Corporate America is going to have to retool itself

With more than 85% of the S&P 500 companies having reported quarterly results in the last few weeks, we’ve put the bulk of June quarter earnings season behind us.

While somewhat better than expectations from just a few weeks ago, en masse the S&P 500 group of companies have delivered their sixth consecutive quarter of falling earnings.

If we look at how companies are managing their earnings, they continue to focus on the cost side of the equation, which has meant under-spending on property, plant and equipment as well as research and development efforts. They’re instead spending on both share repurchase programs and dividend increases.

This is not all that shocking given that more often than not, a company’s management team is compensated by hitting certain financial performance goals that are laid out in their proxy statements.

Shrinking the outstanding share count drives better earnings per share optics, while boosting dividends helps return cash to shareholders as well as insiders that own company shares.

For example, Microsoft’s most recent proxy filing for 2015 referenced total shareholder return, cash returned to shareholders and annual revenue as compensation performance metrics. Other companies utilise earnings per share growth, return on invested capital, operating income growth and other metrics.

Research firm TrimTabs estimates US companies spent $725 billion on share repurchases during 2015, second only to the $810 billion spent in 2007. According to Dow Theory Forecasts, buyback activity among the S&P 500 group of companies has increased for three consecutive years and if the current pace is continued, buybacks in 2016 could break the prior record of $589.1 billion in 2007.

Even if a new record isn’t established this year, it’s still four strong years of buyback activity that has shrunk share counts and propped up bottom line comparisons while sacrificing longer-term business investment.

By comparison, data from Credit Suisse Group shows that combined capital expenditures and R&D spending at more than 1,800 US firms was just 7.4% of sales, well below the peak spending level at 9.3% in 1991. Lest one think this is a US phenomenon, Credit Suisse found that combined capex and R&D spending for 815 Eurozone companies was 7.0% in 2015, down from 11.9% at its peak in 2000.

What this tells us is companies are being managed for the short-term, not the long-term or even the medium term.

What this means is that over time companies will develop strategic gaps and technology holes that will need to be filled lest they cede their competitive position and management falters on its financial targets. Internal efforts would need to be ratcheted up significantly in order to catch up on lost ground, but a more likely scenario is for companies to flex their balance sheets and stock prices to acquire small and mid-cap companies or private ones to shore up their competitive position or extend their global foot print.

If they don’t, there is a high probability they will hit what we refer to as the “thematic wall” that will challenge their business much the way a person out of work for several years lacks the required skill set to get back into the job game. Yep, much like workers, companies will need to re-tool themselves to remain competitive.

Consider Apple, which spent $38.3 billion on share buybacks and forked out almost $12 billion in dividend to shareholders for the twelve months ended March 2016. That’s $50 billion compared to the $9.2 billion spent on R&D over the same period. With companies ranging from Amazon to Alphabet and Facebook investing in machine learning and artificial intelligence, Apple opened up its vast piggy bank to buy Turi for a purchase price of around $200 million.

Outside of technology, Danone acquired WhiteWave Foods to jumpstart what we call its Food with Integrity business and Microsoft snapped up LinkedIn to bolster its enterprise-facing offerings at a time when consumers have been shunning software for apps. Just this morning, recruitment center focused Randstand Holding announced its intent to acquire online recruiting website company Monster Worldwide, which should help move Randstand more into the digital age.

For the twelve months ended June 2016, the number of M&A transactions dipped 3% to 12,818, but let’s remember that 2015 was a record year for such transactions. Given the tone of the global economy, as well as the pending fallout from the Brexit vote, the M&A slowdown in June and July was not surprising. This lull is likely to last for only so long as companies continue to underinvest in their businesses and management teams eventually need to focus on revenue and profit growth.

Unless you are an activist investor, complete with board level access, investing in companies for their takeout potential isn’t for the faint of heart. Even when companies put themselves in play, it doesn’t always pan out and as InterDigital found out several years ago, buyers don’t always value a company the same as its management team, board of directors and investment bankers.

One alternative is to invest in best of breed companies that are capitalising on a pronounced shift in consumer preferences, like WhiteWave, an evolving technology landscape, like ARM Holdings, or demographic pain points that will impact a company’s existing business or create new opportunities.

By examining the intersection of evolving economic, demographic, psychographic and technology landscapes, investors can identify these demonstrative thematic tailwinds that companies must respond to through either internal efforts or acquiring external ones.

The upside potential with this strategy is an acquisition offer for the company. The downside is an investment in a company whose business is benefitting from drivers that should yield revenue growth and margin expansion, culminating in faster-than- average earnings per share growth.

That isn’t such a bad choice of scenarios considering the latter has historically been the formula for valuation multiple expansion and higher stock prices.

Chris Versace is the chief investment officer of Tematica Research.

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