Balance Sheet Growth and the Predictability of Stock Returns

Recent empirical research suggests that growth in the size of firms’ balance sheets, or in the size of various balance sheet components, predicts the cross-section of average returns. In particular, firms that experience high growth in total assets earn abnormal returns of -5.88 percent in the following year, and -4.85 percent in the second year. However the economic rationale for the subsequent drift in returns remains unresolved. We explore several hypotheses about the sources of the predictability: the long-run underperformance of acquirers after mergers; investors’ extrapolation of past growth; over-expansion by managers due to agency costs; and underperformance following equity market timing by managers. In line with the agency cost hypothesis, the adverse consequences of asset expansion are aggravated in cases where past profitability is low, or corporate governance is weak. Conversely when asset growth is primarily in the form of cash accumulation, the negative returns are mitigated. An extensive body of empirical work in finance and accounting studies whether there is information in firms’ financial statements for their future stock price performance. One strand of this research follows in the same vein as fundamental stock analysis, and asks whether accounting-based valuation ratios, such as earnings and cash flow yields or book-to-market ratios, forecast the cross-section of average returns. The association between such financial attributes and returns is documented in a voluminous body of research, including Basu (1977), Fama and French (1992), Lakonishok, Shleifer and Vishny (1995). It is hard to know what to make of these findings, however. One interpretation is that investors do not fully incorporate the information in accounting numbers into equity values. Under a rational pricing story, on the other hand, a stock’s price reflects its underlying risks and discount rate, so the information in price-scaled accounting variables originates from the stock price rather than any accounting data. Ball (1978), for example, argues that price-scaled financial ratios stand in for the underlying determinants of expected returns. An association between such proxies and measured future abnormal returns, by this argument, reflects mismeasurement of stocks’ risk, rather than a failure of market efficiency. A more recent, but growing, literature tries to sidestep some of the ambiguities in interpreting the forecast power of financial statement data as captured by valuation multiples. Instead, many studies focus on changes over time in the size of firms’ balance sheets, or various components of assets and liabilities. Sloan (1996), for instance, uncovers the accrual anomaly, whereby operating accruals, or changes in working capital minus depreciation, are negatively related to subsequent returns. Stocks ranked in the top decile by accruals relative to average total assets underperform similarly-sized firms by 5.5 percent in the following year. Chan, Chan, Jegadeesh and Lakonishok (2006) find that each component of accruals, such as changes in accounts receivable, inventory changes, and changes in accounts payable, are associated with the crosssection of future returns. Thomas and Zhang (2002) also report that firms experiencing large increases in inventory experience poor stock returns in the future. Other studies suggest that changes in firms’ fixed assets have predictive power for returns. Titman, Wei and Xie (2004) find some evidence of weak stock price performance following large increases in capital expenditures. Firms ranked in the top quintile by changes in investment spending have average abnormal returns of -0.127 percent per month over the following year. Fairfield, Whisenant and Yohn (2003) report that