Firms’ financial flexibility and the profitability of style investing

Abstract

This thesis examines how firms’ financial flexibility affects the profitability of three of the most commonly used style investing strategies. They are the value-growth trading strategy (going long on stocks with high Book-to-Market ratio and short on stocks with low Book-to-Market ratio), the momentum trading strategy (going long on stocks that have performed well and short on stocks that have performed poorly recently), and the accruals based trading strategy (going long on stocks with low accruals and short on stocks with high accruals).

The findings suggest the value premium exists when controlling for risks using the Fama and French three factor model. However, it is explained when the risk factors are conditioned on firms’ investment irreversibility and the business cycle. Next, the momentum profit can be explained by (a) adjusting returns for risks using the Fama and French model that is conditioned on firms’ financial constraints and the business cycle, and (b) accounting for the interaction between the momentum profit and firms’ investments beyond the risk-return relationship. Finally, the accruals based trading strategy is most successful at the two ends of the financial inflexibility spectrum, supporting both an explanation based on the risk-return relationship and an explanation based on the catering theory. When controlling for the cyclicality in stock returns, the strategy ceases to be profitable.

The results suggest that the understanding of corporate investment decisions can help improve the understanding of securities markets and portfolio investment strategies. There are a few lessons that investors can learn from the findings of this thesis. Value-growth investors should focus on value and growth firms with high investment irreversibility gap. Momentum investors should pursue the trading strategy among firms with high financial constraints and during economic upturns. They could also benefit from forming their portfolio from past winners and past losers with high investment gaps. Accruals based investors would benefit from pursuing the strategy among firms with high investment and financing flexibility and during economic upturns.