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.


"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.'"

Well, Apple's market value fluctuates tick-by-tick, along with shareholders' portfolio decisions. Does Tim Cook change his operating, investing, and financing decisions tick-by-tick? To be fair, investors' assessments and expectations of Tim Cook's operating, investing, and financing decisions could be changing tick-by-tick.

I applaud the author for breaking from convention, convention that may have been accurate at one time but not so much today. More is needed, the more being thinkers like Cowen adding some meat to the bones of the new theory. As to this theory, stock buybacks come to mind and how they inflate stock prices by both augmenting demand for the stock and reducing the number of shares. In international economics, the theory has even greater relevance. Yesterday the president tweeted that the US is on the verge of a breakthrough in trade negotiations pursuant to which the US would cut back on existing tariffs and postpone new tariffs. Some observers have pointed out that the depreciation in China's currency this year offsets the effect of the tariffs. My point is that asset pricing in international trade has the added component of currency pricing, making the task of evaluating asset pricing that much more difficult (opaque). [An aside, my view is that the action today is in asset prices, namely rising asset prices, in particular rising stock prices. The president's tweet caused stock prices around the world to spike, which in turn will affect the prices of goods. Whether the president's tweet about a trade deal with China was intended to inflate the president's ego or to inflate stock prices I will leave to psychologists.] https://www.nytimes.com/2019/12/12/business/economy/trump-china-trade-deal.html

Maybe the arbitrage is occurring in stock prices rather than in the goods the firms produce. In either case, arbitrage reduces price volatility (just as futures markets reduce both quantity and price volatility). Traders in currencies, often maligned, serve the same positive role.

It may be just a fancy and complicated way to say that there are "hot", "trendy" or "fashionable" sectors to invest in and that it changes over time.

An opaque investment strategy inscrutable to even Tyler himself. To whom do we make the checks out to?

It is not a strategy, but an attempted explanation of how assets are priced.

I'm very interested but can't access the underlying paper (or at least it would cost me $5...)

Can someone explain this sentence to me: "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.)"?

It sounds like the mechanism being described is - a firm is over-valued, so it issues shares, which drives down the unit price of shares. But the firm would still be over-valued, no? Like whether Uber has 10 shares at $4B share price or 10B shares at $4 share price doesn't change whether it's over-valued at $40B?

I'm sure I just don't understand so would appreciate clarification if anyone can offer.


“ The new story is that investment (sometimes) pours into the overpriced firm, increasing the number of shares...”

Seems infelicitously phrased. I am guessing what is meant is that dilution is less of a factor for an overpriced firm selling more shares. And it seems like there would be demand for shares in an underpriced firm so selling more shares dilute less.

But it is unclear whether share buyers have equivalent firm valuation information.

Sounds like someone discovered Behavioral Finance.

In a global economy, a domestic firm's goods may have components (intermediate goods) produced anywhere, the finished goods having a value that is difficult to price, although one assumes that the firm imports intermediate goods because they are cheaper and, hence, augment profits. Thus, many firms are mere vessels for distributing finished goods in the domestic market, which derives a high level of profits as a result, the high level of profits at first raising the stock price, which the firm exploits by issuing additional shares which depress the stock price. But the favored technique today by many firms is to buy back shares in order to maintain or increase the stock price, management often benefiting the most from a rising stock price (because their compensation is largely in stock). As for Tim Cook and Apple, he is the executive Jobs hired to build the supply chain in China. It is Cook's talent in building the supply chain that has made Apple the most valued firm in America, it's stock price rising (or at least holding steady) by the firm's use of ample profits to fund stock buybacks. Are Apple's goods overpriced or are they produced more efficiently and thereby generate a higher profit margin when sold at a reasonable (market) price? Again, my main point is how the global economy (and rising inequality that concentrates capital that is invested rather than being consumed) defies much of pricing theory. We aren't in Kansas anymore.

Also in this week’s NBER working papers, John Cochrane’s “Rethinking Production Under Uncertainty” yields a typically clear and accessible discussion of production-side asset valuation.

All assets are created by workers, except those created by government granting authoritarian power to private parties, ie, trademarks, patents, copyrights, etc.

The value of land is created by workers, because lots of land has almost no value in a marketplace. For example, even in California, lots of land is vacant because the amount workers must be paid to be able to use the land is extremely high. Land without transportation access, water and sewer, utility service is of value only because of "free work" done by nature, like producing animals than can be harvested by work for consumption. Many people will buy land to ensure nature can do this free work for the common good. Eg, Ted Turner to bring back the prairie with bison, prairie dogs, wolves, etc., which provide water and air benefits for the common good.

But a firm like GM or Tesla is both the factories, etc, durable goods built by paying workers, or the network of workers with a reputation of standards represented by brands.

The price of GM is low relative to Tesla in the market because investors want more Tesla or more Teslas. Tesla has virtually no power to prevent new substitutes for Tesla being created, just as GM had no power to stop substitutes for GM being built. GM was built by paying workers directly, or paying those who had built substitutes by paying workers, thus creating the almost incoherent set of assets represented by all the brands. Ford and Tesla build most assets by directly paying workers to build them. Ford mostly funds building assets by taking a share of revenue to pay workers instead of paying a return to shareholders. Tesla has largely paid workers by selling new shares, often by selling bonds that can be converted into shares. Thus, Tesla needs to create lots of optimism of future assets producing far more goods producing revenue in excess of the labor costs of the goods. Many others, like GM and Ford tried to increase their share prices without paying workers to build assets by spreading pessimism about any possibility of a non-fossil fuel vehicle substitute for their products, largely because paying workers to build assets is so costly, GM and Ford shareholders believe in government granted monopoly powers to allow products be sold at prices higher than all in labor costs, including factories.

Apple is a brand that exists due to extraordinary work by some workers plus lots of effort to create barriers to producing substitutes. But lots of substitutes for Apple exist, but Apple shares are priced on the optimism Apple workers will create new products with no substitutes. Lots of firms were like Apple: Sears, GM, Ford, Univac, RCA, GE, Magnavox,....

Economists since the 70s have tried to argue for free lunches. "Wealth" created without paying workers, but instead inflating asset prices. Ironically, they argued for "getting government out of the way" which means getting government to grant monopolies to block workers building new assets that will drive down asset prices.

I grew up with government taxing and paying workers to open up ever more land for use, thus destroying the "value" of land and property in the cities. California has plenty of land, but a shortage of land improved by paying workers to build roads, water and sewer, utilities, etc, prior to Prop 13. Ie, a government created monopoly blocking new useful land being created. All in the name of getting government out of the way of building new assets. The demand for detached single family homes is not met by rezoning to allow hundred unit or even four unit appartment buildings. Only by building new roads, water and sewer, etc can the demand for housing in California be met, which is mostly for detached single family homes.

There is a fine line between genius and insanity.

— Oscar Levant

"The new story is that investment (sometimes) pours into the overpriced firm, increasing the number of shares "

Cannot check the paper -- gated -- but this statement just doesn't make sense to me. New investments in the over-priced security, itself, doesn't increase the number of shares so would not be expected to reduce the price.

Is the claim that the over-pricing is a signal of an production limited operations and the new investments are real investment, perhaps a secondary issuance of equity, that allows increased production and then a return to a normal valuation.

If that is the nature of the argument I'm not sure it is really anything new -- seems a bit like the standard excess profits causing increased investments and then a return to normal profit level; though clearly a slightly different mechanism and dynamics that is interesting.

This was my confusion. That sentence from Tyler makes no sense. Shares don't increase just because people want them, and stock splits don't solve the overvaluation since it is not the price per share but total market cap that the paper is concerned about.

It might be an allusion to punters thinking shares are cheaper after a split.

Yeah, would be nice to hear a bit more about the argument on this point. I'm not sure what the q-factors are but perhaps they are modern versions of the old Tobin Q idea or something like that. In any case, I don't see how the dynamics work there unless there is some underlying constrain on firm output/productivity that is relived by some additional financial inputs.

Not sure it that is something of a micro version of the non-neutrality of money or something like that.

I suppose we will hear more...

It is just a mistake. Yes, Tyler makes mistakes and admitted that he did not fully understand the paper. When investment flows into a firm through the stock market, the stock price goes up. The number of shares does not change unless the company coincidentally issues more shares (there is no reason for them to do this unless they need more capital). But the market capitalization, price times number of shares outstanding, does rise.

Very good, great article. Thank you.

I would say, based on this publicly available excerpt, that this is true .. but still an insufficient abandonment of efficient market hypotheses.

In aggregate, markets may look somewhat efficient, and we may hope that "anomalies do not last forever" but there is not and can never be a guarantee that any price "returns to normal" as it were. Nor that efficient prices represent any kind of "normal."

(Efficient-ish as a maximum.)

It is obvious to this human, but perhaps not yet to formal economic theoreticians, that prices move forever from one regime to the next, and it is forever opaque to what degree a price is efficient vs anomaly.

Every price of every thing is forever a composite of shrewd efficiency and wild emotion.

I do recognize that this paper has an interesting look at second order effects of "pricing inefficiencies." Obviously yes, firms either embraced or pummeled by the markets do make decisions shaped by those public opinions. Celebrated firms may get carried away (Apple Watch(*)), and disgraced firms may pull back from good bets.

It's all part of the many ways one pricing regime leads to another.

* - https://sciencebasedmedicine.org/the-apple-heart-study/

That’s a lot of words to say precisely nothing.

Except maybe, “I don’t understand asset pricing theory.”

I understand that asset pricing theory. It's essentially a model for risk in a continuation of a pricing regime. Its practicioners now caution, especially after 2005-2007, that it does not give a heck of a lot of forewarning about changes in pricing regimes.

It works in "normal" times when prices are "efficient-ish" and woe to anyone who expects more.

I am still hoping that the Cybertruck is a good idea, but I recognize the possibility that it grows out of a mania.

I don't know if you saw it, but the Porsche Taycan was served a somewhat poor EPA rating for MPGe (69 MPGe combined efficiency, and therefore only 201 mile EPA range). It might be and indication that a big ol truck will go lower, making it less clear a win.

With the stock market, the primary assumption is that it shouldn't exist. In a perfectly standard accounting system, a company does not need the 'market' institution to sell shares based on balance sheet. individual Q is enough. This would be the bare insight from shares being agents of information.

There should be one factor in stock price, the individual Q. There isn't and capital value theory is mostly about why not. The answer is mostly about central banking and the time to completion uncertainty. and the CAPM model introduces the safe rate to measure the variable. Whose safe rate? Dunno, they add beta to weight it.

Treasury, and Congress absorbs much of the time to completion error which has to be handled within the primary dealer system. Thus, the shadow banking system intrudes which estimates the time to completion insurance cost. We end up with the market playing a value added role in debt planning and CAPM needs to factor this in.

Walk this through a bit.

Assume no central banking, just a standard, automated S/L with asynchronous, adaptable interest charges. The S/L bank is arbitrage free, some other insurance company prepares term loans with an insurance payment. In that case the insurance company causes the beta, gamma, and other factors to be incorperated into the company balance sheet as =debt insurance. In that case, shares need not be allocated at all, the company can find its share price internally balancing its insurance rate with its debt load. Investors can just loan the company money. That is the starting point, the theoretical minimum model.

"beta, gamma, and other factors" are forever about the past though, and only a proxy (emotionally judged) to be about the future.

I manage over $30b of global equities. I've studied CAPM and its critiques and been in global investment management for 30 years.
I found a freely accessible paper from Zhang to try to better figure out what he's after. Here's a quote that's somewhat accessible: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2699190&download=yes
"The intuition behind the investment CAPM is just capital budgeting. Investment predicts returns because given expected profitability, high costs of capital imply low net present values of new capital and low investment, and low costs of capital imply high net present values of new capital and high investment. Profitability predicts returns because high expected profitability relative to low investment must imply high discount rates. The high discount rates are necessary to offset the high expected profitability to induce low net present values of new capital and low investment. If the discount rates were not high enough, firms would instead observe high net present values of new capital and invest more. Conversely, low expected profitability relative to high investment must imply low discount rates. If the discount rates were not low enough to counteract the low expected
profitability, firms would instead observe low net present values of new capital and invest less."
Consider also this paper Zhang contributed to:

He's basically trying to explain the "asset growth anomaly" under the standard CAPM.

But I tire of these rationalistic, deductive types of papers that start off by assuming various formulas, and try to explain some big cross-sectional data. Why not look first at observations of what companies actually have done, what decision makers think, what investors think and have done? This paper may get some things right, but it's presented in such an ivy-tower way that it is unlikely to gain traction outside of some quant practitioners, and only so long as the anomaly holds up.
Despite it being taught in basic corporate finance, I don't think corporate finance teams really know what their cost of capital is, and for their biggest investment decisions, I don't think they even care that much. They call such investments "strategic".

Going back to Cowen's paraphrasing. Yes, CAPM sucks. But "Investment CAPM" might be wrong too. My colleagues and I think of things from a different angle. Sometimes companies invest too much in dumb investments, given what we know about a company's industry structure and competitive advantage (or lack thereof). Sometimes investors catch on early, sometimes they don't. Sometimes investors pay too much for stocks relative to their future value creation, sometimes too little. Investors and management often disagree about what are going to be good investments, if any. Sometimes investors and management have a different idea of appropriate investment hurdle rates or levels of investment. Anyway, I've made a lot of money over the decades by being right more often that others (including company managements) on these kinds of issues. I surely don't assume that whatever gets decided is based on a very efficient process. Particularly after hearing stories from people who worked in the sausage factories of corporate finance decision making.
Don't get me wrong - it's still 100x more efficient than government-led economic investment decision making.

"Sometimes companies invest too much in dumb investments"

A little while back -- but don't as where I don't recall -- I read an argument about the growth versus dividend returns approaches to companies and share price performance. The standard view has been that companies paying mostly dividends much not have very good growth related investment options.

Apparently the data suggests that is not quite the case. Many of the good dividend paying companies were actually better at internal growth and investments. The idea being that they necessarily need to be better targeted investments because the investment fund was scarcer.

Companies not constrained by the dividend commitment made more bad/poor performing investment. While not mentioned one might also wonder about the potential rent-seeking aspects of the investment decisions here too.

Comments for this post are closed