Understanding on Technological Origin of the Value Premium Dynamics

Understanding on Technological Origin of the Value Premium Dynamics: In asset pricing, mean reversion in productivity is known to explain the value premium when investment entails irreversible costs. In this paper, I show that the speed of mean reversion in idiosyncratic productivity is time-varying: it switches between high persistence state and low persistence state. Firms have different optimal investment decisions anticipating this time-varying persistence of productivity, which adds more dynamics to the value premium. More specifically, in low persistence state or in the state with fast mean reversion, there is more cost irreversibility, disinvestment rate is low, and value premium is positive, while in high persistence state or in the state with slow mean reversion, there is less
cost irreversibility, and disinvestment rate is high, and value premium is negative and more uncertain.

Equity Duration Based on Bayesian Hierarchical Model: Accurate and robust long-term cash flow forecasting is crucial for computing the intrinsic value of stocks. Bayesian Hierarchical model (BH) takes advantage of massive information sharing across firms and across time to model firm level mean-reversion speed and offers a better forecast for long-term cash flows. The BH model improves forecasting accuracy for both ROE and revenue growth from traditional cross-sectional pooled model or firm-level AR(1) type of time series model. BH’s superior forecasting performance holds true across different horizons, different industries and different styles of firms. Moreover, the equity duration factor based on cash flows projected by the firm level persistence ratio with BH model generates higher and more significant excess returns, FF-5 alphas and q-5 alphas than the duration factor based on uniform persistence ratio. Moreover, the broken mean-reversion mechanism calibrated from the BH model can be attributed to explain the under-performance of duration factor during the post Great Financial Crisis (GFC) period.