q-Factors and Investment CAPM

The new paper by Lu Zhang with that title strikes me as potentially important, though I am just starting to grasp the main argument.  So far I understand it as such.  The great weakness of finance theory has been that it assumes asset pricing and the production side of the economy, and production adjustments, are entirely separable. But maybe they are not, and in a way that matters for asset pricing anomalies.

Let’s say that an asset price rises too high, above its fundamental value.  The old story was that arbitrageurs sell short and force the price back down.  The new story is that investment (sometimes) pours into the overpriced firm, increasing the number of shares and thereby pushing the price of those shares back down.  (The opposite may hold for underpricing.)

But sometimes the new investment does not pour in, the overpricing remains, and that can give rise to eventual asset pricing anomalies.  Such anomalies in fact arise from imperfections on the investment side, and that explains why asset price anomalies a) tend to cluster around stocks of a common kind in common sectors, and b) do not last forever, because the investment inflexibilities are not forever either.  In any case, the Q-factor approach, unlike consumption CAPM, explains where the anomalies come from (and why they might end).  Consumption CAPM is sadly quite deficient when it comes to explaining cross-sectional variation in returns across stocks.

Most generally, this “investment CAPM” theory is pricing assets from the perspective of their suppliers — firms — rather than their demanders.  Doesn’t this sentence make some sense to you?: “Tim Cook most likely has more impact on Apple Inc.’s market value via his operating, investing, and financing decisions than many Apple Inc. shareholders like me via portfolio decisions in their retirement accounts.”

You will note that when expected investment is high/strong relative to current investment, the model predicts “momentum and Roe premiums.”

I still don’t understand most of this!  And apologies to the author for any misstatements.  In any case I am intrigued.  Here are further papers by Zhang on this topic.


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