A two-factor model of value and growth with adjustment costs

This paper examines a two factor model of value and growth, in an economy with many different industries consisting of identical competitive firms. A cyclical (value) factor cap-tures permanent shocks to industry or aggregate demand, and innovations to this shock are assumed to command a generous risk premium. A growth factor captures transitory shocks to the growth rate of aggregate demand or demand for an industry’s output, and innova-tions to this factor are assumed to command a small risk premium. Competitive firms have several distinct mechanisms to adjust capital, each modeled as a quadratic adjustment costs for investment modified by a maximum growth rate cap (fixed exogenously). There is also an option to scrap capital at low valuations. Firms are valued numerically as real options in a model with two state variables: revenues per unit of capital and the expected growth rate of demand. Since demand is more volatile than costs, firms possess ”real leverage, ” which tends to make them more volatile when firms are losing money. It is shown that adjustment cost parameters can be chosen so that stocks with low growth rates (“value stocks”) load rel-atively strongly on the value factor and stocks with high growth rates (“growth stocks”) load relatively strongly on the growth factor. In addition, these parameters can be chosen so that growth stocks have relatively high volatility. Returns on value stocks correlate relatively strongly with innovations in demand, while returns on growth stocks correlate relatively strongly with innovations in future demand growth. Distressed stocks, close to scrapping capital, have particularly high returns since they load most strongly on the cyclical factor