Markets watch the capital allocation decisions of listed company chief executives very closely. How much are bosses investing back into the business via capital expenditure or research and development? How much are they paying out to shareholders via dividends or share buybacks? After falling every year since 2012, global listed company capex should increase by 3 per cent in 2017. This is welcome, but shareholder payouts look set to rise by 5 per cent. The structural shift towards paying out to investors continues.
The US is at the forefront of this theme. Back in 2000, US listed companies spent $2 on capex for every $1 they gave to shareholders. Now they spend just $1. Alternatively, Asian companies have found it harder to kick the capex habit. In Japan the capex/payout ratio is 4:1. In South Korea it is 5:1. But even here, things are changing. In Korea the ratio used to be 12:1. Asian companies are coming under increased pressure to reduce their capex and raise their payouts.
This rebalance partly reflects shareholder preferences. The markets currently value a dollar paid out more highly than a dollar reinvested in the business. This is down to three factors. There’s subdued global growth, the legacy of previously bad capex decisions and investors’ desire for income. This preference is unusual so late in a bull market when markets more often give a green light for CEOs to over-expand. As ever, there are individual exceptions to the current caution (Tesla), but investors generally remain wary of capex-heavy business models.
Does this mean that payout-hungry investors are forcing CEOs to underinvest? Perhaps, but continued low inflation suggests that there is still ample capacity out there. And while restrained capex may prove a drag on overall economic growth, a market-based system shouldn’t let companies do capex just for the sake of it. They should only invest if a good return on that investment is likely. Japan has shown us what happens if that basic rule is ignored.
The ongoing shift away from capex towards payouts may also reflect the emergence of more capex-lite business models. Amazon just doesn’t need to spend as much as Walmart did when it was in land-grab mode. We have seen businesses form formidable market positions in the past, but we have never seen them use so little capital to do it. This combination of high profitability and low capex means there’s lots of cash left over for dividends and share buybacks.
This helps to explain the success of free cashflow (FCF) investment strategies in this cycle. FCF measures the difference between operating cashflow and capex. It is a capex-cynical valuation metric – to maximize FCF CEOs need to raise profitability and reduce capex. It tends to favour capex-lite businesses or companies in capex-heavy industries which have just finished a major investment program.
In this cycle, using FCF yield to pick stocks has been much more successful than other more traditional valuation metrics such as PE or dividend yield. Right now FCF yield still favours many capex-lite US tech stocks. Most traditional value investors think these shares are wildly overvalued. Amongst the traditional capex-heavy sectors, a FCF-driven value investor would be warming to the mining sector, but remain cautious on oil stocks.
CEOs have been reluctant to invest, partly because they know their shareholders prefer payouts. Those boards which defy the markets’ preferences might find themselves attracting the unwelcome attention of activist shareholders. Instead, bosses have used cheap debt to fund buybacks or M&A. Both do more to stimulate share prices than economic activity. Hence the complaint that quantitative easing has done more for asset owners than the average voter. The subsequent rise in inequality has boosted populist politicians everywhere.
What could drive a switch back towards capex?
The best indication that companies have been underinvesting would be a rise in inflation. This would indicate that output gaps have closed and it is time to add meaningful new capacity. For now, that moment remains elusive. Alternatively, there could be a populist backlash against the shift towards investor payouts. Dividends might go down well with shareholders but capex is more popular in the ballot box. Finally, maybe policymakers should get more directly involved in capex, especially in much-needed infrastructure. After all, they could find a ready buyer.
Equity markets might not like to fund capex-heavy projects but they love to own them once they are built.
Robert Buckland is chief global equity strategist for Citi research