The Great Divorce Between Investment and Profitability: Implications for Asset Pricing

Abstract

Using data over the last century, we show that the cross-sectional relation between investment and profitability among U.S. public firms is positive in the first half-century but negative in the recent four decades. The negative fundamental relation explains the high level and the positive correlation of investment and profitability premiums after 1980. In out-of-sample environments including the pre-1980 U.S. stock market where investment and profitability premiums are low and insignificant, the fundamental relation is positive. Given the time-varying investment-profitability correlation, both the in and out-of-sample behaviors of investment and profitability premiums are consistent with the neoclassical investment framework.

Keywords: Neoclassical Investment Theory; Cross-Section of Stock Returns; Investment Premium; Profitability Premium; Out-of-Sample Test.

JEL Classification: G10, G12, G31, D92