Reinvesting In American Business by Columbia Management
May 12, 2014
- The markets have rewarded U.S. corporations that have embraced a discipline of strict cost oversight and a rigorous focus on returning capital to shareholders.
- We strongly favor such discipline unless it ends up crowding out reinvestment for innovation and profitable revenue growth.
- From the bare bones levels of the post-crisis period, it is encouraging to see a new willingness to reinvest in American growth and innovation.
It’s a trend we have seen for more than 15 years, accelerating in the post-crisis era: U.S. corporations have increasingly embraced a discipline of tight controls on spending and a focus on returning capital to shareholders in the form of share repurchase and dividends. We have long been strong advocates for such disciplines. The financial markets have rewarded the companies which have executed these strategies most rigorously (Exhibit 1) and those rewards have incented an ever increasing emphasis on such a focus. Most recently, the “activist” investing community has seen great success in forcing corporate holdouts from these disciplines to bend and adopt them. However, we must bear in mind that there are natural limits to how far businesses can take such tactics. Taken to an extreme, a strategy of single-minded focus on returning cash to shareholders without proper reinvestment in the business can be extremely harmful to individual businesses. Taken in aggregate, if all of corporate America goes too far in such a focus, it will lead to a decline in U.S. competitiveness and global market shares. Given some signs of excessive focus on cash returns to shareholders, it has been encouraging to see signs of growing balance in such decisions emerging.
Exhibit 1
Source: Strategas. Past performance does not guarantee future results. It is not possible to invest directly in an index.
The ability of American corporations to lead the global recovery in recent years has been a testament to the power of capitalism and its incentives. Almost nowhere else has the focus on driving down costs and improving capital efficiency been so intense. Today’s historically high returns on capital and profit margins reflect the benefits of such focus. However, there are cautionary tales amidst the success. An interesting example of the extremes of capital discipline is Sears Holdings (SHLD). Sears is controlled by Eddie Lampert, a hedge fund billionaire whose management strategies center on extracting capital from the business and being extremely tight with reinvestment. A Fortune magazine cover story in 2006 called him “the Steve Jobs of investing” and “the best investor of his generation.” He is one of the real 21st century pioneers of this flavor of “activism.” However, since that article was written, Sears Holdings has dramatically underperformed the broader markets, declining 50% in value vs. the S&P500 up over 75%. Why? Well, have you been to a Sears store or a Kmart (another SHLD brand) recently? It is a dreadful consumer experience and (not surprisingly) sales have declined precipitously. In the end, it is impossible to solely cost-cut one’s way to prosperity. This is at the heart of concerns recently raised by Charles Munger and Warren Buffett regarding the rise of activist short-termism. Voicing his concern on the growth in such tactics, Munger said at the recent Berkshire Hathaway annual meeting, “I don’t think it’s good for America.”
I should be clear on this point. We strongly favor strict cost oversight and a rigorous focus on returning cash to shareholders and demand as much from the companies to whom we entrust capital. What concerns us is when those pieces of management strategy completely crowd out a rational and disciplined focus on reinvestment for innovation and profitable revenue growth. That is why it is encouraging to see signs of “green shoots” in corporate capital expenditure. And not only are we seeing modest new growth in spending, but we have seen markets show tolerance for this new direction. While it is an admittedly short period, stocks with higher capital spending to sales have outperformed their low spending peers in every month YTD (Exhibit 2). This holds true on a risk-adjusted basis as well (the yellow bars), which largely removes the influences of the factor volatility we have seen in recent months. Seeing the market reward a modest pickup in spending seems likely to encourage corporate managements to consider following those returns.
Exhibit 2
Sources: Thomson Reuters, Morgan Stanley Research. Past performance does not guarantee future results.
Clearly, capital expenditures are not a universal good. We seek management teams that invest their capital prudently with strict disciplines on returns for their dollars invested and we are very conscious of the universal human tendency towards hubris and empire building when such disciplines lapse. However, for corporate America to pursue an ever-increasing focus on “burning the furniture to stay warm” strategies would be dangerous and ultimately collectively self-defeating. As we see capex tick higher, we remain focused on positioning in areas where we believe those dollars will reap the highest returns. Eventually, undue optimism and greed will lead to undisciplined capex, but from the bare bones levels we have seen in the post-crisis period, it is encouraging to see the confidence embodied by new willingness to reinvest in American growth and innovation.
