Finance is in a funny place now. Corporate finance operates under the guidance of the NPV Rule. NPV Rule provides the following guidance to corporate executives: To the extent a corporation sources investment opportunities with returns in excess of the company’s cost of capital, the assumption is firms should pursue those opportunities as they will increase the overall value of the firm. Conversely much of the investment management profession, which is responsible for investing in public corporations, has been guided by influential research that essentially concludes higher corporate investment is associated with lower expected stock returns.
In a recent Applied Finance working paper – The Wealth Creation Effect in Stock Returns, Francesco Franzoni, Dan Obrycki, and I propose a path to reconcile these seemingly contradictory positions by exploring a long-time Applied Finance investment concept – Wealth Creation. Our insight is simple: Firms invest with the expectation of generating future earnings. However, generating earnings is not enough, as those earnings need to be backed by projects that earn ROI’s greater than the cost of the capital required by those investments. Unlike prior research, we recognize profits and investment are interactive, and measure corporate wealth creation directly from company fundamental data to test the robustness of our assertions.
Table 1 below illustrates how Wealth Creation leads to significant alpha against existing popular asset pricing frameworks. In other words, Wealth Creation fills a gap in current asset pricing models, and in the paper, we provide a complete theoretical model to explain why. Another interesting aspect of the Wealth Creation Effect is that it does not significantly load on existing asset pricing factors. In other words, this is a unique attribute not captured in existing popular variables deemed important to explain stock returns. Tables 5 and 6 in the paper cover these concepts in greater detail.
Table 1 – Wealth Creation Factor Alpha, using ROE, Equity Growth, and Equal Weighted Returns
*Table 6 in The Wealth Creation Effect in Stock Returns
Applied Finance did not create the NPV Rule, or the Wealth Creation concepts we research in our paper. Those insights stem back to Irving Fisher. However, we led the investment industry in researching and harnessing these concepts to understand intrinsic value and corporate actions since our inception. We designed the Economic Margin® to directly link corporate actions with corporate performance in order to better understand whether firms are being managed to create or destroy wealth. We created the Wealth Creation Matrix™ decades ago to help our clients easily and quickly apply these concepts to differentiate themselves and help their clients avoid wealth destroying stocks.
In March we completed a new tool we are rolling out to our partners called Risk Sage™. Based on Applied Finance Valuation and Wealth Creation concepts, this tool helps frame the importance to avoid owning Overvalued, Wealth Destroying companies. Chart 1 demonstrates with our live, out-of-sample database, how consistently avoiding overvalued wealth destroying companies would have significantly improved portfolio performance. We believe this topic will become increasingly important in the years to come and encourage you to learn more about our research by staying current on our writings and as we ramp up our seminars and training, attending those sessions.
Chart 1: Risk Sage – Returns to Overvalued, Wealth Destroying Companies significantly underperforms all other stocks.
Please reach out to us for a demo and access to the Risk Sage application.