Top 4 reasons businesses cut their investments in the United States?
And what does it mean for you
For most businesses, investments involve acquisition of fixed assets, investment in tacit human resources or in various types of intangible assets like intellectual property, human knowledge, software etc.
Weak private investment is a major issue globally. Dottling, Gutierrez and Philippon (2017) have shown that even though profits of firms have been high in the U.S., especially since 2010, the business investment in the U.S. has been very weak since the 2000s after slightly peaking in the early 2000s due to the dotcom bubble. They analyzed the issue of stagnating business investment in the US in context of the Q-theory which is used as a measure of business valuation and profits. A high Tobin’s Q implies that the firm is valued more in the stock market as compared to the replacement cost of its assets and this should ideally translate to higher investment. In their paper Philippon and Gutierrez (2017) discuss eight theories/explanations that potentially lead to low private business investment in spite of a high Tobin’s Q. These eight potential drivers are grouped into four categories of “Financial Constraints”, “Modifications to nature of investment in terms of more globalization and increasing intangible assets”, “Reduction in Competition” and “Stricter Corporate Governance”. They have explained these drivers as follows:
Financial Constraints
External Finance: Philippon and Gutierrez (2017) draw on a large literature, which includes Fazzari, Hubbard, and Petersen (1988) and Rajan and Zingales (1998), which points out that sectors that are in a high need of external funding / financing, grow faster where financial conditions are conducive for them (e.g.: presence and access to financial markets). So, firms that depend on external finance show under-investment if they are not able to secure the required funds (Dottling, Gutierrez and Philippon, 2017).
Bank Dependence of Firms: Dependency on banks is a constraint that affects those firms which do not have (easy) access to financial markets. The authors have found support for this hypothesis that shows that small firms show underinvestment when business lending (e.g.: bank loans) is reduced.
Scarcity of Safe Assets: The authors have maintained that scarcity of safe assets like government bonds etc. or modifications to asset composition of firms, in itself, will not correlate to and affect investment. However, if businesses are not willing to make use of opportunities like low costs of funding, then it may affect the investment.
Take-away: Financial constraints in terms of difficulty in securing loans and access to finance will affect smaller firms more than it would affect the bigger firms during a crisis. In such scenarios, job cuts follow as firms prefer to liquidate investments and projects that do not yield sufficient ROI or to make room of perceived profitable investments
Modifications to nature of investment in terms of more globalization and increasing intangible assets
Intangible Assets: Philippon and Gutierrez (2017) have shown how intangible assets can affect business investment in many ways. They show that there is an observed underinvestment in firms that have high intangible assets. Also, businesses that invest relatively heavily in intangible assets can have low needs for overall investment or tangible asset investment.
Globalization: In the U.S., the firm-level and national-level data are consolidated differently (Philippon and Gutierrez, 2017). If we consider national-level data, then we can observe underinvestment if U.S. firms have more investment in foreign countries and less in U.S. or if foreign firms make less investment in the U.S. However, on a firm-level, the investment remains the same. Thus, globalization may not be a very good determinant of business investment.
Take-away: While the degree of globalization might not be a good measure of business investment, the percentage of intangible investments possessed by a firm is considered to be a good measure of overall investment. Firms tend to underinvest in physical assets if their alternative intangible investments like those in knowledge, software, brand etc. are yielding a high ROI. This could imply lay-offs for more human-intensive / manual business units. However, this also provides opportunities for skilling-up of personnel and doubling down on the intangible investments with low incurred costs.
Reduction in Competition
Uncertainty and Regulation: The authors say that increase in regulation can reduce competition in an industry by increasing the barriers to entry for new firms. Drawing upon investment theory, they have further mentioned that firms may not invest if there is regulatory uncertainty and if they are unsure about the return on their investment. Firm-related uncertainty can also lead to low investment (Philippon and Gutierrez, 2017). Small businesses have pointed that uncertainty is one of the biggest factors that constrains economic activity (Lewis and Menkyna, 2014).
Market Concentration: Philippon and Gutierrez (2017) have pointed out that competition fosters innovation and business investment. This is because if the competition is low then firms may not have incentives to innovate and make new business investments. Markets with high concentration or with incumbent firms have low competition and thus, exhibit a weak tendency to make business investments. They have also shown that market concentration has increased in the United States while it has remained fairly constant or even decreased in Europe.
Take-away: Constant innovation is the key to maintain market dynamism. It not only generates additional employment opportunities but also facilitates the entry of new businesses.
Stricter Corporate Governance
Shareholder Influence and Ownership: We can define institutional ownership as the available stock of a company that is owned by large agencies like mutual funds, pension funds etc. who manage funds on behalf of other people (Kenton, 2021). Stock-based compensation and its ownership is on the rise since the 1980s. This suggest that firms consider stock-based compensation to be of significant importance (Fenn and Liang, 2001). Furthermore, Fenn and Liang (2001), show that companies that mostly rely on stock-based compensation, tend to repurchase their shares as compared to other companies. This is done because stock repurchase increases the value of the share, thus leading to higher compensation. Since there is a shift towards stock-based compensation and an increase in institutional ownership, companies may cut back long-term investment in favor of short-term profits and payouts (Philippon and Gutierrez, 2017). Thus, institutional ownership and shareholder influence also affects business investment.
Based on data gathered from various sources like Compustat and the U.S Bureau of Economic Analysis (BEA) and performing industry and firm-level regression analysis, Philippon and Gutierrez (2017) have found support for the three possible explanations of weak business investment in the U.S. out of the many drivers that are explained above. They have found that companies in business industries that have less competition invest less. Also, those companies that have high amounts of their stock owned by institutions including mutual funds and pension funds also invest less. Finally, according to the third explanation, increase in the intangible assets explains some of the investment gap. But it also leaves quite some gap unexplained which can be attributed to the first two explanations – decrease in competition and increase in institutional ownership in businesses. Furman (2018) in his note on market concentration has also made arguments in which are in-line with the conclusions by Philippon and Gutierrez (2017). Furman (2018) concludes that reduced competition and increase in market power is linked with less private business investment in the U.S. Furthermore, it is also mentioned that reduced competition and increase in market concentration has invariably led to reduction in labor wage share and thus to increase in income inequality. Furman (2018) argues that these conclusions can “possibly” be generalized for other OECD economies. These findings and possible explanations for a weak private business investment in the U.S. have been corroborated in the literature by Dottling, Gutierrez and Philippon (2017). Grullon, Larkin, and Michaely (2016) have found that more than three-fourths of the businesses / sectors in the U.S. have become concentrated in the past 20 years and they concluded that the U.S. economy has undergone structural changes that have weakened competition in the product markets. Additional studies by Autor, Dorn, Katz, Patterson, and van Reenen (2017), and Gutierrez and Philippon (2017) indicate that the decrease in private business investment in the U.S. has been due to an increase in concentration of firms and a decrease in competition.
Thus, based on our review of existing literature, we can say that explanations of decreased competition and increase in market concentration, as well as an increase in intangible assets can be considered to be causes of declining private business investment in the United States.
