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19-09-2024 | Original Research

The endogeneity of profitability and investment

Authors: Peter Chinloy, Matthew Imes

Published in: Review of Quantitative Finance and Accounting

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Abstract

In academic research, stock returns are frequently regressed on financial variables such as profitability, value, and investment. Managers, who are incentivized through equity compensation, may make decisions which affect financial variables. If such decisions are endogenous, statistical significance in the financial variable coefficient estimates may stem from correlation rather than causation. This study presents a causality framework between U.S. firm decisions and stock returns. A set of instruments is first correlated with stock returns. When fitted values predict returns, there is a confirmed anomaly. Fitted values then replace profitability, investment, and investment growth. Return significance falls by more than half for profitability and investment, while its predicted growth is insignificant. Vector autoregressions and graphic analysis confirm the flow of causality from predicted profitability and investment to stock returns.

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Footnotes
1
Only a few factors survive in extensive testing among hundreds correlated with returns (Cochrane 2011). Using their $$t>|3|$$ criterion, only nine of 313 return correlated variables survive (Harvey, Liu, and Zhu 2016). Of 452 anomalies, removing the bottom 20% in size and using a significance hurdle of 2.78, 82.5% lose statistical significance (Hou etal 2020). Including 94 correlates simultaneously in a single equation, only two are significant over time (Green, Hand, & Zhang 2017). Out-of-sample and post-publication returns fall by half for 97 correlates (McLean & Pontiff 2016). Feng, Giglio, and Xiu (2020) use a procedure to add new correlates, and profitability survives, suggesting this as a candidate for further testing.
 
2
A variable is regressed on its own lags and that of another. If the group of lags on the other variable is significant, it is causal. Sims (1972) introduces leads, but Chamberlain (1982) shows that lags are sufficient. The lag length increases with the degree of integration of the time series (Toda & Yamamoto 1995), though constrained by financial statement frequency. More recently, Babii, Ghysels, and Striaukas (2024) used the Granger Causality Test to study the relationship between financial news and the VIX.
 
3
An alternative is the user cost. When interest rates, depreciation, and asset price deflation are entries with unit weights, the discount rate is the user cost of capital (Keynes 1936, Chapter 6 Appendix, Jorgenson 1960). With debt and equity and their shares as leverage proportions, the weighted average cost of capital applies (Solomon 1963, 1973). The q of Keynes (1936) and Tobin (1969) is the ratio of the market value of assets to their replacement cost.
 
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Metadata
Title
The endogeneity of profitability and investment
Authors
Peter Chinloy
Matthew Imes
Publication date
19-09-2024
Publisher
Springer US
Published in
Review of Quantitative Finance and Accounting
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI
https://doi.org/10.1007/s11156-024-01357-2

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