The empirical finance literature has documented tantalizing associations between future stock returns and firm characteristics. As surveyed in, for example, Fama (1998) and Schwert (2003), traditional asset pricing models have failed to predict many of these associations, which have therefore been dubbed anomalies. Several prominent studies, such as Shleifer (2000) and Barberis and Thaler (2003), have interpreted this failure as prima facia evidence against the efficient markets hypothesis.
We use the neoclassical q-theory of investment to provide the microfoundations for time-varying expected returns in the cross section, thus establishing a structural framework for understanding anomalies and for capturing them empirically. As first shown by Cochrane (1991), under constant returns to scale stock returns equal investment returns, which are tied to firm characteristics through the optimality conditions for investment. We use these conditions to show how expected returns vary in the cross section with firm characteristics, corporate policies, and events.
We show that q-theory can generate the following asset pricing anomalies. The first is the investment anomaly: The investment-to-assets ratio is negatively correlated with average returns. The second is the value anomaly: Value stocks (stocks with high book-to-market ratios) earn higher average returns than growth stocks (stocks with low book-to market ratios), especially for small firms. The third is the post-earnings-announcement drift anomaly: Firms with positive earnings surprises earn higher average returns than firms with negative earnings surprises, especially for small firms.