As investors scour the globe for yield, one consequence of the low return environment is that companies making the highest payouts to shareholders are being rewarded by the market with higher valuations. This is the opposite of previous equity bull markets where it was companies investing for growth that reaped the rewards.
The preference for shareholder payouts over capex is being reflected in valuations with the rerating of those defensive quality stocks that have been adopted as ‘bond proxies’. Many of these stocks are now very expensive as investors have crowded in. (See our recent blog on the dangers of crowded trades)
The following left-hand chart shows the investment/payout ratio of markets and sectors against their current valuations. Those that pay out more than they invest seem to be awarded higher multiples than those that do the opposite. Contrast this with the right-hand chart which shows the valuation vs investment payout relationship in the late 1990s when companies with corporate investment high on the agenda were in favour.
How have we reached this point?
Weak growth and weak inflation coupled with previous poor experiences of capital overinvestment has left investors nervous. In the commodity sector in particular, investors had their fingers burnt after excessive capex between 2000-2013 resulted in a supply glut and lower prices, and subsequently, poor shareholder returns. This has been closely followed by the search for yield as traditional bond investors have been forced to look elsewhere for income. CEOs have been under pressure to return cash to shareholders rather than spend on capex – an unintended consequence of loose monetary policy by central banks perhaps.
Yet in some respects, perhaps we should not be surprised by the trend. General pessimism over global growth, widespread fears of deflation and deflationary excess capacity have fuelled shareholder pressure to cut back. There has been an increase in investor anxiety about market vulnerability to deflationary shocks. Arguably, capex needs to stay low for output gaps to close and pricing power to return.
How long can this trend last? Interestingly, in the latest Global Fund Manager survey from Bank of America Merrill Lynch, when asked what would you most like to see companies do with cash flow? an increasing percentage of investors actually indicated they want to see companies increase capex, while reducing cash to shareholders. In a separate question, a record 69% of respondents said they thought that corporates are underinvesting.
This must be presenting company boards somewhat of a dilemma. Ultimately, for companies to grow they need to invest. In the meantime those offering shareholders an income stream are being rewarded with higher valuations. And of course, there is the other argument that buybacks and dividends can prop up EPS and total shareholder return - lifting CEO pay as a result!
But that’s a whole other subject for another blog.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.