The Great Divorce Between Investment and Profitability

Abstract

We study the cross-sectional relation between investment, profitability, and equity returns over the last century. We document that high-profit firms invest more than low-profit firms before the late 1970s but invest less than low-profit firms afterwards. This reversal coincides with the emergence of the investment and profitability asset pricing factors and a corresponding reversal in the two factors' correlation. We link these changes to decreased long-term discount rates, which we document in the data. We develop a model where firms invest in short- and long-term projects. Responding to low discount rates, firms invest more in long-term projects, leading to high investment from low-profit firms and high average factor returns, as we observe in recent decades. The influx of long-term focused firms following the rise of venture capital in the late 1970s may explain the divorce between investment and profitability.

Keywords: Investment, Profitability, Cash Flow Duration, Long-Term, CMA Factor, RMW Factor, Venture Capital

JEL Classification: G12, G31, G24, D92