Capital spending: In search of momentum
October 17, 2014
There are signs that the current economic recovery may have finally reached a point where an important measure of momentum — capital expenditures — is on the rise. Consider, for instance, a recent Wall Street Journal survey that revealed that 51% of small companies plan to increase capital spending in the next 12 months.
An increase in capital expenditures (or capex) may not come quickly or all at once, but already there are signs of mild improvement; companies within the S&P 500® Index reported a capex increase of 16% in the second quarter of 2014 versus the same period in 2013.
Capital spending: Is there a confident uptrend?
It’s too early to declare that capex is set to expand at a healthy pace across the broad economy. We believe that perhaps it’s more appropriate to consider potential spending on a sector-by-sector basis. That is to say, certain industries might reap the benefits of pent-up demand and other drivers, while other industries could be met with relatively few capex drivers. (For instance, we have already seen a significant uptick in spending within the energy sector, and we believe more may be in store as the build-out of energy complexes along the Gulf Coast occurs over the next five years.) A few notes about each side of the coin, looking at potential drivers first, then potential headwinds:
- In the United States, a good deal of industrial equipment is quickly approaching the end of its useful life. When you consider that the average age of industrial equipment is more than 10 years (its highest since 1938), the point becomes even clearer. (Data: Morgan Stanley, via Dow Jones.)
- A manufacturing revival in the U.S. could spur an uptick in capital spending. Results of a manufacturing survey released in early September showed new orders for August jumping to a high that hasn’t been seen in more than 10 years (data: Reuters). The overall utilization rate is another signal that bodes well (see Chart 1). The reading for August 2014 came in just shy of 80%, which has historically been the level at which companies begin investing more aggressively. (We note here that this is not an automatic trigger; it is merely a flashpoint that has generally held true in prior cycles. What’s more, utilization rates of 80% only induce spending so long as they are sustained. In other words, hitting the 80% threshold only to subsequently fall below it would not be enough to stimulate significant capital spending.)
- U.S. manufacturing has become increasingly viable versus overseas competitors. The U.S. advantage is partly explained by factors that include lower energy prices (natural gas in particular), an adequate supply of skilled labor, a mature logistics system, and regulatory stability.
Chart 1. Capacity utilization rate across all industry
Data: U.S. Federal Reserve. Monthly observations.
- Companies are looking at ways to deploy excess cash on their balance sheets, and in many cases, other means have been more tempting than capital investments. Chief among these are share buybacks (see box below) and company acquisitions. In the first half of 2014 alone, U.S. industrial firms spent $80.7 billion in acquisitions, the highest level since 1999 (data: Dealogic via Dow Jones).
- Uncertainty about economic growth is a notable headwind; if growth comes to a halt again, spending that is not absolutely necessary is likely to be trimmed back.
The appetite for buybacks
As of late, stock buyback programs have enjoyed much support as a use of excess cash. Despite their role in potentially improving earnings-per-share performance, buybacks often come with drawbacks, particularly if other uses of capital — such as capital investments — are forced to take a back seat.
It’s not hard to see why buybacks have entered the picture. They make economic sense in today’s low-rate environment, which allows companies to finance repurchases at reasonable terms. What’s more, repurchases carry fewer administrative hurdles when compared to capital spending. (Capital projects can be risky and can take a long time to approve and implement, whereas buybacks can be approved at a single shareholder meeting and are more easily executed.)
Still, the recent volume in buybacks doesn’t change the natural pecking order of corporate spending, in which organic investments traditionally come first, followed by acquisitions, and then buybacks and dividends. With this hierarchy in mind, we believe the recent flurry of buyback activity, combined with the prospect of stronger economic growth, increases the likelihood that companies may turn to other forms of spending — including capital expenditures.
So where are we now?
As important as they are, capital expenditures are difficult to forecast. That said, we think it’s fair to say that we may be in the earlier stages of the capex cycle, with 2011 as the likely starting point. (It helps here to keep in mind that U.S. total capex as a percentage of nominal gross domestic product remains slightly below its long-term average, supporting the view that spending has yet to move out of the early phase of the cycle.)
In the next couple of years, if capex begins moving along in the cycle, we hope to see broad-based gains that are truly indicative of growth while at the same time making sure companies maintain financial discipline. As it stands today, conditions remain relatively supportive, with good credit availability, record cash on corporate balance sheets, and elevated corporate profits.
As we factor capex into our daily work, we think good investment opportunities will largely be driven by companies that spend responsibly without jeopardizing sustainable cash flows. As value investors, we believe that too much capital spending can sometimes be a drawback, particularly when companies overbuild and fail to maximize the potential of those new assets (or when demand proves lower than anticipated for their goods and services).
At the sector level, possible beneficiaries of healthier capital spending could include software makers, industrial equipment providers, semiconductor companies, and companies involved in engineering and construction.
The views expressed represent the Manager's assessment of the market environment as of October 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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