The Great Divorce Between Investment and Profitability: A Duration-Based Explanation

Abstract

We document novel facts about the U.S. stock market during the past forty years which show opposing characteristics to the prior decades: A negative cross-sectional correlation between firms' investment and profitability, and strong premia of investment and profitability factors which are positively correlated. A model of firms with heterogeneous cash flow duration explains these findings: Firms with higher duration have lower discount rates, leading them to invest more despite having lower current profitability. An influx of high-duration firms boosted investment and profitability premia due to the duration premium. These nuances do not exist in countries where long-term investments are scarce.

Keywords: Cash Flow Duration, Cross-Section of Stock Returns, Investment Premium, Profitability Premium, Duration Premium, Long-Term Investments, Venture Capital

JEL Classification: G10, G12, G31, G24, D92