𝑅𝑡 = 𝐶𝐴𝑃𝐸𝑋𝐺𝑅𝑡−2 − 𝐶𝐴𝑃𝐸𝑋𝐺𝑅𝑡−1

Whereas,

IGR = Investment Growth Rate

CAPEXGR = Capital Expenditure Growth Rate

Asset growth anomaly is define as the negative correlation between expected average

returns and corporate investment or the firms asset growth. This states that, the firms with

low investment growth rates tend to give higher returns and those firms which have high

investment growth rate will likely to provide lesser returns. In other words, the firms which

are doing capital expenditure and asset expansions will provide less or negative returns.

1.2 Research Background:

Nicholas Kaldar (1966) developed the “Tobin’s Q theory” or ratio between market value

of assets and its replacement value. In other words, the ratios, which this theory has

developed, were “market to book ratio” and inversely “book to market ratio”. By using this

theory or ratio and introducing other variables and factors, researchers started studying the

topic of “Investment growth” or “Asset growth” with respect to expected returns and later

called it anomaly when the empirical evidences came into existence.

After getting the motivation from “Q theory”, Fama and French (1993) developed the three

factor model with the help of extending Lintner (1965) “Capital Asset Pricing Model” and

also indulging the “Q ratio” into it and tried to find the relationship with expected returns.

The three factors were: a) systematic risk (defined by CAPM) b) SMB and c) HML. Fama

and French (1993) hypothesized that two types of stocks likely to perform better as

compare to market. These two were, “small caps” and “Companies with high book to

market ratio (named them value stocks)”. Wherein, the two new variables were “Small

minus Big – market capitalization (SMB)” and “High minus Low – book to market ratio

(HML)”. They explained 90% of the returns of different diversified portfolios and

succeeded to develop the positive empirical evidence between “small size” and “value

factors” (initially defined in 1.0 & 1.1). Later on, different researchers continued to study
this “investment growth anomaly” topic using different methods and techniques, data

(markets and geographical location), analytical tools etc.

1.3 Research Aim and Objective:

 This research is concentrating to find the existence and characteristics of the

“Asset/Investment growth anomaly” in the Pakistani stock market.

 What are the explanation factors describing this anomaly?

 This study focusing the impact on asset pricing of investment or asset growth with

expected average cross sectional returns in the equity market.

 This investigation would probably be the first to find out the asset growth anomaly

in one of the emerging market of Asia i.e “Pakistan stock exchange”.

1.4 Rationale of the study:

The reasons for this research is to develop and test the anomaly that value companies tend

to give higher returns than growth companies and those firms which have less capital

expenditure or asset growth gives higher expected average returns. Furthermore, what are

the factors that best describes this anomaly on different market cap companies or portfolios

of assets? The study tries to find those variables under the circumstances of the anomaly

that affects the returns in PSX, so that the investors can analyze the company based on the

explained factors if relationship is developed.

1.5 Research Significance:

This research signifies about how the change in different components of the balance sheet

of the firms can have an impact on the valuation and return of the firm. Under the

boundaries of investment growth anomaly, this study tests the change of different ratios
and factors on the asset pricing of different size of companies, which can help investors to

segregate the companies with their homogenous characteristics and expected future returns.

Investors can also get the insight of future expected returns by checking out the explained

characteristics and comparing them with actual and inverse scenarios and through different

valuations and ratios.

References:
Fama, Eugene, and Kenneth French, 1993, Common risk factors in returns on stocks and
bonds, Journal of Financial Economics, Vol.33, 3–4.

Li, Q., M. Vassalou, and Y. Xing. 2006, An Investment-Growth Asset Pricing Model,
Journal of Business, Vol.79(3), 63-65.

Tobin, J. 1969. A General Equilibrium Approach to Monetary Theory. Journal of Money

Credit and Banking, 5-7.

Lintner, J. (1965), "The valuation of risk assets and the selection of risky investments in
stock portfolios and capital budgets", Review of Economics and Statistics, Vol.47, 13-15.

Markowitz, H (1952), “ Portfolio Selection” The journal of finance, Vol.7, 77-78.