The Great Divorce Between Investment and Profitability
with Mete Kilic and Ben Zhang
We study the cross-sectional relation between investment, profitability, and equity returns over the last century. The correlation between the investment and profitability factors is negative in the data from the 1920s to the late 1970s, and turned positive in the last four decades. The once positive association between firm investment and profitability in the cross-section also became strongly negative since the late 1970s. We ascribe this fundamental change to a downward shift in the discount rates of long-term cash flows, 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, reversing the cross-sectional relation between contemporaneous investment and profitability. Our model quantitatively accounts for the relation between investment and profitability as well as their corresponding return spreads before and after the late 1970s. Further evidence suggests that the rise of venture capital in the late 1970s may have played an important role in the divorce between investment and profitability.
Presentations: SFS Cavalcade 2020, AFA 2021 (scheduled)
Predicting Stock Market Returns with an Accounting Factor (** available upon request **)
A predictive factor constructed from aggregate accounting variables robustly predicts month-ahead stock market returns. The factor obtains out-of-sample R-squared statistics of up to 3.05% and the predictive performance is economically large with mean-variance investors being willing to pay an annual fee of up to 6.81% for access to its forecasts. Furthermore, its predictive ability is higher for short-term returns and it is distinct from other predictors in the forecasting literature. Using Google search volume of stock tickers, we demonstrate that the predictive power stems from slow information diffusion due to investor inattention.