Capex or Payout? Avoiding the Destruction Cycle
Citi GPS Opinion Article
26 March 2014 – It has become fashionable to suggest that rising investor focus on dividends and buybacks has forced CEOs to cut back on capital expenditures (capex). This seems misplaced. Since 2010, global listed company capex is up 26% to $2,567 billion. Over the same period, cash paid out through dividends and buybacks is up 40% to $1,394 billion. So, sure, payouts are up more, but this has not really been at the expense of capex. In fact, there has been a boom in both.
This global aggregation hides significant regional differences. Figure 1 shows the US capex/payout relationship. The death of US corporate capex has been much-exaggerated. Since 2010, investment by Non-Financial companies included in the MSCI US index is up 44%. Nevertheless, it does look like there has been a structural rebasing of the capex/payout relationship. In 2001, US listed companies spent twice as much on capex as shareholder payouts. In 2013 they spent the same.
This relationship looks very different in Japan. We estimate that in 2013 MSCI Japan-listed Non-Financial companies spent ¥27 trillion on capex, five times more than they paid out to shareholders. This is below the 7x ratio in 2001 but still way above the level currently seen in other developed markets. While there has been a structural shift in the US this has been much less evident in Japan, despite low profitability. The US stock market has reinvented itself as a giant capital recycling machine, but Japan remains a giant capital destruction machine.
Another striking theme is the rise of emerging market (EM) company capex. In 2013 they spent more than their US peers. In 2000, EM capex was only a quarter of that seen in the US. Much of the US rebalancing has been countered by a sharp increase in EM company capex. We also suspect that much of the capex increase in developed market (DM)-listed companies has occurred in EM economies. That makes sense given the stronger growth prospects.
What does the market want?
We found a clear relationship between shareholder payouts and stock market valuation. So the more a global sector pays out in dividends and buybacks, the greater the value attributed by investors. Conversely, we found little relationship between capex and market valuation. For example, the global Energy sector might account for 30% of global listed company capex, but it only accounts for 12% of stock market capitalisation. Alternatively, the global IT sector now accounts for only 6% of global capex but it accounts for 16% of market cap. Investor suspicion of capex is supported by the data. The more that an industry spends on capex, the lower future profitability tends to be.
That doesn’t mean that all capex is bad. Companies have to invest to generate future returns. But if they collectively over-invest then future industry profitability is likely to suffer. Lower capex would also have serious implications for economic growth and employment. However, the evidence suggests that equity investors have become increasingly, and justifiably, wary of capex. This is a general observation. There will always be parts of the world stock market where shareholders are more willing to support investment (e.g. Biotech right now), but these are increasingly becoming the exception rather than the rule.
In defense of activism
Why has the US stock market been transformed into a capital recycler while Japanese companies have remained capital destroyers? We identify a classic capitalist process in the US that does not seem to work in Japan.
As the market sees a company’s profitability fall, so the shares derate. This increases the opportunity cost of capex versus share buybacks. It also attracts the attention of more dividend- and less growth-oriented income investors. But even though these shareholders increasingly want to recycle capital out of the company, the CEO may not listen. This is where activism comes in. If a US CEO does not listen then shareholders can replace him/her with one who does. Shareholder activism is a key part of the process through which US companies are shifted towards being capital recyclers. This is how capitalism is supposed to work.
A lack of shareholder activism may explain why Japan’s listed companies haven’t made this shift. Despite low profitability, they still spend way more on capex than they recycle back to shareholders. US investors would not tolerate this behavior. Unsurprisingly, deflation has taken hold. This is not how capitalism is supposed to work.
Perhaps the ongoing derating of the EM equity markets suggests that investors are becoming more concerned about excess capex. Are EM companies next to be trapped in a Japan-style cycle of capital destruction? We would like to see more evidence of EM companies becoming capital recyclers but are not convinced that they care enough about shareholders for that shift to happen.
In the meantime, there is rising pressure on some DM companies to become capital recyclers. Between them, the global Energy and Materials sectors accounted for 42% of world listed company capex in 2013. Lower returns on this giant commitment means that shareholder patience is wearing thin. Share prices are falling. Expansionary CEOs are being replaced by more conservative successors. Capex is starting to roll over. Dividend and share buybacks are starting to rise. The shift towards capital recycler has begun.
Shareholder activism is becoming increasingly unpopular outside the investment world. Activists are being accused of short-termism and favouring dividends and buybacks over job-creating capex. Some of these criticisms are fair, but if shareholder involvement helps to prevent companies from falling into a Japan-style cycle of capital destruction then it should be encouraged not discouraged.