Historically, businesses with the largest cash flows and capital reserves were the biggest investors—but this is no longer the case. Economists have long struggled to explain why the relationship between corporate investment and cash flow has weakened and even disappeared in the last few decades. Thanks to the pioneering work of HKUST’s Chu Zhang and co-author Zhen Wang, this puzzle may finally have been solved. The researchers’ innovative yet simple model empirically outperforms all previous explanations of investment–cash flow sensitivity and its dramatic decline over time.

Fifty years ago, manufacturing businesses used the capital they generated (cash flow) for business development. For such “old-economy” firms, therefore, investment in a given year was closely related to the cash flow generated in that year. By 2000, however, this relationship had all but disappeared, leaving experts baffled. “This declining pattern of investment–cash flow sensitivity,” say the authors, “has puzzled financial economists.” To shed light on this problem, the researchers’ first step was to develop a simple, intuitive explanation of investment–cash flow sensitivity (and its decline) that hinged on a single critical variable—the tangibility of capital.

“The U.S. economy has experienced tremendous changes in the past 50 years,” the authors explain. “In the early years, old-economy firms dominated, producing traditional products.” For such firms, production and investment relied heavily on tangible capital, i.e., current cash flows and physical assets. Since the 1960s, however, technological advancement has ushered in a “new economy.” For today’s high-tech manufacturing firms, operating in a highly volatile and competitive environment, production and investment depend mainly on intangible capital, such as brand engagement, intellectual property, and market potential.

In short, say the authors, “knowledge-based intangible capital has become more essential to economic growth.” They hypothesize that the growing importance of intangible capital has weakened the relationship between cash flow (tangible capital) and corporate investment. “New-economy firms have smaller investment–cash flow sensitivity than old-economy firms because they rely less on tangible capital,” they argue.

To empirically test this novel explanation of the historical decline in investment–cash flow sensitivity, the authors analyzed the investment behaviors of 2,000 U.S. manufacturing companies between 1967 and 2016. The results overwhelmingly supported their model. During the sample period, the authors report, “tangible capital and investment in tangible capital as a fraction of total assets declined, whereas intangible capital increased.” This decline in both tangible capital and its economic productivity, along with reduced cash-flow predictability, caused a drop in investment–cash flow sensitivity.

“We verify that, among many variables that can potentially explain investment–cash flow sensitivity, tangible capital is the only one that does so satisfactorily,” explain the authors. “This sensitivity stems from the informational role of cash flow in indicating the productivity of tangible capital in the old economy.” In the new economy, in contrast, intense competition and fast-changing consumer preferences have made cash flow increasingly unpredictable. As current cash flow (tangible capital) no longer contains useful information about future productivity, investment is no longer sensitive to variation in cash flow.

This paper provides the most compelling and conclusive explanation to date of a phenomenon that has long confounded economists—the declining trend in investment–cash flow sensitivity among manufacturing firms in the last 50 years. “No studies have been able to achieve the empirical success presented in this article,” note the authors.