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Interpreting the Value Effect Through the Q-theory: An Empirical Investigation 1 Yuhang Xing Rice University This version: July 25, 2006 1 I thank Andrew Ang, Geert Bekaert, John Donaldson, and Maria Vassalou for detailed comments and suggestions. A previous version of the paper was circulated under the title “Firm Investments and Expected Equity Returns.” All errors are mine. Yuhang Xing: yxing@rice.edu. Abstract This paper interprets the well-known value effect through the implications of standard Q-theory. An investment growth factor, defined as the difference in returns between low- investment stocks and high-investment stocks, contains information similar to the Fama and French (1993) value factor (HML), and can explain the value effect about as well as HML. In the cross-section, portfolios of firms with low investment growth rates or low investment-to- capital ratios have significantly higher average returns than those with high investment growth rates or high investment-to-capital ratios. The value effect largely disappears after controlling for investment, and the investment effect is robust against controls for the marginal product of capital. These results are consistent with the predictions of a standard Q-theory model with a stochastic discount factor. 1 Introduction A firm’s capital investment reflects either changes in future discount rates or changes in future productivity. Traditional investment theory often assumes a constant discount rate, ignoring the effects of time-varying discount rates. However, overwhelming empirical evidence documents time variation in risk premiums. When a stochastic discount rate is introduced into the stan- dard Q-theory model, Q varies with either the future discount rate or future prod