The two charts above — according to Robert Buckland, head of global equity strategy at Citi — illustrate the difference between a market that “has reinvented itself as a giant capital recycling machine” (the U.S.) and one that “remains a giant capital destruction machine” (Japan).
Much has been made of slow growth in business investment in the U.S. in the wake of the Great Recession of 2007-2009. However, while U.S. corporations have spent a lot of cash on share buybacks and dividend payouts since then, they have spent about as much on capex — perhaps suggesting one has not necessarily come at the expense of the other.
In Japan, on the other hand, spending on business investment has outpaced buybacks and dividends by multiples for years, yet corporate profitability has stagnated.
“Why has the U.S. stock market been transformed into a capital recycler while Japanese companies have remained capital destroyers?” asks Buckland.
In a note to clients, Buckland attempts to answer the question:
As the market sees a company’s profitability fall, so the shares derate. This increases the opportunity cost of capex versus share buybacks. It also attracts the attention of more dividend- and less growth-oriented income investors. But even though these shareholders increasingly want to recycle capital out of the company, the CEO may not listen. This is where activism comes in. If a U.S. CEO does not listen then shareholders can replace him/her with one who does. Shareholder activism is a key part of the process through which U.S. companies are shifted towards being capital recyclers. This is how capitalism is supposed to work.
A lack of shareholder activism may explain why Japan’s listed companies haven’t made this shift. Despite low profitability, they still spend way more on capex than they recycle back to shareholders. U.S. investors would not tolerate this behaviour. Unsurprisingly, deflation has taken hold. This is not how capitalism is supposed to work.
Buckland points to a clear correlation between buybacks/dividends and valuations. The correlation between capex and valuation is much smaller.
“Companies have to invest to generate future returns,” he says.
“But if they collectively over-invest, then future industry profitability is likely to suffer. Lower capex would also have serious implications for economic growth and employment. However, the evidence suggests that equity investors have become increasingly, and justifiably, wary of capex.”
The bottom line: U.S. companies’ decisions to increase buybacks and dividends in recent years has gotten a bad rap.
“Activists are being accused of short-termism and favouring dividends and buybacks over job-creating capex,” says Buckland.
“Some of these criticisms are fair, but if shareholder involvement helps to prevent companies from falling into a Japan-style cycle of capital destruction then it should be encouraged not discouraged.”
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