Investment strategies, capital structure, and the cross section of stock returns

The objective of the paper is twofold. Firstly, it aims to investigate the impact that the capital structure of a firm has on its stock price performance and whether capital structure is value relevant for the equity investor. Secondly, it examines the profitability of an investment strategy based on firm level capital structures. The analysis is performed both on a full sample basis and on an industry basis, since industry class is considered as an important risk factor. The industry level analysis may reveal different aspects of the leverage phenomenon because debt requirements for each risk class differ and leverage is regarded as one of the principle sources of financial risk. Sample firms are allocated into portfolios based on their leverage and their return in excess of the risk free rate is calculated. The Fama and Macbeth (1973) methodology is adopted in exploring the relationship between portfolio leverage and expected returns and the levered portfolio returns are regressed against firm leverage, market risk, size and market-to-book ratio. Then, we test if leverage is priced as a risk factor by constructing a leverage factor, based on the methodology of Fama and French (1993), and the levered portfolio returns are regressed against the returns of mimicking portfolios that capture the five risk factors, i.e. market premium, size, value, momentum and leverage. Finally, we evaluate the investment strategy based on capital structure by calculating the future cumulative abnormal returns of the levered portfolios, controlling each time for known idiosyncratic risk factors. The sample consists of listed of non-financial companies from Southern Europe (Portugal, Italy, Greece and Spain) from 2000 to 2010. Thus, the objectives are tested in a group of European countries that have differentiating characteristics from other countries of the Eurozone and which are in the middle of a debt crisis cyclone that threatens the European solidarity, the euro-monetary unity and the stability of the foreign exchange rate of the euro. The main contribution of our work is that we diversify the capital structure studies by broadening the limited work that has been accomplished on the base of leverage as an explanatory variable of returns. The paper builds on the growing literature that attempts to link corporate decisions to the behaviour of asset returns. Furthermore, by forming portfolios mimicking the leverage factor we broaden the focus of the current asset pricing literature. Finally, by focusing on the role of leverage as a strategic investment instrument or a separate risk factor, we cast light on a notion that has been ignored by the vast majority of European CEOs.