Here is something that caught our eye this week:
As we approach our year-end budgeting and strategic planning sessions, a key question is how much we should plan to spend on capital expenditures. The prudent long-term oriented business owner must first budget for spending to sustain run-rate operations or risk facing ever-increasing catch-up maintenance expenses at some point in the future. In addition to responsible maintenance capex budgeting, one must think about allocating funds toward whatever strategic growth plans have been formulated (in econ textbook jargon, the amount of investment in excess of depreciation).
While we have generally seen either the need or the opportunity to increase capital spending at our portfolio companies, we were interested this week to read more about global trends in corporate capex, which has suffered from a “lost decade” with aggregate spending in 2017 expected to be less than 2007 ($2.7 vs. $2.8 trillion). While spending is expected to pick up due to the continuing global economic recovery, it seems there is a broader paradigm shift underlying the framework for evaluating capital expenditures from an investment perspective.
Right now, markets value a dollar paid out in distributions more highly than a dollar reinvested in the business. According to an FT article by Robert Buckland, chief global equity strategist for Citi research, the amount US-listed companies spend on capex relative to shareholder payouts has gone from 2:1 in 2000 to 1:1 today. It seems much of this has been driven by the rise of technology-based, asset-light business models (think Amazon vs. Walmart) alongside a shifting preference among investors for current income over long-term capital appreciation. Buckland explains further:
“We have seen businesses form formidable market positions in the past, but we have never seen them use so little capital to do it. This combination of high profitability and low capex means there’s lots of cash left over for dividends and share buybacks. This helps to explain the success of free cashflow (FCF) investment strategies in this cycle. FCF measures the difference between operating cashflow and capex. It is a capex-cynical valuation metric – to maximize FCF CEOs need to raise profitability and reduce capex. It tends to favour capex-lite businesses or companies in capex-heavy industries which have just finished a major investment program. In this cycle, using FCF yield to pick stocks has been much more successful than other more traditional valuation metrics such as PE or dividend yield.”
Furthermore, within the world of growth capex, there is a market dichotomy emerging — outlined in a recent Goldman Sachs research note — between those investing funds that will result in expansion (i.e., winners) and those “spending to defend” (i.e., losers). As Goldman puts it, those in the latter category are “not expansionary, but defensive in nature; companies are spending more on capex to fight against disruptive competition and counter regulatory costs.” Put another way, one should expect the loser companies “spending to defend” to see declining returns on invested capital in the years ahead.
Our reading this week highlights where there can be a breakdown between an investing, as opposed to an operating, mindset. The structural problem with the current paradigm is that, as Buckland aptly puts it, “equity markets might not like to fund capex-heavy projects but they love to own them once they are built,” which creates a chicken-or-egg situation that is not great for anybody’s long-term economic prospects. Although Chenmark’s operating framework is focused on free cash flow, we believe there is an important distinction between the absolute amount of free cash in any one period and the trajectory of free cash generation over time. Concentrating on the former can lead to systematic under-investment, even when good opportunities abound. Optimizing for the later, on the other hand, ensures a commitment to pursuing only those opportunities that present the highest return on capital whether they are internal or external. Ultimately, we care about generating a consistent, high-quality, and durable stream of free cash flow. As we pursue this goal, we fully expect there will be times when capex will be our single largest use of free cash flow dollars, so maximizing the return on those dollars while being otherwise frugal is a balance we will continue to try and optimize.
Have a great week,
Your Chenmark Capital Team