- The aggregate decision-making around capital allocation would appear to continue to support a strong global competitive position for U.S. companies.
- Leading American companies are making long-term investments and investors are giving the most compelling of them a lot of credit for those long-term choices.
- While many continue to underestimate the power of American innovative strengths, the speed of disruptive new developments will only increase the cost to those who do so.
There has been a growing hue and cry in the U.S. over the risks of short-termism: the perception that the quest for a quick buck at the expense of investments for longer term growth poses a serious economic threat. Politicians, the media, academia, and increasingly even investment pundits have decried the tyranny of quarterly capitalism. Certainly, elements of these concerns are supported by facts. Corporate leverage has grown, share repurchases have increased, activist investors are clearly growing in influence, and there have been notable shifts in capital expenditure policies in corporate America. All of that said, we think that this broad narrative around short-termism is at least incomplete and, in many ways, simply incorrect. When one looks at the bigger picture, aggregate American decision-making around capital allocation would appear to continue to support a strong global competitive position.
In an increasingly globalized world, U.S. corporations have been reducing their direct capital intensity while increasing their profit margins and returns on invested capital (Exhibits 1 & 2). Quite simply, American corporations have concentrated a growing percentage of their business on more proprietary intellectual property and less on the undifferentiated, lower return portions of the supply chain. They did this by outsourcing to others (China as key example) the actual building of ‘stuff,’ while retaining the lion’s share of the profits by focusing on operating systems, software and brand building. This has been a powerful trend, but I believe it is increasingly important. The effects of globalization offer opportunities but also present new competitive pressures. Products without significant barriers to entry are facing growing levels of pricing downside, but truly distinctive technologies, products and services can access broader markets in an efficient (and profitable) manner. A growing share of the U.S. economic engine is fueled by the latter.
Exhibit 1: Large-cap stocks — Free cash flow margins (1953–08/15)
Source: Corporate Reports, Empirical Research Partners Analysis
Excludes financials and utilities; data smoothed on a trailing six-month basis.
Exhibit 2: Large-cap stocks — Capital spending as a share of gross cash flow (1953–08/15)
Source: Corporate Reports, Empirical Research Partners Analysis
Excludes financials and utilities; data smoothed on a trailing six-month basis.
Looking at the declining capital spending as a percentage of cash flow, one might wonder: Isn’t that proof that short-termism is starving businesses of reinvestment in future growth? Not exactly. To get a clear picture, one must dig a little deeper and examine where capital expenditures are going. Overall capital spending continues to grow at a reasonably healthy clip (and this includes recent cuts in oil/gas spend). However, the really interesting story is the shift in where the spending is taking place in the information age. On one hand, reinvestment in structures (a data category that includes mines, wells and commercial property) and industrial equipment has fallen as a percentage of overall capex and corporate revenues; on the other hand, reinvestment in technology, research and development, and intellectual property has been accelerating to historical highs (Exhibits 3 & 4). This includes no adjustments for the accounting challenges related to capturing the total investments in intangible assets.
Exhibit 3: Growth in real private non-residential investment (and components) indexed to Q4 1980
Sources: Bureau of Economic Analysis, Haver Analytics
Exhibit 4: Real private investment in intellectual property (and components) as a percent of real GDP
Sources: Bureau of Economic Analysis, Haver Analytics
All data expressed in chained 2009 dollars.
Consider the sectors that have led equity market returns in recent years, such as biotechnology, software, consumer brands and internet. Leading American companies in those industries are making very long-term investments and investors are giving the most compelling of them an awful lot of credit for those long-term choices. Companies such as Amazon, Tesla and a raft of biotechnology companies are currently valued at extremely high multiples of current earnings as investors are willing to bet on the longer term value of those businesses. In a world of vast liquidity and low interest rates, the asset in short supply is the great idea. It appears to me that: a) the pace of investment in those new ideas looks pretty robust in the U.S. and b) the U.S. share of successful implementation of those ideas would appear to be growing rather than declining, as measured by global market share in innovative sectors.
Interestingly, as I investigated this topic, I became increasingly aware that concerns about American short-termism are not just a recent phenomenon. I was particularly entertained by rereading a 1992 report on the principal findings of a two-year research project sponsored by the Harvard Business School and The Council on Competitiveness (led by Michael Porter)*. With the benefit of hindsight, the report’s primary conclusions seem pretty far off the mark. Its key finding was:
“The U.S. system of allocating investment capital both within and across companies is failing. This puts American companies in a range of industries at a serious disadvantage in global competition and ultimately threatens the long-term growth of the U.S. economy.”
However, when one digs a little deeper into the report, one finds the seeds of a more accurate conclusion:
The United States “is at its best with companies in obviously high-technology or emerging industries, especially those with rapid growth and high perceived upside potential. The American system also supports investment in turnarounds or other situations of clear discontinuity. In these cases, investors recognize that current earnings are irrelevant and seek other value proxies such as patents, new product announcements, research pipelines, and growth of new service locations that are more supportive of investment. This explains why the United States invests more than its competitors in some industries but less in others, why it performs well in funding emerging companies.”
The report saw particular competitive risk to the U.S. from Japan and Germany, given a perceived “longer term focus” supported by lower investor turnover, but here too the details do have some underlying insights:
“The Japanese and German systems also have strengths and weaknesses. These systems encourage continued, aggressive investment to upgrade capabilities and increase productivity in existing businesses. They also encourage internal diversification into related fields, building upon and extending corporate capabilities. These qualities, however, also exact a cost in Japan and Germany. For example, these systems create their own tendency to overinvest in capacity, to proliferate products, and to maintain unprofitable businesses indefinitely in the name of corporate perpetuity. They also exhibit a slower tendency to redeploy capital out of genuinely weak businesses and an inability to enter emerging fields rapidly, particularly through start-ups. Managers generally have fewer performance incentives, and companies have a harder time dismissing poor performers.”
I believe these passages are the underappreciated wisdom of the work, and I highlight them because they appear more relevant than ever today. Shareholder holding periods have only declined further, particularly in the U.S., but the American system still appears to be exceptionally effective at nurturing and investing in “emerging industries” and “situations of discontinuity.” A large part of what the report got wrong was how significant those emerging and disruptive businesses would prove to be. This is extremely important as I believe that the pace of technological change and disruption to current business models is still accelerating, and those entities who cling to marginal improvements of existing businesses (particularly those with low barriers to entry and a tendency towards overcapacity) will struggle to keep up.
This brings us to the new big player on the global scene today, China. Many observers have been concerned that the rise of China will inevitably marginalize the U.S. as an economic power and have expressed admiration for the long-term view that the guiding hand of the state supposedly brings to the table. I cannot help but see amazing parallels to the comments in the 1992 report (and many others from the 80s to early 90s) on Japan. The report raised the warning that “leading American companies in many manufacturing industries such as construction equipment, computers, and tires are out-invested by their Japanese counterparts.” That sounds awfully similar to fears about China competition today. However, comments made about 1992 Japan — “tendency to overinvest in capacity,” willing to “maintain unprofitable businesses indefinitely,” and “managers generally have fewer performance incentives” — certainly sound very similar to some of the weaknesses we observe in the Chinese model today. In short, being “out-invested” in the likes of construction equipment, consumer desktop computers and tires shouldn’t worry investors too much as long as the U.S. continues to stretch its lead in the revolutionary technologies that are disrupting industries and driving future growth.
There is an inherent chaotic messiness to U.S. capital markets that confounds many observers, but history and current evidence suggests that embedded in that noisy capital allocation process is an underlying aggregate wisdom when it comes to handicapping opportunities in important areas for emerging industries and business models. I believe that that particular skill is very difficult for others to learn, particularly when the ponderous machinations of state bureaucracy intrude in the process. I believe that the consistent underestimation of the power of American innovative strengths continues today and that the speed of disruptive new developments will only increase the cost to those who do so.
Sources:
Capital Disadvantage: America’s Failing Capital Investment System
The New Yorker, The Short-Termism Myth, August 24, 2015
© Columbia Threadneedle Investments
© Columbia Threadneedle Investments
