The neoclassical q-theory provides a good start to understanding the cross section of returns. Under constant return to scale stock returns equal levered investment returns, which are tied directly to firm characteristics. This equation predicts the empirical relations of average returns with book-to-market, investment, and earnings surprises. We estimate the model via GMM by minimizing the differences between average stock returns and average levered investment returns. Our model captures the average return patterns in portfolios sorted on capital investment and double-sorted on size and book-to-market, including the small-stock value premium. The model also partially captures post-earnings-announcement drift and its higher magnitude in small firms.

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Ingolf Dittmann