The US economic recovery has been a jigsaw with a missing piece, but if the capital expenditure part of the puzzle is finally slotted into place, it poses opportunities for investors.
Corporate America has allowed cash from record profits to pile up on balance sheets or has handed it back to shareholders in the form of stock buybacks and increased dividends. When companies have tapped ultra-cheap debt financing, that money too has largely flowed back to shareholders.
Capex, meanwhile, has been the poor relation of spending options and has been directed largely at replacing old equipment or replacing jobs with technology.
Standard & Poor’s estimates that capex spending by the S&P 500 companies in the third quarter matched an all-time record of $165bn, but that this included very few big projects such as factories or warehouses. The proportion of cash flows reinvested in capex has averaged just 42 per cent since the recession ended, compared with 48 per cent in the previous economic expansion and considerably higher than that in the last millennium.
Investors who have been dazzled with share buybacks are showing signs of shifting their focus. Anything suggesting that markets will reward capex over cash returns could encourage corporate executives to choose the former and could add to the gathering economic momentum.
Large institutions, including Capital Group and BlackRock, have for a while been publicly urging companies to prioritise investing for the long term. Now it is a theme being taken up in fund managers’ product innovation, which is always a sign of what’s trending.
Rather incongruously, Mark Spitznagel, the ultra-bearish hedge fund manager, is raising money to invest in equities. His company, Universa, advised by Nassim Taleb of Black Swan fame, is marketing a fund that will buy into companies it believes are undervalued because they are spending heavily now on capex that will generate future returns not yet factored in by the market.
Mr Spitznagel has not abandoned his belief that markets puffed up on monetary stimulus will slump by 30 per cent or more. According to documents circulated to potential investors, the new fund will use his “black swan” hedges as catastrophe insurance while his stockpicking is based on another area of Austrian school economic theory, the idea of “roundabout production”, which emphasises the time it takes for capital investment to pay off.
Estimated capex spending by the S&P 500 companies in the third quarter
He is not alone in tapping capex as an investment theme. At least one exchange traded fund provider is examining the possibility of launching a capex-focused fund.
An intriguing question for investors is whether any reliable link can be made between capital expenditure and share price performance. A preponderance of academic work suggests capex spending may in fact be a lagging economic indicator and that companies that report rising investment subsequently underperform the market. This would hint that, by the time most executives find the courage to make their biggest long-term bets, the business cycle may already be quite aged.
“It is misguided to invest only in companies with heavy capital expenditure,” says Aye Soe, senior director of global research and design at S&P. “The question is a nuanced one of whether the capex is effective, or whether companies have been able to turn it into higher sales.”
Rates of return on capital expenditure will be idiosyncratic, depending on the industry and the kind of spending, notably whether it is automation designed to cut costs or new plant designed to substantially expand the business. However, Ms Soe has designed one potential proxy, aimed at finding companies where capex has led to a surge in revenue: the S&P 500 Capital Efficiency index comprises the 100 companies whose revenue-to-capex ratio has increased the most over the previous three years.
These capex-efficient companies handily beat the market over five, 10 and 20 years, without being especially concentrated in any one sector, but it is worth noting they gave back a lot, though not all, of their outperformance when the Great Recession hit. If the same pattern were to hold this time around, those who buy in now will need to be quick to sell when the economy turns.
That still looks a way off. And if new indices and new funds give courage to executives already considering long-term capex, then it is likely there will be more strength yet, in the recovery and in the stock market, as the economic jigsaw finally comes together.
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