Are businesses under-investing?

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1 July 2015 Est. reading: 4 min read

In this article, independent investment strategist Gerard Minack questions the widely perceived notion that companies are under-investing. His analysis finds that corporates are investing, but most of them are receiving a diminishing return on this investment. In turn, this is likely holding back the prospect of the significant increase in business investment that policymakers yearn for. Despite declining corporate profitability (defined here by return on equity), investors have ironically been prepared to pay higher valuations for equities. The last chart here is superb – one of the best we have yet seen to demonstrate the impact QE has had on financial assets.

Business investment has recovered slowly since the Great Recession – policymakers are hoping businesses will spend more. But there are few signs of under-investment. Return on equity in developed markets has oscillated around a flat trend despite a 35 year trend decline in investment spending as a share of GDP (Exhibit 1).

Exhibit 1: less capex required to maintain returns

Chart showing OECD business investment and developed market return on equity

The situation in emerging economies is the reverse – there seems solid evidence that the corporate sector has excess capacity. That’s partly reflected in the pervasive weakness – often out-right decline – in producer-level prices. It’s also reflected in declining return on assets in the listed sector (Exhibit 2).

Exhibit 2: too much investment in emerging markets

Chart showing non-financial sector return on assets

Declining returns have been widespread in emerging markets as the sharp slowdown in sales has reduced margins. The biggest swing has been in markets outside Asia – they saw a bigger boom in the last cycle, and are now experiencing a bigger bust (Exhibit 3).

Exhibit 3: emerging market returns fall faster outside Asia

Chart showing non-financial sector return on equity in emerging markets

As an aside, the decline in return on equity (Exhibit 4) understates the decline in return on assets because corporate leverage has also increased through the period (Exhibit 4). Leverage has risen more in non-Asian markets than in Asia.

Exhibit 4: declining asset return partly offset by leverage

Chart showing non-financial sector net debt to ebita

The resilience in average developed market returns (Exhibit 1) obscures divergences between those markets. Exhibit 5 shows that return on equity in markets outside the US has also been weak – although arguably it was the high returns in the last cycle that were abnormal, and the current return on equity is around normal. Regardless, there seems little incentive for non-US companies to begin a major investment cycle with return on equity below the last cycle average and, for now, falling at the margin.

Exhibit 5: US maintains high returns – not so elsewhere

Chart showing non-financial sector return on equity in US markets

Returns on equity and assets are higher in the US than in any other major market, developed or emerging. However, this premium is due to a fairly small group of companies – the top 10% of S&P500 companies, ranked by return on equity, have been able to increase returns over the past 25 years. Returns for the other 90% of the market have cycled around a flat trend (Exhibit 6).

Exhibit 6: high US return on equity due to a few companies

Chart showing S&P500 return on equity by RoE rank

This is a significant split – despite the apparent attractive returns on equities in aggregate, the returns being generated by 90% of the market have been flat. Put another way, there seems little evidence of under-investment by most listed companies.

That still leaves the top 10%. On average, they have two unusual attributes. Firstly, they seem able to maintain a very high return on incremental capital (Exhibit 7 shows incremental return, defined as the operating income relative to the change in invested capital). Secondly, these companies are increasingly ‘capital-lite’: investment spending has declined as a share of sales. Moreover, there has been a massive change in the capex undertaken by high returning businesses. In the late 1990s the average company ranked in the highest 10% (by return on equity) spent twice as much (in dollar terms) on investment as the average company in the bottom 90%. Now companies ranked in the top 10% by returns spend half as much on average as companies in the bottom 90%. The return winners are capex misers.

Exhibit 7: the top 10% – less capex to generate return

Chart showing top 10% incremental capex return and capex/sales

In short, the fact that returns on assets and equity are falling suggests that investment – at least for incumbents – is not significantly below required levels. Indeed, the decline – particularly in emerging markets – suggests that there has been excess investment. Ironically, investors have been willing to push valuation higher despite the decline in most market’s return on equity. Exhibit 8 shows the change in price-to-book and return on equity over the past three years (with the grid-lines showing the implied price-to-earnings ratio).

Exhibit 8: lower returns, but higher valuations!

Chart showing valuation change over the past 3 years

Gerard Minack has been analysing, forecasting and advising on financial markets since 1987. He focuses on the fundamental factors that usually drive investment performance: valuation, currency, monetary policy and the economic cycle, all with a focus on the medium-to-long-term outlook. Gerard retired from Morgan Stanley in May 2013, where he had served as global cross-asset strategist and before that global developed market equity strategist. Gerard has stopped working at big banks, and started Minack Advisors in 2013, providing independent fundamentally-based research on financial markets for institutional investors around the world.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address: 27 Old Gloucester Street, London, WC1N 3AX.

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