This study shows that when profitability exceeds the cost of equity, investment drives higher expected returns. A “wealth creation” factor combining both improves alphas and Sharpe ratios.
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Abstract
Practitioners often inherit an anti-growth tilt from factor models, yet corporate finance implies that scaling positive–net present value opportunities creates value. We reconcile these views by showing that the investment–return relation is conditional on profitability: When profitability exceeds the cost of capital, additional investment raises value and predicts higher returns, holding valuation constant. We operationalize this wealth-creation channel as the interaction of profitability and investment. In US equities (1963–2024), a long–short wealth creation factor delivers alphas up to 31 bps per month (25.5 bps per month net of transaction costs) and raises the tangency Sharpe ratio by up to 10% over the Fama–French five-factor model.