Organizational Capital, Tobin's Q, and the Cross Section of Stock Returns

Asset growth factor (AG) – the return on a portfolio that is long in shares of low asset growth firms and short in shares of high asset growth firms - is an economy-wide pervasive risk factor in the widely used Fama and French (2015) five-factor model (FF5) and in the Hou, Xue, and Zhang (2015) four-factor model (HXZ4). The latter model relies on a variation of Tobin’s Q model, which assumes that firms face convex adjustment costs associated with adding and disposing of physical capital. I modify the adjustment cost function to allow management to reduce adjustment costs by investing in organizational capital. The model implies that, when the expected productivity is held constant, the firms whose productivity is less prone to market risk, should have higher organizational capital-adjusted asset growth (AAG), and at the same time, are valued higher by the investors, and therefore have lower expected returns.I find empirical support for the implied negative relationship between AAG and expected returns. An AAG factor mimicking portfolio that is long low AAG stocks and short high AAG stocks has a significantly positive risk-adjusted return, with an annualized FF5 alpha of 2.4% (t=3.9) and HXZ4 alpha of 2.5% (t=3.3). In the squared Sharpe ratio tests, AAG-augmented FF5 and HXZ4 models, with AAG as an additional factor, dominate FF5 and HXZ4 models respectively in the full sample period. The AAG-adjusted FF5 and HXZ4 models, with CMA and IA replaced by AAG, dominate FF5 and HXZ4 models respectively in the second half of the sample period from January 1996 to December 2020