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Burning Down the Cash

Author: Dan Skelly
Burning Down the Cash

With slower-than-expected GDP both in the US and abroad, and a stronger US dollar weighing on multinationals’ and exporters’ earnings power, many investors are wondering if US companies can use their tremendous cash reserves, nearly $2 trillion, to drive further growth and earnings. Moreover, as we’ve written before, activist investors are also shining a brighter light on how companies allocate capital and organize themselves. Notably, in recent weeks—and even before any formal activist involvement— two megacap US blue chips announced significant restructurings that mark changes in their capital allocation strategies. Given this backdrop, we want to examine recent trends regarding capital allocation and how the market is rewarding varying strategies. We will also outline the likely implications for equity investors going forward.

Our broad conclusion is that we are shifting toward an environment in which the equity market is rewarding companies that invest more in growth, including cash driven mergers and acquisitions (M&A) and spending on research and development (R&) (see table). For instance, from 2013 through April of this year, R&D spending was rewarded handsomely, 9.1%. This represents a notable shift from the post-financial-crisis years (2009 to 2012) when the market rewarded companies that returned cash to shareholders via dividend and buybacks (see table).

We also note that CEO confidence was lower in those years given various foreboding macro risks at the time—the US fiscal situation, a possible Euro Zone breakup and the “bunker mentality” that lingered in the aftermath of the financial crisis. Therefore, it is only natural that six years into the recovery, with higher equity markets, not only are corporate managements more willing to invest more in growth opportunities, but also the market is more likely to reward those capital allocation strategies.

M&A Surges

After a three-year lull, M&A activity jumped 23% to $3.7 trillion last year. Volume continues to be robust this year, too, with $620 billion in announced deals thus far and notable “megadeals” in energy, health care and packaged foods. With CEO confidence improving and interest rates—and with them, financing costs—likely rising before the end of this year, we believe merger activity will continue to build. Some may be concerned that rising merger activity has typically occurred just before a market top, but we note that, while overall volume is increasing, the important metric is M&A as a percentage of GDP. By this measure, the latest reading of 2.6% is still far below the prior peak of 5.4% that occurred in the second quarter of 2007 (see chart).

Modest CAPEX Improvement

While we see M&A as being a prominent use of cash going forward, we are less certain about capital expenditures. Our view is consistent with that of Adam Parker, Morgan Stanley & Co.’s chief US equity strategist, who believes capex-to-sales ratios will likely only rise modestly through 2016. Digging deeper, Nigel Coe, industrials analyst for MS & Co., notes that several capex cycles are in longer term declines; the mining and metals cycle has been driven downward by China’s shift toward a more consumer-focused economy while the collapse in oil prices has depressed energy sector spending. Additionally, companies that are big spenders have not been rewarded by the market longer term, according to Parker—another reason why managers may make capital spending a low priority. Last, we live in an investment and business culture that is increasingly driven by the need for instant gratification, and it’s clear that managements can see a quicker stock price reaction for an acquisition than for an investment in a new factory, which takes several years before the payoff materializes.

Buybacks Rewarded

As another use of cash, we believe buybacks will continue to be important, especially where companies use them as a means to complement healthy organic growth trends and where there are no clear strategic deals to be made. Indeed, according to Parker, buybacks continue to be rewarded by investors. We believe buyback programs should be in excess of 5% of available shares to garner the most attention from investors.

Dividend Growth

With interest rates likely heading higher by the end of the year, we would expect the market to reward stocks with high dividend growth more than stocks with high dividend yields. Broadly speaking, companies are boosting their dividends; 86% of S&P 500 companies raised their payouts in 2014 and this year, the amount paid out in the first quarter was up 14% from the first quarter of 2014.

In our view, the sectors likely to provide the most robust dividend growth are technology, consumer discretionary and financials. Our bias toward dividend growth stocks and a tilt away from conventional high yield equity exposure is consistent with our positioning in the Dividend Equity model portfolio as well as Adam Parker’s underweights on consumer staples and telecom.

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