The interaction between the risky growth of investment and future earnings plays a central role in predicting stock returns, giving rise to an investment puzzle associated with the risk inherent in growth. Our parsimonious theoretical model provides a connection between stock returns and uncertainties in investment growth, company profitability, book-to-market ratio, and earnings systematic risk. This analytic approach to the determinants of stock returns contrasts with conventional factor models that augment the simple CAPM model with empirically determined accounting variables. Our analysis sheds light on several empirical anomalies resulting from interactions between explanatory variables used in empirical analysis and offers insights into the nature and structure of the book-to-market factor.
Ashton et al. (Fri,) studied this question.
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