1 Asp

The Inventory Growth Spread
Frederico Belo
University of Minnesota
Xiaoji Lin
London School of Economics and Political Science
Previous studies show that firms with low inventory growth outperform firms with high in-
ventory growth in the cross-section of publicly traded firms. In addition, inventory invest-
ment is volatile and procyclical, and inventory-to-sales is persistent and countercyclical.
We embed an inventory holding motive into the investment-based asset pricing framework
by modeling inventory as a factor of production with convex and nonconvex adjustment
costs. The augmented model simultaneously matches the large inventory growth spread in
the data, as well as the time-series properties of the firm-level capital investment, inven-
tory investment, and inventory-to-sales. Our conditional single-factor model also implies
that traditional unconditional factor models such as the CAPM should fail to explain the
inventory growth spread, although not with the same large pricing errors observed in the
data. (JEL E22, E23, E44, G12)
Inventory investment is highly volatile and positively correlated with the busi-
ness cycle. This observation has led macroeconomists to examine inventory
investment as an important driver in the propagation and the amplification of
shocks in the economy. At the same time, the asset pricing literature docu-
ments substantial variation in risk premiums over the business cycle, both in
the time series and in the cross-section. The previous facts are naturally linked
if inventory investment, like physical capital investment, responds to changes
in risk premiums, a measure of firms’ cost of capital. Thus, understanding the
economic mechanism behind these facts seems important to understand both
the business cycle itself and the variation in risk premiums over the business
cycle, which are central questions in macroeconomics and finance.
This article provides an empirical and theoretical analysis of the link be-
tween inventory investment and risk premiums in the cross-section of publicly
We thank Robert Goldstein, François Gourio, Erica Li (CEPR discussant), Selale Tuzel, Pietro Veronesi (the
editor), and Lu Zhang for helpful comments and suggestions. We are especially grateful to the anonymous
referee for constructive comments that have significantly improved the exposition of the article. We also thank
seminar participants at CEPR/Studienzentrum Gerzensee European Summer Symposium in Financial Markets,
the Econometric Society World Congress, the London School of Economics and Political Science, and the
University of Minnesota. Xiaoji Lin is thankful for the research support of Financial Market Group (FMG)
and STICERD Research Grant. All errors are our own. Send correspondence to Frederico Belo, Department of
Finance, University of Minnesota, 321 19th Avenue South, Office 3-137, Minneapolis, MN 55455; telephone:
(612) 626-7813. E-mail: [email protected].
c The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies.
All rights reserved. For Permissions, please e-mail: [email protected].
doi:10.1093/rfs/hhr069 Advance Access publication August 25, 2011
traded firms. On the asset price side, as first documented in Thomas and Zhang
(2002), there is a large inventory growth spread: Firms with low inventory
growth rates outperform firms with high inventory growth rates by a value be-
tween 6.6% (value-weighted) and 10.7% (equal-weighted) per annum. The in-
ventory growth spread is pervasive: It shows up in both small and large firms,
although it is larger among small firms. In addition, we show that the stan-
dard CAPM and, to a lesser extent, the Fama and French (1993) three-factor
model cannot explain the size of the inventory growth spread in the data. On
the real quantity side, extending previous work by Khan and Thomas (2007a)
to the firm level, we document that the inventory investment rate is volatile and
strongly procyclical, and the inventory-to-sales ratio is smooth, persistent, and
countercyclical.
To understand the empirical facts, we incorporate an inventory holding
motive into the investment-based asset pricing framework (e.g., Cochrane
1991; Zhang 2005; Cooper 2006). This framework has been successfully
used to explain several asset pricing facts and thus provides a natural frame-
work for understanding the economic determinants of the inventory growth
spread.
The macroeconomics literature has proposed several alternative mechanisms
to rationalize positive holdings of the inventory stock, typically viewed as a
zero return asset. Here, following Ramey (1989), we specify inventories as a
factor of production. Thus, like the physical capital stock, in this specification
the inventory stock provides a flow of services to the firm. This approach can be
motivated in several ways. For example, cars in the showroom are necessary to
generate sales. More generally, the existence of setup costs in the production
process makes it optimal for firms to accumulate half-completed items and
finish them in a batch job. This procedure reduces the number of periods during
which machines must be set up—that is, periods in which workers are idle and
thus unproductive.
In addition to modeling inventories as a factor of production, we consider a
flexible representation of inventory adjustment costs that includes both convex
and nonconvex costs. Adjustment costs have been shown to be important to
match several asset pricing facts both in the cross-section and at the aggregate
level, and we investigate here the importance of these costs in the context of
an investment-based model with inventory holdings.1
In the model, firms make physical capital investment and inventory invest-
ment decisions to maximize the value of the firm for shareholders. Optimal
capital and inventory investment determine firms’ dividends and market value,
thus establishing an endogenous link between the inventory investment rate
and firms’ risk. Through simulations, we then investigate if the model can en-
dogenously generate a sizable inventory growth spread, and simultaneously
1 Examples include Zhang (2005) and Li, Livdan, and Zhang (2009) in the cross-section, and Cochrane (1991)
and Jermann (1998) at the aggregate level.
279
The Review of Financial Studies / v 25 n 1 2012
match the properties of inventory investment and inventory holdings observed

in the data.
The main results from the model can be summarized as follows. On the
real quantity side, we show that the model overall matches the business cy-
cle facts well. The model is calibrated to match the time-series properties
(volatility and autocorrelation) of the physical capital and inventory investment
rates. The model then endogenously matches key properties of the inventory-
to-sales ratio. The inventory-to-sales ratio is countercyclical, because sales
are highly procyclical and co-move more with aggregate shocks than the in-
ventory stock. In addition, the inventory-to-sales ratio is smooth and highly
persistent. As emphasized in Ramey and West (1999), the high persistence
of the inventory-to-sales ratio is a key stylized fact of inventories, and thus
should be taken seriously in the evaluation of any candidate model of inventory
behavior.
On the asset pricing side, the model is calibrated to match aggregate asset
pricing moments (aggregate Sharpe ratio and properties of the risk-free rate)
as well as the value premium. Our analysis then shows that the model en-
dogenously generates a sizeable inventory growth spread. For value-weighted
portfolios, the inventory growth spread is 4.6% in the model versus 6.6% in the
data. In addition, the model matches the pattern of the inventory growth spread
across firms with different sizes observed in the data: The inventory growth
spread is higher among small firms than across large firms. When we compute
the model-implied levered returns, we show that the difference between the in-
ventory growth spreads generated by the model and the data is not statistically
significant.
The investment-based model is less successful at replicating the failure of
the CAPM across the inventory growth portfolios. Even though the model gen-
erates a pattern of pricing errors that is qualitatively consistent with the data,
the size of the pricing errors is too small. In the data, the mean absolute pricing
errors for the CAPM are 5.3% per annum across equal-weighted portfolios,
and 2% per annum across value-weighted portfolios, while the corresponding
pricing errors in the model are only 0.6% and 0.5% per annum. This result con-
trasts with the findings in Gomes, Kogan, and Zhang (2003) and Li, Livdan,
and Zhang (2009), who show that a production economy with one aggregate
systematic shock, as we have here, can replicate the failures of the CAPM. Our
analysis is different because we test the CAPM using the Fama–French port-
folio approach, whereas the previous studies use Fama and MacBeth (1973)
cross-sectional regressions. This difference is important. By performing the
asset pricing tests at the portfolio level, the effect of measurement errors in the
betas is significantly reduced in our approach. In addition, the sorting proce-
dure based on a variable (inventory growth) that is correlated with the firm’s
true conditional beta generates portfolio betas that are significantly more sta-
ble over time than the firm-level betas. As a result, the portfolio’s uncondi-
tional betas are on average closer to its true conditional betas, thus helping
280
improve the performance of unconditional asset pricing models at the portfo-

lio level.
To understand the economic mechanism driving the results in the model,
we investigate the sensitivity of the results across alternative specifications of
the model. Our analysis shows that a combination of both convex and noncon-
vex inventory adjustment costs is essential for the good fit of the investment-
based model on both quantities and asset prices. Without inventory adjustment
costs, the inventory growth spread generated by the model is tiny, the in-
ventory investment rate too volatile, and the inventory-to-sales ratio not per-
sistent enough relative to the data. Intuitively, without inventory adjustment
costs, firms take advantage of the costlessly adjustable inventory input (a
storage technology) to smooth their dividends. In turn, this mechanism de-
stroys the large risk dispersion generated by the standard one-capital-good
investment-based model, despite the existence of physical capital adjustment
costs.
The negative relationship between inventory growth and future stock re-
turns generated by the model follows naturally from standard q-theory. The
mechanism is analogous to standard explanations of the well-documented neg-
ative relationship between physical capital investment and future stock returns.
Since the inventory stock is a capital input that provides a flow of service over
time, inventory investment responds to changes in the cost of capital (risk pre-
mium). Naturally, firms increase their inventory stock when their cost of capital
is low, generating the observed negative relationship between inventory growth
and future stock returns. Our contribution is thus quantitative: We show that the
investment-based model augmented with inventory holdings can quantitatively
match the magnitude of the link between inventory growth and future stock re-
turns observed in the data.
Taken together, the results in this article provide support for modeling in-
ventories as a factor of production, as well as for the existence of nonconvex
inventory adjustment costs, consistent with the results in Khan and Thomas
(2007b). In addition, the ability of the model to simultaneously match the
large inventory growth spread observed in the data and key business cycle
moments in a setup with rational expectations and profit maximizing firms
suggests that the observed inventory growth spread is consistent with a risk-
based interpretation. Firms with low inventory investment rates have a high
cost of capital (risk), which explains the high average returns of these firms in
the data.
The work most closely related to ours is that of Jones and Tuzel (2011), who
show that risk premiums are strongly negatively related to future inventory
growth at the aggregate, industry, and firm levels. In addition, they show that
the effect is stronger for firms in industries that produce durables rather than
nondurables, exhibit greater cyclicality in sales, and require longer lead times
for new orders. We instead focus on evaluating quantitatively the ability of an
investment-based asset pricing model to explain the inventory growth spread as
281
well as the time-series properties of inventory. Our work is also related to the
large macroeconomic literature on aggregate inventory behavior and business
cycles.2 Our article contributes to this strand of literature by examining the
asset pricing implications of existent macroeconomic models as well as the
importance of nonconvex costs for matching asset pricing facts. Finally, our
work contributes to the investment-based asset pricing literature with multiple
and heterogeneous capital goods by showing the importance of inventories for
explaining cross-sectional asset pricing moments.3
The article proceeds as follows. Section 1 documents the business cycle
properties of inventory investment and its related asset pricing facts in the
cross-section. Section 2 presents the investment-based model with inventory
holdings. Section 3 calibrates the model and reports the cross-sectional mo-
ments generated from the simulation of the model, which we compare with the
real data. Section 4 provides a detailed analysis of the economic mechanisms
driving the results in the model. Section 5 concludes. An online appendix with
additional analysis and robustness checks is available from the author’s Web
pages.
1. Facts
In this section, we document the business cycle properties of inventory invest-
ment and its related asset pricing facts in the cross-section. To characterize
the business cycle facts, we document the summary statistics of firm-level in-
ventory investment, physical capital investment, sales growth, and inventory-
to-sales ratio. To characterize the asset pricing facts, we construct portfolios
sorted on the firm-level inventory growth rate, as well as portfolios two-way-
sorted on size and inventory growth rate. We then investigate the characteristics
of the portfolio’s average stock returns and perform standard asset pricing tests.
The analysis of the business cycle facts in this section complements the anal-
ysis in Khan and Thomas (2007a) for the aggregate U.S. economy (see their
Table 1). The analysis of the asset pricing facts complements the analysis in
Thomas and Zhang (2002); Lyandres, Sun, and Zhang (2008); and Jones and
Tuzel (2011).4
2 Our approach of modeling inventories as a factor of production follows that of Ramey (1989) and has also
been used in Kydland and Prescott (1982), Christiano (1988), Jones and Tuzel (2011), and several other stud-
ies. Blinder and Maccini (1991) and Ramey and West (1999) emphasize the production-smoothing motive for
holding inventories, while Kahn (1987, 1992) and Bils and Kahn (2000) focus on the stockout avoidance motive
for the firm to hold inventory. More recently, Fisher and Hornstein (2000) and Khan and Thomas (2007b) stress
the importance of (S,s) rules implied by nonconvex costs for explaining inventory investment over business
cycles.
3 For example, Bazdresch, Belo, and Lin (2010), Lin (forthcoming), and Tuzel (2010) also study economies with
multi-capital inputs (labor, R&D capital, and real estate capital, respectively).
4 Because inventory is part of accruals, the asset pricing results reported here are also related to the large literature
on the accruals anomaly initiated with Sloan (1996).
282
The results in this section provide the facts that we use to evaluate the per-
formance of the investment-based asset pricing model with inventory holdings
that we present in Section 2 below.
1.1 Data
Monthly stock returns are from the Center for Research in Security Prices
(CRSP), and accounting information is from the CRSP/Compustat Merged
Annual Industrial Files. The sample is from July 1965 to December 2009. We
exclude from the sample any firm-year observation for which total assets or
the capital stock are either zero or negative. In addition, as standard, we omit
firms whose primary standard industry classification (SIC) is between 4900
and 4999 (regulated firms) or between 6000 and 6999 (financial firms). Fol-
lowing Fama and French (1993), we require each firm to have at least two
years of data in Compustat before it is included in the sample. The data for the
three Fama–French factors (small-minus-big [SMB], high-minus-low [HML],
and market) are from Kenneth French’s Web page.
The key variable for the empirical work is the firm-level inventory invest-
ment rate. We construct this variable as follows. Total inventory stock (Nt ),
which includes raw materials, finished goods, and work-in-progress, is given
by Compustat data item INVT. We transform this variable into real terms by
dividing it by the consumer price index. Net inventory investment is given by
the change in the stock of total inventories in year t from year t −1 (Nt −Nt−1 ).
The inventory investment rate is then given by the ratio of the change in the
stock of total inventories to the beginning of the period stock of inventories
(HNt = (Nt − Nt−1 )/Nt−1 ). Thus, our inventory investment rate is effectively
the real net growth rate of total inventories of the firm. Firms that do not report
inventory holdings are excluded from the sample because the theory in this
article does not apply to those firms.
In addition, we also keep track of several other firm-level variables. To con-
struct the physical capital investment rate (IK), we measure firm-level capital
investment (It ) by data item CAPX (capital expenditures) minus SPPE (sales
of property, plant, and equipment). The physical capital stock (Kt ) is given
by data item PPENT (net property plant and equipment). The physical capital
investment rate is then given by the ratio of physical capital investment to the
beginning of the period capital stock (IKt = It /Kt−1 ) . Firms’ sales are given
by data item SALE. Real sales growth (SG) rate is thus measured by the ratio of
the change in the sales from year t to year t −1 to the sales in year t −1, deflated
by the consumer price index. The inventory-to-sales ratio (NS) is measured as
the ratio of total inventories in year t divided by sales in year t. Market eq-
uity (Size) is price times shares outstanding at the end of December of t, from
CRSP. BM is the book-equity-to-market-equity ratio, in which book equity is
computed as in Fama and French (1993). Physical-capital-to-market-equity ra-
tio (K/ME) is physical-capital stock divided by market-equity. Leverage (Lev)
283
Table 1
Summary statistics
Percentile Correlations
Mean S.D. AC1 10th 90th HN SG NS
IK 0.29 0.27 0.17 0.05 0.60 0.26 0.27 0.03
HN 0.04 0.33 −0.07 −0.30 0.40 1 0.43 0.25
SG 0.07 0.23 0.06 −0.18 0.33 0.43 1 −0.1
NS 0.17 0.07 0.50 0.03 0.31 0.25 −0.1 1
This table reports the mean, standard deviation (S.D.), autocorrelation (AC1), the 10th and 90th percentiles,
and the pairwise correlation of the following variables: (1) firm-level physical capital investment rate (IK),
measured by Compustat data items CAPX minus SPPE divided by PPENT; (2) net real inventory growth rate
(HN), measured by the net growth rate in Compustat data item INVT deflated by the CPI; (3) net real sales
growth rate (SG), measured by the net growth rate in Compustat data item SALE deflated by the CPI; and (4)
inventory-to-sales ratio (NS), measured by the ratio of Compustat data items INVT and SALE. To decrease the
influence of outliers, the firm-level data are winsorized at the top and bottom 1%. The data are annual, and the
sample is July 1965 to December 2009.
is book liabilities (given by total assets, Compustat data item AT, minus book
value of equity) in year t divided by the market value of the firm (market equity
plus total assets minus book value of equity).
1.2 Business cycle facts

Table 1 reports summary statistics of the firm-level physical capital investment
rate (IK), inventory growth rate (HN), inventory-to-sales ratio (NS), and real
sales growth (SG) variables. All variables are reported at annual frequency.
The firm-level inventory and physical capital investment rates are very
volatile (standard deviation of 33% and 27% per annum, respectively), are
positively correlated (26%), and have low autocorrelation (−7% and 17%, re-
spectively). In addition, both investment rates are procyclical, as measured by
the positive correlation with sales growth (43% for inventory growth and 27%
for physical investment).
The inventory-to-sales ratio is on average 17% per annum, and it is smooth,
with a standard deviation of 7%. In addition, it is persistent, with an autocorre-
lation of 50%, and is countercyclical (correlation with sales growth of −10%).
Overall, these summary statistics are roughly consistent with those reported in
Khan and Thomas (2007a) for the U.S. economy at the aggregate level.
1.3 Asset pricing facts

1.3.1 One-way-sorted inventory growth portfolios. We construct ten one-
way-sorted inventory growth portfolios as follows. Following Fama and French
(1993), in June of year t, we first sort the universe of common stocks into
ten portfolios based on the deciles of the cross-sectional distribution of the
inventory growth rate at the end of year t − 1. Once the portfolios are formed,
their value- and equal-weighted returns are tracked from July of year t to June
of year t + 1. The procedure is repeated in June of year t + 1.
284
Panel A in Table 2 reports the average equal- and value-weighted excess

stock returns (r S , in excess of the risk-free rate) of the ten one-way-sorted
inventory growth portfolios, and Panel B reports average portfolio characteris-
tics. Consistent with the results in Thomas and Zhang (2002), both the equal-
and value-weighted average excess returns of these portfolios are decreasing
in the inventory growth rate. The Patton and Timmermann (2010) monotonic
relationship test strongly rejects the hypothesis that the average returns of these
portfolios are all equal against the hypothesis that they are decreasing in the
level of inventory growth, with a p-value of 0.1% for equal-weighted port-
folios and 2.2% for value-weighted portfolios. The spread in the average ex-
cess returns of these portfolios is large. For equal-weighted portfolios, firms
with low inventory growth rates outperform firms with high inventory growth
rates (L-H) by 10.7% per annum, and this value is more than 6.6 standard er-
rors from zero. For value-weighted portfolios, the spread is 6.6% per annum
and is 3.2 standard errors from zero. We label this fact as the inventory growth
spread.
Panel B in Table 2 also reports the time-series average of median portfolio-
level characteristics of the inventory growth portfolios. The characteristics of
these portfolios reveal that the book-to-market ratio (BM) is significantly nega-
tively correlated with the average inventory growth rate. This fact is consistent
with standard q-theory since, in general, the book-to-market ratio can be shown
to be a decreasing function of firms’ investment rate. The average (log) size
characteristic across portfolios exhibits an inverted U-shape, with the portfo-
lios in the middle having slightly larger firms. Finally, firm leverage (Lev) and
inventory growth rates are slightly negatively correlated.
1.3.2 Two-way-sorted inventory growth and size portfolios. A well-

established fact in the empirical asset pricing literature is the observation that
the link between stock return predictability and firm characteristics in the
cross-section tends to be stronger among small or tiny firms. In fact, many
of the so-called asset pricing anomalies are robust only across small firms and
do not exist among large firms (for several examples and a survey of the liter-
ature, see Fama and French 2008). If this is also the case for the link between
inventory growth and stock returns, then the economic relevance of this link is
debatable because small/tiny firms tend to be less liquid and thus more difficult
to trade. In addition, the universe of small firms represents a disproportionately
small fraction of the overall total stock market value.
To investigate if the link between inventory growth and stock returns is a
robust feature of the overall economy, we form nine portfolios two-way-sorted
on size (market capitalization) and inventory growth rates. At the end of June
of year t, the universe of common stocks is allocated to groups based on its size
and inventory growth rate at the end of year t − 1. The nine portfolios are con-
structed as the intersection of three inventory growth and three size portfolios
(the breakpoints are the 33th and 66th percentiles of the corresponding sorting
285
286
Table 2
One-way-sorted inventory growth portfolios
Panel A: Returns
Low 2 3 4 5 6 7 8 9 High L-H MAE
Equal-Weighted Portfolios
rS 15.37 13.17 12.39 11.70 10.76 10.58 10.30 9.24 8.04 4.68 10.68
[t] 3.22 3.37 3.38 3.36 3.28 3.12 2.99 2.52 2.08 1.08 6.64
α 9.17 7.61 6.99 6.38 5.52 5.27 4.86 3.52 2.03 −1.79 10.96 5.31
[t] 3.18 3.72 3.72 3.71 3.54 3.25 2.98 2.07 1.15 −0.80 6.85
α FF 4.90 3.66 2.85 2.36 1.88 1.82 1.53 0.61 −0.75 −4.34 9.24 2.47
[t] 2.65 3.20 2.63 2.39 2.05 2.10 1.74 0.70 −0.71 −3.31 5.88
Value-Weighted Portfolios
rS 10.41 8.22 7.25 7.03 5.47 4.91 5.65 5.31 3.22 3.79 6.62
[t] 3.11 2.96 2.68 2.91 2.36 1.98 2.23 1.89 1.00 1.04 3.25
α 4.79 3.26 2.45 2.54 1.16 0.40 0.90 0.27 −2.36 −2.33 7.12 2.04
[t] 2.86 3.04 2.30 2.91 1.17 0.40 1.08 0.28 −2.00 −1.41 3.54
α FF 3.84 2.86 1.86 2.17 0.65 0.19 1.51 1.31 −1.06 −0.38 4.22 1.58
[t] 2.45 2.58 1.76 2.52 0.68 0.20 1.84 1.52 −0.95 −0.27 2.20
Panel B: Accounting Variables
HN −0.43 −0.18 −0.09 −0.03 0.01 0.06 0.11 0.18 0.28 0.57 −1.00
IK 0.14 0.15 0.16 0.18 0.19 0.20 0.22 0.25 0.29 0.36 −0.22
Size 3.45 3.92 4.34 4.63 4.79 4.82 4.80 4.68 4.50 4.29 −0.84
BM 0.88 0.97 0.92 0.88 0.83 0.79 0.75 0.70 0.64 0.56 0.32
K/ME 0.54 0.55 0.52 0.49 0.45 0.41 0.37 0.32 0.27 0.21 0.33
Lev 0.43 0.44 0.43 0.41 0.39 0.38 0.37 0.36 0.34 0.34 0.09
This table reports the average excess returns and alphas of ten portfolios sorted on inventory growth rate. Panel A reports the statistics for the following variables: r S is the average
annualized (×1200) excess stock return; α is the intercept from the monthly CAPM regression in annual percentage; and α FF is the intercept from the monthly Fama–French (1993)
three-factor regression in annual percentage. t are heteroskedastic and autocorrelation-consistent t-statistics. L-H stands for the low-minus-high inventory growth portfolio, and the average
returns of this portfolio is the inventory growth spread. MAE is the mean absolute pricing error. Panel B reports the time-series averages of median characteristics of the ten inventory
growth portfolios. HN is inventory growth rate, IK is the physical capital investment rate, Size is the log market capitalization, BM is the book-equity-to-market-equity ratio, K/ME is the
physical-capital-to-market-equity ratio, and Lev is the leverage ratio. The sample is from July 1965 to December 2009.
variable). Once the portfolios are formed, their value- and equal-weighted re-
turns are tracked from July of year t to June of year t + 1. The procedure is
repeated in June of year t + 1.
The results reported in column L-H of Table 3 show that the inventory
growth spread is a robust feature of the overall economy, although it is larger
among small firms. The inventory growth spread is statistically significant
across small, medium, and large firms for both equal- and value-weighted port-
folios. Across small firms, the inventory growth spread is 7.1% and 5.8% for
equal- and value-weighted portfolios, respectively. Across large firms, the in-
ventory growth spread is 3.3% and 3.8% for equal- and value-weighted port-
folios, respectively. Although the inventory growth spread for large firms is
smaller than that for small firms, the spreads are all more than 2.9 standard
errors from zero for both equal- and value-weighted portfolios.
1.3.3 Asset pricing tests. We also investigate if the spread in the average
returns across the inventory growth portfolios is explained by exposure to stan-
dard risk factors, as captured by the capital asset pricing model (CAPM) and
the Fama and French (1993) three-factor model. To test the CAPM, we run
monthly time-series regressions of the excess returns of each portfolio on a
constant and the excess returns of the market portfolio (Market). To test the
Fama-French three-factor model, we augment the previous CAPM regressions
with the SMB and HML factors.
Panel A in Table 2 reports the intercepts (alphas) for both the CAPM (α)
and the Fama–French three-factor model (α F F ) on the ten portfolios
one-way-sorted on inventory growth. The CAPM cannot explain the pattern
of the returns of these portfolios. The CAPM alphas are large and in general
statistically different from zero, especially for equal-weighted portfolios. The
CAPM mean absolute pricing errors are 5.3% per annum for equal-weighted
portfolios and 2.0% per annum for value-weighted portfolios.
The Fama-French three-factor model is more successful than the CAPM at
explaining the average returns of these portfolios, but the magnitude of the
alphas is still large and in general statistically significant, especially across
equal-weighted portfolios. The Fama–French mean absolute pricing errors are
2.5% per annum for equal-weighted portfolios and 1.6% per annum for value-
weighted portfolios. The analysis of the results for the nine portfolios two-
way-sorted on inventory growth and size reported in Table 3 is qualitatively
similar to the analysis for the one-way-sorted inventory growth portfolios, and
so its analysis is omitted here.
To sum up, the results in this section document an economically large and
statistically significant inventory growth spread: Firms with low inventory
growth significantly outperform firms with high inventory growth. This inven-
tory growth spread is pervasive across the economy: It shows up in small,
medium, and large firms, although it is larger among small firms. Finally, the
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288
Table 3
Two-way-sorted inventory growth and size portfolios
Inventory Growth Inventory Growth Inventory Growth
Low Mid High L-H Low Mid High L-H Low Mid High L-H MAE
rS α α FF CAPM FF
Small 19.23 15.29 12.15 7.08 13.70 10.13 6.48 7.22 8.36 4.95 1.93 6.43 5.28 2.69
Mid 11.09 10.90 5.71 5.39 5.04 5.37 −0.58 5.63 0.87 1.10 −3.80 4.67
Big 8.81 7.74 5.56 3.25 3.22 2.49 −0.56 3.78 1.42 0.70 −1.04 2.47
t rS t(α ) tα
Small 3.79 3.54 2.55 5.56 4.06 3.71 2.18 5.73 3.64 2.90 0.95 5.19
FF
Mid 2.78 3.10 1.41 5.21 2.39 2.95 −0.28 5.44 0.76 1.31 −3.49 4.33
Big 2.85 2.70 1.62 3.19 2.81 2.47 −0.47 3.86 1.46 0.84 −1.08 2.70
rS α α FF CAPM FF
Small 13.49 11.00 7.72 5.78 7.91 5.81 1.90 6.01 3.23 1.14 −2.05 5.28 3.46 1.82
Mid 10.59 10.43 5.57 5.02 4.65 5.04 −0.66 5.30 1.27 1.40 −3.28 4.55
Big 7.77 5.34 3.99 3.78 2.87 0.93 −1.39 4.26 2.63 1.06 0.34 2.28
t(r S ) t(α ) tα FF
Small 2.86 2.71 1.69 4.92 2.67 2.30 0.68 5.13 1.87 0.81 4.53

−1.25
Mid 2.83 3.14 1.46 4.54 2.43 3.02 −0.36 4.84 1.36 2.00 −3.48 3.82
Big 2.90 2.33 1.32 2.93 3.16 1.47 −1.43 3.36 2.85 1.93 0.43 1.99
This table reports the summary statistics of nine portfolios two-way-sorted on inventory growth rate and firm size. r S is the average annualized (×1200) excess stock return. α is the intercept
from the monthly CAPM regression in annual percentage. α FF is the intercept from the monthly Fama–French (1993) three-factor regression in annual percentage. t are heteroskedastic and
autocorrelation-consistent t-statistics. Low, Mid, and High stand for the sorting on inventory growth rates, and Small, Mid, and Big stand for the sorting on size (market capitalization). L-H
stands for the low-minus-high inventory growth portfolio, and the average returns of this portfolio is the inventory growth spread. MAE is the mean absolute pricing error. The sample is
monthly from July 1965 to December 2009.
inventory growth spread is not explained by standard asset pricing models such
as the CAPM and, to a lesser extent, the Fama–French three-factor model.5
2. An Investment-based Model with Inventory Holdings

In this section, we specify an investment-based asset pricing model with in-
ventory holdings that we use to understand the empirical evidence presented
in the previous section. By studying the producers’ optimal production deci-
sions, the model establishes an endogenous link between the firm’s inventory
growth rates and the firm’s level of risk and expected stock return.
2.1 Economic environment

The economy is composed of a large number of firms that produce a homo-
geneous good. Firms are competitive and take as given the market-determined
stochastic discount factor Mt,t+1 , used to value the cash flows arriving in pe-
riod t + 1. The existence of a strictly positive stochastic discount factor is
guaranteed by a well-known existence theorem if there are no arbitrage opport-
unities in the market (see, for example, Cochrane 2001, Chapter 4.2).
2.1.1 Technology. We focus on the optimal production decision problem of

one firm in the economy (we suppress any firm-specific subscript to save on
notation). The firm uses capital inputs K t and inventory inputs Nt to produce
output Yt , according to the following constant elasticity of substitution (CES)
technology:
h i −θ
−ρ −ρ ρ
Yt = e xt +z t αk K t + (1 − αk )Nt , (1)
where αk > 0 controls the relative weight of the two inputs in the produc-
tion process, 0 < θ ≤ 1 is the degree of returns to scale, and the parameter
ρ determines the elasticity of substitution (ES) between physical capital and
the inventory stock, defined as ES = (1 + ρ)−1 . In the limit, when ρ → 0 the
CES aggregator collapses to the standard Cobb-Douglas case, when ρ → −1
the two inputs are perfect substitutes, and when ρ → ∞ the two inputs are
perfect complements (Leontief). x t is aggregate productivity, and z t is firm’s
specific productivity.
Aggregate productivity follows the process
x
xt+1 = x(1
ˉ − ρx ) + ρx xt + σx εt+1 , (2)
5 In the online appendix for this article, we show that inventory growth retains its strong predictive power in
cross-sectional regressions that include several firm-level stock-return predictors such as the physical capital
investment rate as well as size, book-to-market ratio, momentum, asset growth, and sales growth. In addition,
we show that the inventory growth spread is mostly a within-industry effect, not a cross-industry effect.
289
x
where εt+1 is an independently and identically distributed (i.i.d.) standard
normal shock. Firm-specific productivity follows the process
z
z t+1 = ρz z t + σz εt+1 , (3)
z
where εt+1 is an i.i.d standard normal shock that is uncorrelated across all firms
in the economy, and εt+1 x is independent of ε z
t+1 for each firm. In the model, the
aggregate productivity shock is the driving force of economic fluctuations and
systematic risk, and the firm-specific productivity shock is the driving force of
firm heterogeneity.
In every period t, the capital stock K t depreciates at rate δk and is increased
(or decreased) by gross investment It . The law of motion of the capital stock
is given by
K t+1 = (1 − δk )K t + It , 0 < δk < 1. (4)
Similarly, the firm’s inventory stock Nt depreciates at rate δn and is in-

creased (or decreased) by gross inventory investment Ht . The law of motion of
the inventory stock is given by
Nt+1 = (1 − δn )Nt + Ht , 0 < δn < 1. (5)
Following Bils and Kahn (2000) and Ramey and West (1999), net sales are
measured as
Salest = Yt − Ht ;
that is, net sales are specified by total output minus the gross investment in the
inventory stock.
2.1.2 Adjustment costs and operating fixed costs. The production activity
of the firm is subject to three different types of costs: physical capital adjust-
ment costs, inventory adjustment costs, and operating fixed costs.
Capital adjustment costs are specified by the following adjustment cost func-
tion
 2
 ck+


 a+ Kt + 2
It
Kt Kt if It > 0

K adjt ≡ 0 if It = 0 (6)

 2

 ck−
 a− Kt + It
Kt if It < 0,
2 Kt
where ck+ , ck− , a + , a − > 0 are constants. This specification includes both non-
convex adjustment costs, captured by the first term a +,− K t , as well as convex
2
c+,− It
adjustment costs, captured by the last term k2 Kt K t . In addition, we al-
low these costs to be asymmetric, as in Zhang (2005), to capture the fact that
290
cutting the capital stock may be more costly than expanding it. The nonconvex
costs capture the costs of adjusting capital that are independent of the size of
the investment (e.g., Abel and Eberly 2002). To scale these costs across firms
with different sizes, we make the size of the nonconvex cost to be proportional
to the firm’s size of capital stock. As standard from the q-theory of investment
literature, the nonconvex and convex capital adjustment costs include planning
and installation costs, learning the use of new equipment, or the fact that pro-
duction is temporarily interrupted.
Firms also incur in inventory adjustment costs, which are specified by the
following functional form:

+ 2

 b + N + cn Ht
Nt if Ht > 0

 t 2 Nt

N adjt = 0 if Ht = 0 (7)



 c − 2
 b− Nt + n Ht Nt if Ht < 0,
2 Nt
where cn+ , cn− , b+ , b− > 0 are constants. For symmetry, this specification is
similar to the specification of capital adjustment costs. Naturally, because the
two capital inputs are different, the adjustment cost parameters will be dif-
ferent in the two specifications as well. The convex component of inventory
adjustment cost in Equation (7) follows from Gomes, Kogan, and Yogo (2009)
and, apart from its asymmetries, it is the standard specification used in stan-
dard q-theory of investment. The nonconvex adjustment cost specification for
inventories was first proposed in Scarf (1960) and captures a fixed cost in-
curred when the firm adjusts its stock of inventories. This fixed cost includes,
for example, the number of labor hours that the firm hires to undertake in-
ventory investment, irrespective of the size of the investment. Using firm-level
U.S. data, McCarthy and Zakrajsek (2000) provide evidence that the inventory
adjustment is nonlinear and asymmetric. These features are both captured here
by the asymmetry and nonconvexity of the adjustment cost function. We dis-
cuss the magnitude of the adjustment cost parameters in the calibration section
below.
Finally, the firm also incurs in operating fixed costs of production that are
independent of firm size, which are captured by a positive parameter f . The
positive fixed cost captures the existence of fixed outside opportunity costs for
some scarce resources, such as managerial labor used by the firms.
2.1.3 Stochastic discount factor. Following Zhang (2005), we directly

specify the stochastic discount factor without explicitly modeling the con-
sumer’s problem. The stochastic discount factor is given by
log Mt,t+1 = log β + γt (xt − xt+1 ) (8)
γt = γ0 + γ1 (xt − x)
ˉ , (9)
291
where Mt,t+1 denotes the stochastic discount factor from time t to t + 1. The
parameters {β, γ0 , γ1 } are constants satisfying 1 > β > 0, γ0 > 0 and γ1 < 0.
According to this specification, the risk-free rate (R f,t ) and the maximum
Sharpe ratio (S Rt ) in the economy are given by
1 1 ˉ 12 γt2 σx2
R f,t = = e−γt (1−ρx )(xt −x)− (10)
E t Mt,t+1 β
q
σt Mt,t+1 2 2
S Rt = = eγt σx − 1. (11)
E t Mt,t+1
Equation (8) can be motivated as a reduced-form representation of the in-

tertemporal marginal rate of substitution for a fictitious representative con-
sumer or the equilibrium marginal rate of transformation, as in Belo (2010).
According to Equation (9), γt is time varying and decreases in the demeaned
aggregate productivity shock xt − xˉ to capture the well-documented counter-
cyclical price of risk with γ1 < 0. The precise economic mechanism driving
the countercyclical price of risk can be, for example, time-varying risk aver-
sion, as in Campbell and Cochrane (1999).
2.2 Firm value, risk, and return

All firms in the economy are assumed to be all-equity financed, so we define
Dt = Salest − It − N adjt − K adjt − f (12)
to be the dividends distributed by the firm to the shareholders. Negative divi-

dends are interpreted as equity issuance.
Define the vector of state variables as st = (K t , Nt , xt , z t ) and let V cum (st )
be the cum-dividend market value of the firm in period t. The firm makes
capital investment It and inventory investment Ht decisions to maximize its
cum-dividend market value by solving the problem
  
 ∞
X 
V cum (st ) = max Et  Mt,t+ j Dt+ j  , (13)
It+ j ,Ht+ j , j=0..∞  
j=0
subject to the capital and inventory accumulation Equations (4) and (5) and
the flow of funds constraint (12) for all dates t. The operator Et [.] represents
the expectation over all states of nature given all the information available at
time t.
In the model, risk and expected stock returns are determined endogenously
along with the firm’s optimal production decisions. To make the link explicit,
292
we can evaluate the value function in Equation (13) at the optimum,

V cum (st ) = Dt + Et Mt,t+1 V cum (st+1 ) (14)
s

⇒ 1 = Et Mt,t+1 Rt+1 (15)
s s
⇒ Et Rt+1 = R f t − R f t × Covt Rt+1 , Mt,t+1 , (16)
where Equation (14) is the Bellman equation for the value function, the Euler
Equation (15) follows from the standard formula for stock return Rt+1 s =
cum
V cum (st+1 )/ V (st ) − Dt , and Equation (16) follows from simple algebra
−1
using Equation (15) and R f t = E t Mt,t+1 . According to Equation (16),
firms whose stock returns have a high negative covariance with the stochastic
discount factor (i.e., provide low returns when the marginal utility of consump-
tion is high) are risky, and thus the average stock returns of these firms must
be high in equilibrium to compensate investors for bearing the risk of holding
these assets.
3. Model Implications for the Cross-section

This section reports our main findings. We investigate the ability of the
investment-based model to match the cross-sectional empirical facts reported
in Section 1. To generate the model’s implied cross-sectional moments for as-
set prices and quantities, we calibrate the model and simulate 200 artificial
panels, each of which has 3,600 firms and 480 monthly observations. We then
replicate the empirical procedures on the artificial data simulated by the model
and report the cross-sample average results.
All the endogenous variables in the model, including the firm’s physical cap-
ital and inventory investment rates, risk, and expected returns, are functions of
the state variables. Because the functional forms are not available analytically,
we solve for these functions numerically. Appendix A1 provides a description
of the solution algorithm and the numerical implementation of the model.
3.1 Calibration
The model is solved at monthly frequency. Because all the quantity variables in
the data are available only at the annual frequency, we aggregate the monthly
quantity variables to the annual frequency and we calibrate the model to match
selected annual moments as closely as possible.
Table 4 reports the set of parameter values used to solve the model. The
first set of parameters specifies the technology of the firm. The second set of
parameters describes the exogenous stochastic processes that the firm faces, in-
cluding the aggregate and idiosyncratic productivity shock, and the stochastic
discount factor. The choice of the parameter values is based on the parameter
values reported in previous studies whenever possible, or by matching known
293
Table 4
Parameter Values
Parameter Symbol Value
Technology
Weight of physical capital in the production function αk 0.78
Returns to scale θ 0.70
Elasticity of substitution between capital and inventory ρ 0.5
Rate of depreciation for capital δk 0.01
Rate of depreciation for inventory δn 0.02
Convex parameter in capital adjustment cost ck /ck−
+ 3/30
Convex parameter in inventory adjustment cost cn+ /cn− 6.5/65
Nonconvex parameter in capital adjustment cost a + /a − 0.05/0.12
Nonconvex parameter in inventory adjustment cost b+ /b− 0.20/0.07
Operating fixed cost f 0.007
Stochastic Processes
Persistence coefficient of aggregate productivity ρx 0.951/3
Conditional volatility of aggregate productivity σx 0.007/3
Persistence coefficient of firm-specific productivity ρz 0.97
Conditional volatility of firm-specific productivity σz 0.10
Time-preference coefficient β 0.994
Constant price of risk γ0 50
Time-varying price of risk γ1 −1000
This table presents the calibrated parameter values of the baseline investment-based model.
aggregate asset pricing facts, as well as key firm-level moments reported in

Table 1.
Firm’s technology. We set the returns to scale in the production function (1)
to be θ = 0.7, roughly in the lower end of the estimates in Basu and Fernald
(1997) and Burnside, Eichenbaum, and Rebelo (1995). The share of capital in
the production function is set to be αk = 0.78 and the elasticity of substitution
between capital and inventory stock to be ρ = 0.5 to match the inventory-
to-sales ratio of 17%. The capital depreciation rate δk is set as 1% per month
as in Zhang (2005). The depreciation rate of inventory is set at δn = 2% per
month, following Jones and Tuzel (2011), who argue that the depreciation rate
for inventory is higher than that of physical capital.
The empirical evidence on inventory adjustment costs is scarce. Although
intuition suggests that inventory adjustment costs are likely to be low, the
empirical evidence is mixed. Chirinko (1993) estimates inventory adjustment
costs to be small. However, Chirinko’s analysis takes the data (e.g., firms’ sales
and inventory investment) as given, and thus it ignores the importance of ad-
justment costs in a setup in which the data are endogenously determined, as we
have here. Ramey and Vine (2006) document that a typical plant in the U.S.
automobile industry closes for about 4% of the total working weeks in a typical
year due to inventory adjustments. Similarly, Hall (1996) reports average plant
shutdowns of about 8.5 weeks each year for inventory adjustments. Although
these costs have been interpreted as evidence of fixed setup costs of production
294
(e.g., the fixed cost of opening a plant for a week), they also show that inven-
tory adjustments are associated with substantial losses due to interruptions in
the production process for relatively long periods.
Since the inventory adjustment cost parameters determine the dynamics of
inventory investment, we calibrate these parameters to match as closely as pos-
sible the volatility and autocorrelation of the firm’s level inventory growth rate.
Convex adjustment costs are important in determining the volatilities, while
nonconvex adjustment costs are crucial to match the autocorrelation. We set
the convex inventory adjustment costs to be cn+ = 6.5, ck− = 65 and the non-
convex inventory adjustment costs to be b+ = 0.20, b− = 0.07. The asym-
metry in the adjustment cost function is consistent with the empirical evidence
in McCarthy and Zakrajsek (2000), who show that firm-level inventory adjust-
ment is nonlinear and asymmetric.
Similarly, we calibrate the physical capital adjustment costs to match as
closely as possible the firm-level volatility and autocorrelation of the phys-
ical capital investment rate. This exercise leads to the following combina-
tions of parameters: The convex capital adjustment costs are set to ck+ =
3, ck− = 30, and the nonconvex capital adjustment costs are set to be a + =
0.05, a − = 0.12. The asymmetry between upward and downward costs is set
to be ck− /ck+ = 10, consistent with Zhang (2005).
We set the operating fixed cost f to match as closely as possible the value
premium in the data (5.46% per annum), defined as the difference in the av-
erage value-weighted returns of the high-minus-low decile portfolio sorted on
book-to-market ratio, and at the same time generate a reasonable firm-level
physical-capital-to-market-equity ratio (K/ME) of 0.41.6
Stochastic processes. We set the persistence of the aggregate productivity

shock at ρx = 0.951/3 and its conditional volatility at σx = 0.007/3, which
roughly corresponds to the quarterly estimates in Cooley and Prescott (1995).
The long-run average level of aggregate productivity, x, ˉ is a scaling variable.
We set xˉ = −2.1, which implies the average long-run physical capital in the
economy at one-half. To calibrate the persistence parameter ρz and the condi-
tional volatility parameter σz of the firm-specific productivity shock, we follow
Zhang (2005) and restrict these two parameters using their implications on the
degree of dispersion in the cross-sectional distribution of firms’ stock return
volatilities. Thus, we set ρz = 0.97 and σz = 0.10, implying an average an-
nual volatility of individual stock returns of 34%, approximately the value of
32% reported in Vuolteenaho (2001).
Following Zhang (2005), we pin down the three parameters governing the
stochastic discount factor, β, γ0 , and γ1 in Equations (8) and (9), by matching
6 We target the physical-capital-to-market-equity ratio instead of the more standard book-equity-to-market-equity

ratio because in the theoretical model we can measure the stock of physical capital but not the book value of
equity (since we have two capital inputs).
295
three aggregate return moments: the average real interest rate, the volatility
of the real interest rate, and the average Sharpe ratio in the U.S. economy
(approximately 0.4). This procedure yields β = 0.994, γ0 = 50, and γ1 =
−1000.
The previous parameter values specify the main calibration of the model,
which we define as the baseline model (specification 1). To help understand
the economic determinants of inventory investment and risk in the model, we
also consider six additional alternative specifications (specifications 2 to 6),
which we analyze in Section 4.
3.2 Matching business cycle facts

Panel A of Table 5 reports averages of selected firm-level moments (real quan-
tities) of the firm-level physical capital investment rate, inventory growth,
inventory-to-sales ratio, and sales growth across simulated data from the
model. The table reports the results for the baseline model (specification 1) as
well as across the alternative specifications of the model (specifications 2 to 7).
In this section, we focus the analysis on the results for the baseline model.
Overall, the baseline model successfully matches several firm-level quan-
tity moments. The calibration of the model targets the mean inventory-to-sales
ratio, as well as the volatility and autocorrelation of the physical capital invest-
ment rate and inventory growth rate. The calibration of the model matches
these moments well, although the autocorrelation of inventory growth is
slightly higher in the model, −7% in the data versus 11% in the model.7
More interestingly, the model also matches quantity moments not used in
the calibration. The moments for firm-level sales growth are close to the data,
although the model slightly overshoots its volatility, 23% in the data versus
40% in the model, as well as its autocorrelation, 6% in the data versus 21%
in the model. The implied correlations generated by the model are also qual-
itatively consistent with the data: Both physical capital investment and inven-
tory growth are procyclical (positively correlated with sales growth), and the
inventory-to-sales ratio is countercyclical, because sales are procyclical while
the inventory stock is much smoother. However, the magnitude of these corre-
lations is considerably higher than in the data, a result that can be partially ex-
plained by the absence of measurement error in the simulated data. These high
correlations are also expected given the very simple stochastic structure of the
model in which economic fluctuations are driven by one aggregate shock.
Finally, and most importantly, the model also successfully matches the high
autocorrelation of the inventory-to-sales ratio, 50% in the data versus 54% in
the model. As emphasized by Ramey and West (1999), the high autocorrelation
and the countercyclicality of the inventory-to-sales ratio is a key stylized fact
7 We do not report the mean of physical investment rate because it is pinned down by, and hence is equal to, the
physical capital depreciation rate. Similarly, the mean inventory growth and sales growth are pinned down by the
aggregate growth rate in the economy. Because there is no growth in the model, these values are approximately
zero.
296
Table 5
Data versus model-implied moments across alternative calibrations
Panel A: Real Quantities
Avg S.D. Autocorrelation Correlation
Spec. NS σ (IK) σ (HN) σ (NS) σ (SG) AC(IK) AC(HN) AC(NS) AC(SG) ρ(IK,HN) ρ(IK,SG) ρ(HN,SG) ρ(NS,SG)
Data
− 0.17 0.27 0.33 0.07 0.23 0.17 −0.07 0.50 0.06 0.26 0.27 0.43 −0.10
Baseline model
1 0.17 0.26 0.30 0.05 0.40 0.22 0.11 0.54 0.21 0.84 0.79 0.73 −0.61
Alternative specification without nonconvex inventory adj. costs (b+ = b− = 0)
2 0.76 0.23 0.21 0.27 0.33 0.36 0.50 0.72 0.29 0.90 0.77 0.77 −0.51
Alternative specification without convex inventory adj. costs (cn+ = cn− = 0)

3 0.19 0.27 0.77 0.06 0.81 0.25 −0.14 0.29 0.01 0.56 0.66 0.14 −0.20
Alternative specification without inventory adj. costs (b+ = b− = cn+ = cn− = 0)

4 0.74 0.28 0.69 0.46 2.45 0.27 0.01 0.19 −0.08 0.72 0.11 −0.10 −0.06
Alternative specification without fixed operating costs ( f = 0)
5 0.17 0.26 0.33 0.06 0.41 0.23 0.12 0.55 0.21 0.82 0.78 0.69 −0.60
Alternative specification with low K and N elasticity of substitution (ρ = 0.7)
6 0.21 0.27 0.36 0.07 0.41 0.22 0.13 0.55 0.22 0.86 0.77 0.72 −0.62
Alternative specification with high K and N elasticity of substitution (ρ = −0.05)
7 0.10 0.26 0.46 0.03 0.40 0.26 0.12 0.51 0.22 0.75 0.81 0.70 −0.61
(continued)
297
298
Table 5
Data versus model-implied moments across alternative calibrations (cont.)
Panel B: Asset Prices
Inventory Growth Spread
Sharpe Value Equal-weighted Value-weighted
Spec. Ratio Rf σ Rf K/ME Premium All Small Mid Big All Small Mid Big
Data

− 0.43 1.80 3.00 0.41 5.46 10.68 7.08 5.39 3.25 6.62 5.78 5.02 3.78
Baseline model
1 0.41 1.84 2.78 0.32 5.58 5.56 3.92 1.59 2.80 4.61 3.78 1.57 2.40
Alternative specification without nonconvex inventory adj. costs (b+ = b− = 0)

2 0.42 1.71 2.74 0.20 0.63 2.39 1.07 0.46 1.37 2.28 1.11 0.57 1.34
Alternative specification without convex inventory adj. costs (cn+ = cn− = 0)

3 0.42 1.89 2.80 0.31 4.34 3.52 2.21 1.31 1.79 2.90 2.39 1.31 1.30
Alternative specification without inventory adj. costs (b+ = b− = cn+ = cn− = 0)

4 0.33 1.85 2.70 0.21 1.17 2.36 1.61 1.20 1.92 2.32 1.75 1.29 1.77
Alternative specification without fixed operating costs ( f = 0)
5 0.38 1.6 2.65 0.18 1.00 2.76 1.29 0.76 1.53 2.82 1.43 0.86 1.47
Alternative specification with low K and N Elasticity of Substitution (ρ = 0.7)
6 0.51 1.66 2.71 0.32 6.76 8.86 5.56 1.55 3.08 6.62 4.91 1.54 2.59
Alternative specification with high K and N Elasticity of Substitution (ρ = −0.05)
7 0.48 1.70 2.68 0.28 3.16 4.61 2.27 0.94 2.41 4.41 2.51 1.07 2.20
This table presents selected moments in the data and implied by the simulation of the model under alternative specifications (Specifications 1 to 7). The reported statistics are averages
from 200 samples of simulated data, each with 3,600 firms and 480 monthly observations. Panel A reports firm-level moments–real quantities. It reports the mean of the inventory-to-sales
ratio (Avg NS) as well as the standard deviation, denoted by σ (.), the autocorrelation, denoted by AC(.), and the correlation, denoted by ρ(x, y), of the firm-level investment rate (IK), net
inventory growth rate (HN), inventory-to-(net) sales ratio (NS), and real sales growth (SG). Panel B reports aggregate and cross-sectional asset pricing moments: the aggregate Sharpe ratio,
the mean and the standard deviation of the risk-free rate, the physical-capital-to-market-equity ratio (K/ME), the value-weighted value premium, as well as the equal- and value-weighted
inventory growth spread across the ten one-way-sorted inventory growth portfolios (All), as well as across the portfolios two-way-sorted on inventory growth and size (Small, Mid, and Big).
of inventories and thus must be taken seriously by any candidate theoretical

model of inventory behavior.
3.3 Matching asset pricing facts

Panel B of Table 5 reports the averages of aggregate and selected cross-
sectional asset pricing moments in the data simulated from the model.
The calibration of the baseline model targets key aggregate asset pricing mo-
ments, as well as the value premium. Despite the nonlinearities in the model,
the model matches these moments well. The model generates a large Sharpe
ratio (0.41) and a low and smooth risk-free rate (mean of 2% and volatility
around 3%). The level of asset prices (firm value) in the model is also close
to the data: The mean physical capital to market equity ratio (K/ME) is 0.41
in the data, and 0.32 for the model. Finally, the model matches the value pre-
mium. In our data sample, the value premium is 5.46% (value-weighted), and
in the model is 5.58%.
3.3.1 One-way-sorted portfolios. Table 6 reports the average equal- and

value-weighted excess returns and asset pricing test results of the ten one-way-
sorted inventory growth portfolios (Panel A), as well as of the nine portfolios
two-way-sorted on size and inventory growth (Panel B). We replicate the con-
struction of these portfolios and the asset pricing tests on the simulated data
following the procedure used in the real data, as described in Section 1.3.
The model generates a positive inventory growth spread: Firms with low
inventory growth outperform firms with high inventory growth. Focusing on
the returns across the ten one-way-sorted inventory growth portfolios, Panel A
shows that the model generates an inventory growth spread that is more than
three standard errors from zero, and is economically large. For equal-weighted
portfolios, the inventory growth spread is 5.56% in the model versus 10.68% in
the data. The model is considerably more successful on value-weighted port-
folios. Here, the inventory growth spread is 4.61% in the model versus 6.62%
in the data, a difference of only two percentage points. The magnitude of the
spreads generated by the model is slightly lower than those observed in the
data, which can be partially explained by the absence of debt (leverage) in
our model (in the data reported in Panel B of Table 2, firms with low inventory
growth rates have slightly higher leverage ratios than firms with high inventory
growth rates).
To test if the difference between the model’s implied inventory growth
spreads is significantly different from those observed in the data, Figure 1 plots
the histogram of the levered inventory growth spread based on the two hundred
simulated panels. We levered the inventory growth spread in the model to make
it directly comparable to the data.8 Interestingly, the inventory growth spread in
8 We compute the model-implied levered return as R e = R a + Lev × (R a − R ), where R a is the return of the
t t t ft
all-equity firm in the model, R f is the risk-free rate, and Lev is the portfolio-level average leverage ratio from
Panel B in Table 2.
299
300
Table 6
Inventory growth portfolios on simulated data
Panel A: One-Way-Sorted Inventory Growth Portfolios
Low 2 3 4 5 6 7 8 9 High L-H MAE
rS 16.79 15.51 15.13 14.50 13.71 13.02 12.48 12.24 11.92 11.24 5.56
[t] 4.84 4.68 4.75 4.66 4.66 4.48 4.38 4.38 4.23 4.18 3.03
α 1.67 1.31 1.21 0.97 0.50 0.18 0.12 0.11 −0.06 −0.23 1.90 0.63
[t] 3.60 3.66 3.42 2.63 1.08 0.51 0.37 0.40 −0.20 −0.81 3.52
α FF 0.22 0.24 0.21 0.21 −0.18 −0.16 0.09 0.08 0.09 0.16 0.06 0.16
[t] 0.53 0.63 0.54 0.52 −0.49 −0.40 0.24 0.23 0.28 0.49 0.13
rS 14.77 13.59 13.37 12.81 11.98 11.35 10.88 10.72 10.58 10.16 4.61
[t] 4.54 4.43 4.45 4.38 4.38 4.18 4.09 4.10 4.01 3.99 3.04
α 1.15 0.80 0.69 0.45 −0.03 −0.31 −0.33 −0.31 −0.45 −0.57 1.72 0.51
[t] 3.05 2.96 2.29 1.43 −0.07 −1.03 −1.21 −1.21 −1.63 −2.25 3.54
α FF 0.15 0.13 0.10 0.06 −0.32 −0.31 −0.03 −0.01 0.00 0.03 0.12 0.11
[t] 0.39 0.38 0.29 0.15 −0.85 −0.75 −0.12 −0.03 0.01 0.11 0.29
(continued)
Table 6
Inventory growth portfolios on simulated data (cont.)
Panel B: Two-Way-Sorted on Size and Inventory Growth Portfolios
Inventory Growth Inventory Growth Inventory Growth
Low Mid High L-H Low Mid High L-H Low Mid High L-H MAE
rS α α FF CAPM FF
Small 18.46 17.46 14.54 3.92 2.25 1.88 0.60 1.65 0.31 0.39 −0.08 0.39 0.85 0.17
Mid 13.92 13.58 12.33 1.59 0.71 0.51 0.10 0.61 0.21 0.03 0.16 0.05
Big 12.71 10.39 9.92 2.80 0.39 −0.59 −0.67 1.06 0.17 −0.16 −0.02 0.18
tr S t(α ) tα
Small 5.11 5.07 4.67 6.08 4.46 3.31 1.56 3.52 0.86 0.75 0.79
FF
−0.17
Mid 4.48 4.55 4.34 3.00 2.31 1.85 0.30 1.45 0.65 0.14 0.44 0.10
Big 4.25 4.03 3.97 4.66 1.15 −2.09 −3.29 2.50 0.47 −0.53 −0.08 0.41
rS α α FF CAPM FF
Small 16.61 15.35 12.83 3.78 1.79 1.24 0.16 1.62 0.12 0.17 −0.19 0.31 0.65 0.14
Mid 12.70 12.60 11.14 1.57 0.37 0.21 −0.26 0.63 0.05 −0.11 0.07 −0.02
Big 11.75 9.67 9.35 2.40 0.13 −0.81 −0.86 1.00 0.06 −0.32 −0.17 0.24
t rS t(α ) tα FF
Small 4.87 4.75 4.39 6.19 4.44 2.72 0.55 3.59 0.36 0.39 0.65

−0.52
Mid 4.33 4.38 4.12 3.60 1.29 0.95 −0.98 1.62 0.15 −0.62 0.22 −0.03
Big 4.14 3.92 3.89 4.57 0.42 −3.32 −4.55 2.61 0.20 −1.33 −1.00 0.58
This table reports the average excess returns, alphas, and corresponding t-statistics of ten one-way-sorted inventory growth portfolios (Panel A) and nine two-way-sorted inventory growth
rate and size portfolios (Panel B), constructed from data simulated by the baseline investment-based model. r S is the average annualized (×1200) excess stock return. α is the intercept
from the monthly CAPM regression in annual percentage. α FF is the intercept from the monthly Fama and French (1993) three-factor regression in annual percentage. t are heteroskedastic
and autocorrelation-consistent t-statistics. Low, Mid, and High stand for the sorting on inventory growth rates, and Small, Mid, and Big stand for the sorting on size (market capitalization).
L-H stands for the low-minus-high inventory growth portfolio, and the average return of this portfolio is the inventory growth spread. MAE is the mean absolute pricing error. The reported
statistics are averages from 200 samples of simulated data, each with 3,600 firms and 480 monthly observations.
301
Figure 1
Histogram of the levered inventory growth spread across simulations
The figure shows the histogram of the equal-weighted (top panels) and value-weighted (bottom panels) levered
inventory growth spread across ten one-way-sorted inventory growth portfolios (left panels) as well across small
firms (middle panels) and big firms (right panels) generated by the baseline investment-based model with inven-
tory holdings. The histograms are based on data simulated by the model across 200 samples, each with 3,600
firms and 480 monthly observations. The arrow in each panel shows the corresponding inventory growth spread
in the real data reported in Panels A and B of Table 2.
the data is well inside the distribution of the levered inventory growth spread
generated by the model across all firms, for both equal- and value-weighted
portfolios (top and bottom left panels).
3.3.2 Two-way-sorted inventory growth and size portfolios. The average

returns of the nine portfolios two–way-sorted on size and inventory growth
generated by the model are also large and overall consistent with the pattern
observed in the data. In particular, for both equal- and value-weighted portfo-
lios, the inventory growth spread is larger among small firms than across large
firms (see L-H column). However, the model predicts the inventory growth
spread for medium-sized firms to be smaller than the spread for both small and
large firms, a pattern that is not consistent with the data.
Importantly, we cannot reject the hypothesis that the inventory growth
spread in the model across firms with different sizes is equal to the corre-
sponding inventory growth spreads in the data. As reported in Figure 1, the
inventory growth spread across small and large firms observed in the data is
inside the distribution of the levered inventory growth spread generated by the
model (top and bottom middle and right panels).
3.3.3 Asset pricing tests. Finally, we investigate if the model can replicate
the failure of the unconditional CAPM and, to a lesser extent, of the Fama and
French (1993) three-factor model in explaining the inventory growth spread.
302
Table 6 shows that the unconditional CAPM in the simulated data performs
significantly better than in the real data. Panel A shows that the model gen-
erates a pattern of abnormal returns across the ten one-way-sorted inventory
growth portfolios that is qualitatively consistent with the data: Firms with low
inventory growth rates have higher abnormal returns than firms with high in-
ventory growth rates. For equal-weighted portfolios, the CAPM alpha of the
low-minus-high spread portfolio is economically large, 1.9% per annum, and
this value is more than 3.5 standard errors from zero. For value-weighted port-
folios, the CAPM alpha of the spread portfolio is 1.7% per annum, and this
value is also more than 3.5 standard errors from zero. However, the sizes of
the CAPM alphas in the model are considerably lower than those observed
in the data. The mean CAPM absolute pricing errors in the model are 0.6%
and 0.5% per annum for equal-weighted and value-weighted portfolios, re-
spectively, whereas in the data the corresponding values are 5.3% and 2.0%.
The analysis of the results for the Fama–French three-factor model in the
simulated data, as well as the asset pricing test results across the portfolios
two-way-sorted on size and inventory growth (Panel B), is qualitatively sim-
ilar to the analysis of the unconditional CAPM across the ten portfolios
one-way-sorted on inventory growth, and so its discussion is omitted
here.
The inability of the investment-based model to quantitatively replicate the
failure of the CAPM is perhaps surprising in light of the results reported in
Gomes, Kogan, and Zhang (2003, Table 7) and Li, Livdan, and Zhang (2009,
Table 3). These studies examine a production economy with only one aggre-
gate shock, as we have here, and conclude that their theoretical models are con-
sistent with the failure of the CAPM. Specifically, using firm-level Fama and
MacBeth (1973) cross-sectional regressions, they show that betas estimated
using standard rolling regressions (as in Fama and French 2002) based on past
return data are negatively correlated with firms’ future stock returns. In addi-
tion, standard firm characteristics such as size and book-to-market ratio have
predictive power for stock returns even controlling for the firm’s estimated
beta.
The asset pricing tests reported here are different because we test the
CAPM using the Fama–French portfolio approach, whereas the previous stud-
ies use Fama–MacBeth cross-sectional regressions. This difference is impor-
tant. Consistent with the previous studies, our model replicates the failure
of the CAPM using firm-level cross-sectional regressions as well (results re-
ported in the online appendix). As emphasized in the previous studies, the
standard empirical procedures used to estimate the unobserved time-varying
firm-level betas are subject to large measurement errors, which in turn helps
explain the weak performance of the CAPM both in the data and in the
model.
By performing the asset pricing tests at the portfolio level, the effect of
measurement errors in the betas is significantly reduced in our approach.
303
In addition, the sorting procedure based on a variable (inventory growth) that

is correlated with the firm’s true conditional beta generates portfolio betas that
are significantly more stable over time than the firm-level betas.9 As a result,
the portfolio’s unconditional betas are on average closer to its true conditional
betas, thus helping improve the performance of unconditional asset pricing
models at the portfolio level.
To replicate the failure of the CAPM at the portfolio level is likely to require
changes in the setup of the investment-based model. We do not pursue these
changes here because our focus is on the study of the realized inventory growth
spread. A possible reason for the counterfactually good fit of the CAPM at the
portfolio level in the model is the assumption of a single source of aggregate
risk. The better empirical performance of multifactor models such as the Fama
and French (1993) three-factor model or the Chen, Novy-Marx, and Zhang
(2011) model, however, suggests that the single source of aggregate risk might
not be a good assumption. Thus, adding additional sources of aggregate risk
in the investment-based model (for example, investment-specific shocks along
the lines of Kogan and Papanikolaou 2010) is one promising direction for im-
proving the fit of the investment-based model on asset pricing tests.
4. Inspecting the Mechanism

The previous analysis shows that the baseline investment-based model with
inventory holdings generates a large inventory growth spread in the data and
at the same time matches key firm-level quantity and aggregate asset pricing
moments. In this section, we study the alternative specifications of the model
(specifications 2 to 7) to understand the economic forces driving these results.
Table 5 reports the fit of each alternative specification on both asset pricing and
real quantity moments in the cross-section. In each additional specification, we
vary one set of parameters at a time while keeping the other parameters equal
to the calibration of the baseline model. Thus, the results from each alterna-
tive specification can be interpreted as a standard comparative static exercise.
In specifications 2 to 4, we shut down nonconvex (bn+ = bn− = 0) or convex
(bn+ = bn− = 0) inventory adjustment costs, both separately and jointly. In
specification 5, we set the operating fixed cost to zero ( f = 0), and in specifi-
cations 6 and 7, we consider a low (ES = 0.59) and high (ES = 1.05) value of
the elasticity of substitution between physical capital and inventory inputs. We
do not investigate alternative specifications of the physical capital adjustment
cost function because our main focus is on inventory.
To help in the interpretation of the results and in understanding the fun-
damental determinants of inventory investment, Figure 2 plots the policy
function of the gross inventory investment (i.e., the level of total inventory
9 In the simulated data, the average cross-sectional correlation between firms’ inventory growth rate and condi-
tional beta is −50%. In addition, as reported in the online appendix, the standard deviation of the estimated
rolling beta is 7.65 at the firm level but only 0.88 at the portfolio level.
304
Figure 2
Inventory investment policy function
This figure plots the policy functions of gross inventory investment H (K t , Nt , xt , z t ) against the current inven-
tory stock across four alternative specifications of the investment-based model with inventory holdings: Panel A
is the baseline model with both convex and nonconvex inventory adjustment costs; Panel B is a specification with
only nonconvex inventory adjustment costs; Panel C is a specification with only convex inventory adjustment
costs; and Panel D is a specification without any inventory adjustment costs. In the plots, we fix the aggregate
productivity xt and capital K t at their respective long-run average levels of xˉ and Kˉ . The inventory stock is
normalized to be between zero and one. Each of these panels has two curves corresponding to the low firm-level
productivity z t (solid line) and high productivity z t (dashed line).
investment) as a function of the current inventory stock implied by the base-

line model as well as by selected alternative specifications. In addition, to un-
derstand the determinants of firm’s risk, Figure 3 plots the firm’s conditional
beta β(K t , Nt , xt , z t ) against the firm’s current inventory stock in the base-
line model and its alternative specifications. The conditional beta is given by
s −1
βt ≡ −Covt Rt+1 , Mt,t+1 × V art Mt,t+1 , which follows from Equation
(16).10
h i
10 Specifically, we can write Equation (16) in the standard expected return-beta form as E R s
h i
t t+1 = R f t + βt ×λt ,
s ,M −1
in which βt ≡ −Covt Rt+1 t,t+1 × V art Mt,t+1 is the quantity of risk of the asset, and λt ≡ R f t ×

V art Mt,t+1 is the price of risk.
305
Figure 3
Fundamental determinants of risk h i
This figure plots the firm’s conditional beta β(K t , Bt , xt , z t ), given by βt ≡ −Covt Rt+1 s ,M
t,t+1 ×
−1
V art Mt,t+1 , which follows from Equation (16), against the current level of inventory stock. Each panel
reports the conditional beta for the baseline model as well as for an alternative specification of the model: Panel
A is the baseline model across two different levels of productivity (high and low); Panel B is a model with only
nonconvex inventory adjustment costs; Panel C is a model with only convex inventory adjustment costs; Panel
D is a model without inventory adjustment costs; Panel E is a model with no fixed operating costs; and Panel
F is a model with two different levels of physical capital and inventory elasticity of substitution (ES) (high and
low). In Panels B to F, we fix the aggregate productivity xt , firm-level productivity z t , and physical capital K t
stock at their respective long-run average levels of xˉ , zˉ , and Kˉ . The inventory stock is normalized to be between
zero and one.
4.1 The role of nonconvex and convex inventory adjustment costs

To investigate the importance of inventory adjustment costs for inventory in-
vestment dynamics and risk, we examine the results from the alternative spec-
ifications 2 to 4.
Figure 2 shows that, all else equal, more productive firms have higher levels
of inventory investment. In the baseline model (Panel A), for relatively low
levels of inventory stocks, inventory investment is increasing in the current
level of the inventory stock, but at a diminishing rate. This diminishing rate is
due to convex inventory adjustment costs that penalize the firm from making
large and swift changes in the inventory stock.
Importantly, firms’ inventory investment and disinvestment decisions are as-
sociated with inventory stock thresholds levels due to nonconvex adjustment
costs. These thresholds are the levels of inventory stock at which the fixed
306
costs of adjusting inventory are equal to the difference between the marginal
benefits and marginal convex costs of making the adjustment. The region in-
side the thresholds is the inaction region where firms find it optimal not to
make any changes in the inventory stock. The baseline model’s implied opti-
mal inventory investment policy is close to an (s, S) type rule, which leads to
lumpiness in inventory investment.
In the model with only nonconvex inventory adjustment costs (Panel B), the
firm makes full inventory adjustments to the optimal frictionless level except
across a small range of current inventory stock (again, the inaction region) in
which the fixed costs of inventory adjustment are too large relative to the ben-
efits from adjusting the inventory stock. In the model with only convex adjust-
ment costs (Panel C), firms continuously adjust their inventory stock (except
at the point of zero inventory investment), but at a diminishing rate up to a
certain level, which gives rise to the concave policy function. Finally, without
any inventory adjustment costs (Panel D), firms always adjust to the optimal
inventory stock level.
The qualitative properties of the inventory investment policy function help
explain the poor fit of the alternative specifications 2 to 4 reported in Table 5.
Clearly, both nonconvex and convex inventory adjustment costs are crucial for
the model to match the data, both on the quantity side and on the asset pricing
side. In terms of real quantities (Panel A), specification 2 shows that by remov-
ing nonconvex inventory adjustment costs, the model counterfactually gener-
ates an investment growth rate that is too persistent (50% here versus 11% in
the baseline model and −7% in the data). Consistent with the analysis in Panel
C of Figure 2, with only convex inventory adjustment costs, firms spread the
inventory investment over time due to increasing marginal adjustment costs. In
turn, this makes the inventory investment considerably more persistent than in
the data.
The results for specification 3 show that by removing convex adjustment
costs, the model generates an investment growth rate that is too volatile (77%
here versus 30% in the baseline model and 33% in the data). Consistent with
the analysis in Panel B of Figure 2, with only nonconvex inventory adjust-
ment costs, inventory investment is lumpy, with occasional infrequent but very
large inventory investments. In turn, this makes the unconditional volatility of
inventory investment too high relative to the data. Specification 4 shows that
this unreasonably large volatility of inventory investment remains the main
problem in a specification of the model in which both convex and nonconvex
adjustment costs are eliminated.
Turning to the analysis of the effects of inventory adjustment costs on as-
set prices, Panels A to D of Figure 3 plot the firm’s conditional beta in the
baseline model and across the alternative specifications of the inventory ad-
justment cost function considered here. According to Panel A, all else equal, a
firm’s risk is decreasing in the firm’s productivity and decreases with the inven-
tory stock. Because inventory investment is increasing in productivity, this fact
307
helps explain the negative correlation between firms, inventory growth rates
and future returns observed in the data.
Importantly, eliminating either convex (Panel B), nonconvex (Panel C), or
both (Panel D) significantly reduces the firm’s risk relative to the baseline
model. In addition, without any inventory adjustment costs, the firm’s condi-
tional beta is flat as a function of the inventory stock. The positive relationship
between the size of adjustment costs and the firm’s risk is well known (e.g.,
Jermann 1998; Zhang 2005). In production economies, the firm’s risk is in-
versely related to its flexibility in using investment to mitigate the effect of
shocks on its dividend stream. The more flexible a firm is in this regard, the
less risky it is. The size of the adjustment costs controls the firm’s ability to
smooth its dividends, and hence controls its flexibility. Thus, here, the lower
the inventory adjustment costs a firm faces, the more flexible it is in adjusting
its stock of inventories, and thus the less risky the firm is.
Consistent with the analysis of the firm’s conditional beta in Figure 3, Panel
B of Table 5 shows that eliminating the inventory adjustment costs substan-
tially reduces the return’s spreads, and thus deteriorates the fit of the model
on the asset pricing dimension as well. Specification 2 shows that by removing
nonconvex adjustment costs, the model generates a tiny value premium (0.63%
here versus 5.58% in the baseline model and 5.35% in the data) and reduces
the inventory growth spread of both equal- and value-weighted portfolios to
about half the size of the spreads in the baseline model. Specification 3 shows
that removing convex adjustment costs has a smaller effect on spreads than
removing nonconvex costs, but the model-implied spreads are still lower than
those generated by the baseline model. Finally, when both convex and noncon-
vex adjustment costs are removed in specification 4, the model-implied spreads
are too small, especially the value premium (1.17% here versus 5.58% in the
baseline model and 5.35% in the data).
The previous analysis makes an important point about the endogenous de-
termination of risk in investment-based models with multi-capital inputs. Even
though the model has physical capital adjustment costs, which in a one-capital-
good investment-based model can endogenously generate a sizeable risk dis-
persion (e.g., the value premium in Zhang 2005), the addition of a costlessly
adjustable capital input (inventory) destroys the large risk dispersion gener-
ated by the model. Intuitively, without inventory adjustment costs, firms take
advantage of the costlessly adjustable inventory input (a storage technology)
to smooth their dividends. This extra flexibility endogenously reduces overall
risk in the economy to the point that the model loses its ability to match the
size of the stock return spreads observed in the data.
4.2 The role of operating fixed costs

To examine the importance of operating fixed costs, we examine the results
from the alternative specification 5, which sets the operating fixed cost to
308
zero. On the real quantity side, Panel A of Table 5 shows that shutting down
operating fixed costs has a negligible impact on firm quantity moments. In
fact, the real quantity moments generated by this alternative specification of
the model are almost indistinguishable from those generated by the baseline
model. Because operating fixed costs are essentially sunk costs, these costs
have a negligible impact on the inventory investment and physical investment
policy functions.
On the asset pricing side, however, shutting down operating fixed costs has
a strong negative effect on the ability of the baseline model to match the data.
Panel E of Figure 3 shows that eliminating fixed operating costs reduces sig-
nificantly the firm’s risk relative to the baseline model. This result is con-
sistent with that of Carlson, Fisher, and Giammarino (2004), who argue that
operating leverage increases risk: When a firm is hit with negative shocks,
its operating profits fall relative to the fixed costs. As a result, cash flows
are more sensitive to aggregate shocks (see Li, Livdan, and Zhang 2009 for
a similar analysis in the context of an investment-based model with one capital
input).
Panel B of Table 5 reports the quantitative effect of eliminating the operating
fixed costs on the model’s fit. Without operating fixed costs, the value premium
is tiny (1% here versus 5.58% in the baseline model and 5.35% in the data) and
the inventory growth spread for both equal- and value-weighted portfolios is
too low, approximately half the spread in the baseline model. In addition, the
inventory growth spread is slightly larger across larger firms than across small
firms, in sharp contrast with the data. This suggests that operating fixed costs
are especially important for the risk dispersion across small firms, consistent
with the analysis in Li, Livdan, and Zhang (2009).
Finally, without operating fixed costs, the model generates firm values that
are too large, reflected by the low average physical-capital-to-market-equity
ratio (18% here versus 32% in the baseline model and 41% in the data). Taken
together, these results show that without operating fixed costs, the overall risk
in the economy is reduced, which generates small stock return spreads as well
as firm-level market values that are too high due to low discount rates.
4.3 The role of physical capital and inventory elasticity of substitution

Finally, to examine the importance of the elasticity of substitution (ES) be-
tween capital and inventory for the good fit of the investment-based model,
we examine the results from the alternative specifications 6 and 7. In the base-
line model, ES = (1 + ρ)−1 = 0.67. Here, in specification 6, we consider
a low elasticity ρ = 0.7 (ES = 0.59), and in specification 7, we consider a
high elasticity ρ = −0.05 (ES = 1.05), a value that is close to the standard
Cobb-Douglas production function (ES = 1).
The real quantity moments reported in Panel A of Table 5 show that the ES
parameter has a first-order effect in determining the average inventory-to-sales
309
ratio: When the ES is low, firms hold too much inventory (average inventory-
to-sales ratio of 21%), and when the ES is high, firms hold too few inven-
tories (average inventory-to-sales ratio of 10%), relative to the data (average
of 17%). In addition, when the ES is high, the inventory growth volatility is
higher.
The most interesting analysis is the effect of the ES on firms’ risk. Panel F
of Figure 3 shows that, all else equal, firms’ risk decreases with the elasticity
of substitution between physical capital and inventory stock. This result is in-
tuitive. When the ES between the two inputs is high (i.e., capital and inventory
are more substitutable), firms are more flexible because they can use relatively
more of the capital input with lower adjustment costs to smooth the impact
of shocks on dividends. As a result, firms’ overall risk is lower when the ES
is high. Consistent with this analysis, Panel B of Table 5 shows that, all else
equal, the magnitude of the inventory growth spread is negatively related with
the size of the ES: Relative to the baseline model, the inventory growth spread
is higher with a low ES, and the spread is lower with a high ES.
5. Conclusion
We incorporate an inventory holding motive into the investment-based asset
pricing framework by modeling inventory as a factor of production subject to
convex and nonconvex adjustment costs. The model replicates the large inven-
tory growth spread observed in the data, as well as the firm-level properties
of physical capital investment, inventory investment, and inventory-to-sales
ratio. Our conditional single-factor model also implies that traditional fac-
tor models such as the CAPM and, to a lesser extent, the Fama and French
(1993) three-factor model should fail to explain the inventory growth spread,
although not with the same large pricing errors observed in the data. This result
suggests that introducing additional sources of aggregate risk in the standard
investment-based model may be necessary to capture the size of the CAPM
violation observed in the data.
Our results have implications for both the asset pricing and the macroeco-
nomics literatures. For asset pricing, our results, based on a model with ratio-
nal expectations and firm value maximization, suggest that the large inventory
growth spread observed in the data is in principle consistent with a risk-based
interpretation. Firms with low inventory investment rates have a high cost of
capital (risk), which explains the high average returns of these firms in the data.
For the macroeconomics literature, our results show that time-varying risk is
an important determinant of inventory investment. Given the importance of
inventory investment in business cycle fluctuations, our results suggest that in-
corporating time-varying risk premiums in current macroeconomic models of
inventory behavior is important for an accurate understanding of the inventory
investment dynamics over the business cycle and how inventory investment
propagates and amplifies the effect of shocks in the economy.
310
A1. Numerical Algorithm

To solve the model numerically, we use the value function iteration procedure to solve the firm’s
maximization problem. The value function and the optimal decision rule are solved on a grid in
a discrete state space. We use a multi-grid algorithm in which the maximum number of points
is 50 in each dimension. In each iteration, we specify a grid of points for capital and inventory,
respectively, with upper bounds kˉ and nˉ that are large enough to be nonbinding. The grids for
capital and inventory stocks are constructed recursively, following McGrattan (1999)—that is,
ki = ki−1 + ck1 exp(ck2 (i − 2)), where i = 1, ..., 50 is the index of grids points and ck1 and
ck2 are two constants chosen to provide the desired number of grid points and two upper bounds kˉ
ˉ given two prespecified lower bounds k and n. The advantage of this recursive construction
and n,
ˉ ˉ
is that more grid points are assigned around kˉ and n, ˉ where the value function has most of its
curvature.
The state variables x and z have continuous support in the theoretical model, but they have
to be transformed into discrete state space for the numerical implementation. We use a three-state
Markov process for the x and z processes. The popular method of Tauchen and Hussey (1991) does
not work well when the persistence level is above 0.9. Because both the aggregate and idiosyncratic
productivity processes are highly persistent, we use the method described in Rouwenhorst (1995)
for a quadrature of the Gaussian shocks. In all cases, the results are robust to finer grids as well.
Once the discrete state space is available, the conditional expectation can be carried out simply as
a matrix multiplication. Cubic interpolation is used extensively to obtain optimal investment and
inventory investment that do not lie directly on the grid points. Finally, we use a simple discrete,
global search routine in maximizing the firm’s problem.
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The Inventory Growth Spread

match the properties of inventory investment and inventory holdings observed

improve the performance of unconditional asset pricing models at the portfo-

1.2 Business cycle facts

1.3 Asset pricing facts

Panel A in Table 2 reports the average equal- and value-weighted excess

1.3.2 Two-way-sorted inventory growth and size portfolios. A well-

2. An Investment-based Model with Inventory Holdings

2.1 Economic environment

2.1.1 Technology. We focus on the optimal production decision problem of

Similarly, the firm’s inventory stock Nt depreciates at rate δn and is in-

Nt+1 = (1 − δn )Nt + Ht , 0 < δn < 1. (5)

2.1.3 Stochastic discount factor. Following Zhang (2005), we directly

Equation (8) can be motivated as a reduced-form representation of the in-

2.2 Firm value, risk, and return

Dt = Salest − It − N adjt − K adjt − f (12)

to be the dividends distributed by the firm to the shareholders. Negative divi-

we can evaluate the value function in Equation (13) at the optimum,

3. Model Implications for the Cross-section

aggregate asset pricing facts, as well as key firm-level moments reported in

Stochastic processes. We set the persistence of the aggregate productivity

6 We target the physical-capital-to-market-equity ratio instead of the more standard book-equity-to-market-equity

3.2 Matching business cycle facts

Alternative specification without convex inventory adj. costs (cn+ = cn− = 0)

Alternative specification without inventory adj. costs (b+ = b− = cn+ = cn− = 0)

Alternative specification without nonconvex inventory adj. costs (b+ = b− = 0)

Alternative specification without convex inventory adj. costs (cn+ = cn− = 0)

Alternative specification without inventory adj. costs (b+ = b− = cn+ = cn− = 0)

of inventories and thus must be taken seriously by any candidate theoretical

3.3 Matching asset pricing facts

3.3.1 One-way-sorted portfolios. Table 6 reports the average equal- and

3.3.2 Two-way-sorted inventory growth and size portfolios. The average

In addition, the sorting procedure based on a variable (inventory growth) that

4. Inspecting the Mechanism

investment) as a function of the current inventory stock implied by the base-

4.1 The role of nonconvex and convex inventory adjustment costs

4.2 The role of operating fixed costs

4.3 The role of physical capital and inventory elasticity of substitution

A1. Numerical Algorithm

. 2001. Asset Pricing. Princeton, NJ: Princeton University Press.

. 2008. Dissecting Anomalies. Journal of Finance 63:1653–78.

Zhang, L. 2005. The Value Premium. Journal of Finance 60:67–103.

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