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Impact Investing

IPE special report May 2018

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Ahead of the Curve: The investment conundrum

Alan Porter argues that investors should favour businesses that prioritise long-term capital investment rather than simply seeking out those paying high dividends

In conversations with companies I keep returning to a familiar subject – namely, how the significant cash piles, which they have amassed defensively in the years following the global financial crisis, are being used – or perhaps more accurately, not being used. 

One might think that, as an income-focused investor, I always hope for greater dividend distributions, but this is far from the truth. Rather, it is more important for me to establish whether the dividend is sustainable, and this necessitates in-depth analysis of a company’s financials to ensure adequate future cover.

In other words, a high payout ratio, or steep rise in the dividend, is not necessarily a desirable thing, should it suddenly evaporate when more challenging times arrive. Of the many variables I look at when assessing a company’s ability to generate sustainable returns into the long term, capital expenditure (capex) is pivotal, and here the general trend we are witnessing remains somewhat troubling.

Indeed, although companies, by and large, have returned to good profitability in recent years (with many boasting stronger balance sheets) they have kept a lid on capex. This is undoubtedly an echo from the global financial crisis. In the near term, this naturally flatters a company’s profit and loss statement, and frees more funds for dividends and buybacks but, equally, it raises questions about longer-term growth. 

Sure, there are exceptions in less-capital-intensive industries, but it goes without saying that most businesses continually need to invest to protect their competitive position, and make sure that they are not capacity-constrained if and when demand picks up. 

Some observers may counter that an aggressive, but necessary retrenchment has already taken place. In particular, in the capex-heavy materials and energy sectors, which have been buffeted by the collapse in commodity prices. But there has been palpable caution elsewhere too. In some ways this is understandable, as the economic backdrop remains highly uncertain, with monetary policy trajectories now diverging owing to a multi-speed global economy. Additionally, there are many disruptive trends (think ‘clicks and mortar’ and cloud computing) that make it difficult for businesses to rationalise some ‘old economy’ investments.

Specifically, with technology changing at such a rapid pace we are seeing more and more hardware capex shifting towards software operating expenditure. This trend away from physical investments may push the capex-intensity of GDP permanently lower. And, notably, many of the largest corporate cash piles are sitting at technology firms – the Apples and Googles of this world – which, on average, require smaller capex budgets than, let’s say, an oil and gas company, and also are constrained by the tax implications of bringing home their cash (the bulk of which is kept offshore).

Critically, China’s economic slowdown and efforts to steer the economy away from investment, towards consumption and services, could lead to a secular shift downward in capex. 

This undoubtedly has serious implications for capital goods and commodity-related businesses. It is largely on the back of this that the supercycle concept that was bandied about a couple of years ago has lost its lustre. And the ripple effects from this are apparent. As an example, the European capital goods sector has seen a significant deceleration, to the point that it is now growing at a markedly slower pace than the global economy. 

There might be some hope that the replacement cycle – many types of assets are getting old – comes to the rescue, but I would not hold my breath here, as companies may try to get as much mileage as they can out of existing plants and equipment.

As always, investment is a function of confidence, and therefore companies will want to see evidence that the global economy is escaping the doldrums before capex rebounds decisively. However, while valuations are by no means cheap, and firms on the whole remain reticent about their capital expenditure, it is still possible to find businesses that are deploying their cash sensibly. These are typically clustered in areas with strong secular growth drivers and are thus less sensitive to the business cycle. And, importantly, in a low-interest-rate world the hunger for yield is likely to remain strong, with investors at risk of chasing higher paying, but ultimately poor-quality, businesses. 

We do not let this environment cloud our focus on the sustainability of dividends, and tracking a company’s capex plans is integral to this analysis.

Alan Porter is portfolio manager, global equity income at Martin Currie

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