- Investors could find opportunity in capital expenditures.
- Strategic positioning in these areas is key to opportunity.
- Shale gas and automation are leading the charge in innovation.
Cash balances at U.S. non-financials corporations have exploded in the post-crisis era, up 75% since the end of 2007. This is despite a rising return of cash to shareholders in the form of dividends and share repurchases. However, capital expenditures and reinvestment in businesses has been quite restrained by historical standards. We believe that the discipline on reinvestment will continue and are not assuming a sweeping loosening of corporate purse strings. However, within the steadily (if not spectacularly) growing bucket of capital expenditures, we do see some hot spots gaining share of spending and think that investors would be wise to seek exposure to those areas.
A primary driver in the recovery of the U.S. equity market post the financial crisis has been shareholder friendly discipline regarding spending and the usage of free cash. Margins have expanded to historic highs, an expanding commitment towards feeding steadily rising dividends has taken hold, and massive share repurchases have returns cash to shareholders. As Exhibit 1 demonstrates, returning cash to shareholders has been rewarded handsomely, while reinvestment in the business has been viewed with a very skeptical eye.
Source: Lombard Street Research, February 2014
Despite ongoing pressure to grow margins farther from here and pressures from increasingly emboldened activist investors to return cash at an accelerated pace, there is an inevitable need to reinvest in one’s business. Driving earnings growth solely through cost control and shrinking the share base has some natural limits. Businesses that fail to keep pace with change, risk market share loss and revenue declines. Conversely, with borrowing costs low and many businesses still dragging their feet on reinvestment, hoping to squeeze higher profits out of an aging asset base (see Exhibit 2), the time may be ripe for wise tactical investment in innovation in order to steal a march on the competition.
Source: Goldman Sachs Investment Research, February 2014
Again, we do not see a vast acceleration of capital spending on pent-up demand. CFO’s are still anxious to protect the margin gains they have made in recent years and are not going to go on a wild spending spree in what remains a modest growth recovery. Therefore, we do not believe in positioning for a uniformly rising capex tide that will benefit any old seller of widgets. We feel that positioning more strategically in certain areas that can offer one or more of the following value propositions to the corporate spender:
1. Areas experiencing a super-normal growth surge due to disruptive innovation
2. Products/services that offer clear productivity enhancement
3. Products that significantly enhance the customer experience leading to share gains
In the first category, we cite a couple of prominent examples. One would be the downstream impacts of the U.S. shale gas revolution. The dramatically advantaged cost structure of U.S. natural gas production today has created a broad raft of opportunities for investments around the transport (pipelines) and uses (chemical feedstock), as well as for further exploration in new geographies. Another example is the surge in investments deriving from disruptive innovation surrounding biotechnology advancements. Aaron Reames touches on theses downstream growth opportunities (research labs and tools) in his related piece this week.
In the productivity category, we cite industrial automation as a prime example. There is an accelerating global pace of implementation around this theme as increasingly, the level of automation determines competitive cost advantage rather than location in lower human labor cost geographies. This trend has now extended well beyond robotics in factory production. In mining, for example, where general capex has plunged on falling demand from China, spending is moving forward on items such as increasingly autonomous trucks, trains and even drilling machinery. Large scale agriculture is following a similar path where networked machines can plant, irrigate and harvest crops with less human assistance. The next frontier being conquered lies in similar trends in formally white collar functions as artificial intelligence systems begin to perform deep analysis that was formerly reserved for fairly highly educated and compensated professionals.
Finally, we would point to investments that clearly deliver strong customer experiences with greater speed, fewer errors and greater freedom of implementation. Daniel Spelman touched on how some of those sorts of development are affecting market shares in the restaurant business in his piece this week. When you’re a pizzeria owner losing significant share to the major chains that can execute seamless ordering online from mobile devices, how would you not follow suit?