Activist Investors, Capital Allocation, Capital Deployment and Underinvesting
The Fall 2014 issue of the JACF focuses on capital allocation and investment and the a Roundtable including corporate executives and hedge fund managers addresses the question of whether U.S. public companies are “underinvesting,” that is, failing to devote enough of today’s profits to increasing tomorrow’s earnings and value.
In this respect, commentators have often compared US firms unfavorably with their Asian peers but the stock returns of U.S. companies continue to outpace most of their overseas competitors’ by a wide margin. In 2013 the average corporate return on invested capital for the largest 1,500 U.S. non-financial public companies reached its highest level in the last 60 years. The stock returns of U.S. companies during the 36-year period since 1978 have been the best in American history while the Nikkei 225 continues to trade well below half of the peak it reached in 1989. The total average annual return—dividends plus stock price appreciation—of Chinese equities since 1993 is roughly a negative 5%.
But if capital returns are at record levels, growth in capital investment during the last ten years has been below average. As a consequence, U.S. companies have large stockpiles of cash, even after dividends and stock repurchases that are also near record levels. This combination raises the possibility that many companies have been passing up value-adding growth opportunities in misguided efforts to keep raising their operating returns.
According to a number of the Roundtable panelists, many U.S. companies appear to be using hurdle rates on new investments that are well above their cost of capital. To the extent this is so, such companies are likely to be sacrificing valuable opportunities, whether for M&A or “organic growth.”
The highest performing companies may realize this. According to Credit Suisse’s Michael Mauboussin, the companies that have achieved the highest stock market returns in the last five years appear to have made conscious decisions to reduce their returns while increasing investment and growth. U.S. corporate capital spending, particularly on M&A, now appears to be taking off. And corporate spending on R&D, despite popular claims to the contrary, has risen steadily in the last 30 years. As Mauboussin and Dan Callahan point out in their article that follows the Roundtable, total R&D spending by the largest 1,500 U.S companies has increased from 1.4% of sales in 1980 to its current level of about 2.3%.
The second major focus of the Roundtable is the widespread complaint that many U.S. companies are paying out excessive amounts of their capital to investors as dividends and stock buybacks.
But several participants argue that the inclination of U.S. companies, sometimes with prodding from activist investors, to pay out their excess capital is in most ways a reflection of an effective governance system. The two activist investors on the panel—one representing Pershing Square and the other Jana Partners—were quick to point out, such payouts have generally functioned as a demonstration of U.S. corporate managers’ commitment to investing and operating with the optimal, or value-maximizing, level of capital—neither too much nor too little. Getting those decisions right is the main goal of financial management.
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