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

Abstract

We document novel facts in the U.S. stock market during the recent four decades which are in opposite 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: Investment, Profitability, 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