Investment and The Cross-Section of Equity Returns
We confront the one-factor production-based asset pricing model with the evidence on firm-level investment, to uncover that it produces implications for the dynamics of capital that are seriously at odds with the evidence. The data shows that, upon being hit by adverse profitability shocks, large public firms have ample latitude to divest their least productive assets and downsize. In turn, this reduces the risk faced by their shareholders and the returns that they are likely to demand. It follows that when the frictions to capital adjustment are shaped to respect the evidence on investment, the model–generated cross–sectional dispersion of returns is only a small fraction of what documented in the data. Our conclusions hold true even when either operating or labor leverage are modeled in ways that were shown to be promising in the extant literature.
NBER working paper 26372 includes a comment on some of the empirical findings in this paper. A reply to that comment may be found here.
Published Versions
GIAN LUCA CLEMENTI & BERARDINO PALAZZO, 2019. "Investment and the Cross-Section of Equity Returns," The Journal of Finance, vol 74(1), pages 281-321. citation courtesy of 
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