May 6, 2012 4:59 pm

Short-termism may yet derail recovery

Good first-quarter US results obscure a murkier reality

On the surface, the first-quarter US results season is reassuring evidence that the economy is indeed on the mend. A month ago, analysts expected a rise in corporate earnings of some 3 per cent. Given results so far, the forecast is now twice that.

But the underlying picture is still murky. It remains stubbornly unclear whether the remarkable post-crisis recovery in profits can be sustained. And if not, it is equally unclear whether corporate balance sheets are robust enough to take the strain.

The key to the first question is US profit margins, which are still at or around record highs. At some point, logic suggests they will start reverting to the mean. And, aside from events in the eurozone and elsewhere, wringing out more productivity is a finite process. There is only so much juice in the lemon.

In the long run, lack of investment must surely take its toll. According to Smithers & Co, official figures show the proportion of US domestic corporate cash flow devoted to capital investment at record lows of about 57 per cent. This compares with an average of 77 per cent over the past 60 years.

So where has the cash gone? To shareholders, mainly. In the second half of last year, dividends and buybacks by US corporations came to almost exactly the same as capital investment, at just over $2tn.

As recently as the early 1990s, spending on investment was four times the amount handed to shareholders. The ratio has been dropping steadily ever since.

According to Smithers this has resulted mainly from wrong incentives, which have led management to bribe shareholders with their own money rather than invest it productively. Whether or not that is true, some odd things are certainly going on.

In the final quarter of last year, for instance, US companies had $245bn of cash flow in hand after paying for capital investment and dividends. They then chose to spend $515bn on their own shares, presumably borrowing the $270bn difference.

But no, you might say. The money will have come from their own immense cash piles. But US companies still have net debt – after deducting that cash – equal to perhaps 40 per cent of their equity. So whether those buybacks are paid for in cash or through more debt, leverage goes up just the same.

The trend in that debt, meanwhile, is a matter for debate. According to conventional brokers’ analysis, leverage has been falling steadily to record lows. Alternatively, according to government data on all domestic US firms used by Smithers, it has been rising equally steadily for decades.

Two different things are being measured here, in two different ways. So both might be true. But it is worth noting that even credit analysts these days tend to measure debt in relation to cash flow rather than assets. If corporate margins are indeed under threat, that is self-deluding.

All the same, we should hope the conventional brokers’ picture is the right one. For according to a study from Fortuna Advisors, leverage has in fact served shareholders in big US corporations badly over the past decade.

Specifically, companies with high leverage have provided lower total shareholder returns – capital gains plus dividends – than those with lower leverage. Over the decade, the difference has amounted to 0.6 per cent a year.

In part, of course, this is a matter of market fashion. At the height of the credit bubble in 2004-06, the underpricing of risk meant companies with higher leverage outperformed sharply in share price terms, and vice versa in the bust of 2008-10. But the long-run result suggests something else is going on.

Mainly, Fortuna suggests, highly leveraged companies are more risk-averse and less able to respond swiftly to strategic opportunities. As a result, its research shows heavily indebted companies within a given industry producing 3 per cent lower sales growth per year than their less encumbered peers.

It could, of course, be argued that today’s big corporate cash piles are there precisely to take advantage of opportunities. But they are there for other things as well: to fund working capital if the banks cannot, to repay existing debt if it cannot be rolled over, and to buy back all those shares.

This brings us back to where we started. If those good first quarter results should prove a last hurrah, it matters a good deal how robust that companies’ balance sheets are. And that remains an open question.

More broadly, it may prove that managers have indeed been running their businesses for the short-term share price and their own resulting bonuses. If so, shareholders who were foolish enough to condone such behaviour will now pay the price.

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