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 we reconcile these seemingly contradictory positions by exploring a long-time Applied Finance investment concept – Wealth Creation Effect™. 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
As illustrated below, Amazon has been reinvesting in a profitable manner, which led the company to outperform the market.
With these insights, we aim to help our clients invest in companies benefiting from the Wealth Creation Effect™ and avoid wealth-destroying stocks.
Contact us to learn more about we apply Wealth Creation Effect™ to our investment strategies.