Vito D. Gala

Investment and Returns

A general equilibrium production economy with heterogeneous firms and irreversible investment generates the value premium. Investment irreversibility prevents unprofitable value firms from optimally scaling down their capital stock. In contrast, profitable and fast growing - growth - firms can optimally use investment to provide consumption insurance. Value firms are riskier and have higher expected returns than growth firms, especially in bad times when consumption volatility is high. The value premium is larger for small stocks as small value firms are more severely affected by irreversibility. Firms’ investment and capital predict the cross-section of stock returns much like book-to-market and market equity both in the model and data. The model can replicate the failure of the unconditional CAPM. Multifactor models, including the Fama and French (1993) factor model, and to a lesser extent, conditional versions of the CAPM, outperform the unconditional CAPM.

Investment without Q

We estimate investment policy functions under general assumptions about technology and markets. Policy functions are easy to estimate and summarize the key predictions of any dynamic investment model. Because our method does not rely on Tobins Q, it does not require information about market values and can be readily applied to study private firms. In addition, unlike Tobins Q, we show that investment policy functions account for a large fraction of the variation in corporate investment. As such they are much better suited to evaluate and estimate dynamic investment models. Using this superior characterization of firm investment behaviour we then use indirect inference methods to estimate deep parameters of a structural model of investment featuring decreasing returns to scale and generalized adjustment cost functions.

Public Information and Inefficient Investment

In a general equilibrium economy with uninsurable aggregate liquidity shocks, we show that public information may trigger allocative inefficiency and liquidity crises. Entrepreneurs do not internalize the negative impact of their investment decisions on the equilibrium risk of liquidity shortage. A more informative public signal decreases the risk of a liquidity shock, but increases the risk of capital rationing conditional on a liquidity shock. In equilibrium, information quality has a non-monotonic effect on expected returns on investment and social welfare. An increase in the quality of public information has redistributive effects on welfare as entrepreneurs gain and financiers lose. Investment restrictions and targeted disclosure of information achieve constrained efficiency as competitive market equilibrium.

Executive Summary: Investment Strategy

Frederico Belo, Jun Li and Vito Gala. Government Spending, Political Cycles and the Cross Section of Stock Returns. Journal of Financial Economics (forthcoming).