Why Does Capital No Longer Flow to the Industries with the Best Growth Opportunities?

Dong Lee, Han Shin, and René Stulz, 2016 working paper

Industries with the highest average Tobin’s q get more net funding from investors (both debt and equity investors), consistent with properly-functioning capital markets, until the mid-1990s.  Since that time, the industries with the highest q receive less net funding.  There does not appear to have been any breakdown in the efficiency of corporate debt markets.  The findings are driven by high-q industries, which have reduced investment and increased share buybacks.

Methods and Findings:

  • Use the Fama-French 48 industries
  • drop financial and utility firms, as well as regulated industries (per Barclay and Smith (1995))
  • calculate Tobin’s q as the ratio of the market value of industry assets to the book value of industry assets
    • numerator: AT-CEQ-TXDITC + (PRC*SHROUT)
      • assets minus common equity minus deferred tax credit + market cap
    • denominator: AT (total assets)
  • Measure industry funding rate as the sum of net debt issuance (long-term debt) and net equity issuance
  • Firms in the top-funding quintile should have higher q (they don’t)
    • double check that high-funding industries are high-investment industries
  • Measure the cross-sectional correlation between funding rate and q
    • the correlation is mostly positive before 1995, and mostly negative after
  • Examine whether the q-differential between firms assigned to the lowest- and high-funding quintiles at time t=0 disappears over the future, consistent with limited investment opportunities and efficient markets
    • The q of industries in the low-funding quintile converges to the q of industries assigned to the highest-funding quintile over the next 1-5 years.
    • The q of high-funding industries, however, does not fall
  • Compare the high- and low-funding industries along three measures of growth
    • investment (capital expenditures) – high-funding industries also have higher investment, but this difference falls over the five years following assignment to funding quintiles
    • change in number of firms – high-funding industries see greater growth in the number of firms
    • growth in assets – high-funding industries see greater asset growth over the five years following assignment to funding quintiles
      • However, it is not the case that the low-funding indutries are simply financially constrained, since they have higher dividend payout rates at the time of quintile assignment.
  • Regress funding rate on q and cash flow
    • the coefficient on q is significant for the sample period ending in 1996, but insignificant both for the post-1996 sample and for the whole 1971-2014 sample.


  • This was an interesting read, and it addresses a fundamental economic question that perhaps not enough people are talking about:  do capital markets (still) work?
  • Since about the year 2000, firms have been returning funds to investors in the aggregate.  This matches with an essay I read just this morning by Minneapolis Fed president Neel Kashkari, that cites lack of innovation as a possible explanation for the U.S. (and the world) economy’s anemic recovery from the last crisis.  If businesses no longer have anything important to work on, they shouldn’t invest.  Lee, Shin, and Stulz (this paper) find that it is high-q firms with high cash flows that are returning money through stock repurchases.
  • The paper is long on puzzles and short on solutions, but makes an effort to direct the path for future research.
  • This paper relies heavily on a measure of Tobin’s q, standard in corporate finance, which is, roughly, enterprise value divided by book assets.
    • AT-CEQ-TXDITC is supposed to measure the book value of long-term debt.
    • This is not a good measure, and everybody knows it, and everybody still keeps using it!
      • What about a company with home-grown intellectual property?  Consider a firm with one asset – a patent on a new drug.  No buildings, no equipment, not even a stapler – just a patent.  The firm has a market value of $1 million.  The firm’s Tobin’s q, according to the standard measure, is infinity.  Should the firm keep investing?  Now suppose the patent cost $10 million in R&D expense to develop.  Was it worth it? Should the firm keep investing?
      • What about cases where (conservative) accounting depreciation and economic depreciation don’t line up? Consider a firm whose only assets are a plot of land purchased in 1900 for $10,000 and a warehouse built in 1975 (>40 years ago), for total book assets of $10,000.  Now consider another firm with an identical plot of land purchased in 2000 for $1 million, and a warehouse that serves the same purpose but was built in 2010, for total book assets of >$1 million.  Which firm has higher q, by the standard measure?  Which firm has the best investing opportunities?
  • Now, maybe the examples contrived above are too far from reality to be useful. Maybe conservative accounting valuation of assets is just as good today as ever.  But I’m not convinced.  I think today’s economy relies more on assets that are likely to have zero or low book value than in the past.
  • Even when some of these home-grown intangibles are sold and thereby acquire a book value, the most likely scenario is one where the company owning the assets is acquired, and the companies’ investment bankers use comparable transactions to try and assign a price tag to such assets as “trademark,” “customer loyalty,” “research database,” etc.  This is not a neat process, and intuitively should be even harder in a service-based economy than in the manufacturing economy that prevailed in prior decades.


  • Is the ratio of goodwill to book value higher now than in the past?  This would be consistent with conservative accountants systematically undervaluing acquired assets and with this undervaluing getting worse.  However, it would also be consistent with the value of private control benefits and, hence, with deteriorating corporate governance.  This is probably not the case, but would not be too difficult to analyze.
  • How to the “high-q” and “low-q” industries compare on R&D, on advertising expenses, on customer loyalty?
  • Finally, why do the analysis at the industry level?  Are all firms in industry 11 (Healthcare Services) or in industry 35 (Computers) supposed to have approximately similar, or even tightly correlated, investment opportunities?  Taking industry averages masks potentially large intra-industry heterogeneity.  It would be interesting to see if the high-q industries are pulled up by outliers, or vice-versa.

Takeaway: If you use the traditional measure of Tobin’s q, equity markets no longer allocate capital to the most efficient industries.  This measure of Tobin’s q is potentially problematic, and I see this paper as much as an indictment of the measure of q as of the efficiency of the equity markets.