The three Scrooges
March 21, 2007 8:07pm CST
From:www.economist.com Buttonwood The three Scrooges Jan 4th 2007 From The Economist print edition Companies will one day rue today's miserly approach to investment FOR a businessman, if there is anything better than making money, it must be making more money. Profits are accounting for their biggest share of the American economy since 1950. Interest rates and bond yields are low by historical standards. It ought to be a great chance for companies to expand. After all, the logic of capitalism is pretty clear. If returns on capital are high (and much higher than the cost of capital), businesses ought to be falling over themselves to invest. In time, that excess investment (by increasing competition) would reduce returns. Profits would return to the mean. But that does not seem to be happening. Business investment has been rising steadily, rather than spectacularly. From 1993 to 2000, American non-residential fixed investment grew by less than 8% in only one year. It has beaten that mark on only one occasion since. And even that rebound (in 2005) was followed by a temporary slowdown in the second quarter of last year. One answer to this conundrum could be that businesses in America and Europe no longer need to invest as much as they used to. They have “outsourced” their investment to India and China, which are rapidly expanding their productive capabilities and supplying Western companies as sub-contractors. However, Henry McVey, a strategist at Morgan Stanley, says that the answer lies in a “misalignment triangle”, comprising listed companies, private-equity groups and fund managers. Companies are simply not using their balance sheets effectively. They are retaining cash, rather than borrowing to exploit the gap between the returns they can achieve and the cost of finance. Indeed, Mr McVey says that many companies earn a lower return on equity than they make on their operating assets; that is a very poor deal for shareholders. Why is this? One reason is that companies have very high hurdle rates for new projects, higher than seems justified by a world of low interest rates. But that really reformulates the puzzle in a different form; why are hurdle rates so high? Mr McVey thinks that executives are being cautious, given the regulatory scrutiny that followed the collapses of Enron, an energy firm, and others. Executives face possible prison sentences if things go wrong; keeping a bit of cash on the balance sheet is a kind of insurance policy. Managers may also have learned a lesson from the investment splurge of the 1990s. But this cannot be the only factor. Executives are all too happy to return cash to shareholders by buying back equity. This has the great advantage of boosting earnings per share, one of the key measures watched by investors. In turn, this supports the share price on which (thanks to options) bosses' pay often depends. In contrast, investment in new plant and equipment may take years to recoup. Given the rapid turnover of management, executives may feel there is little point in planning for the long term, when only their successors will reap the benefits. A similar issue affects the second point on Mr McVey's triangle; private-equity firms. They usually plan to own companies for no more than five years and the main focus is in maximising cashflow to meet interest payments and to pay down debt. Capital expenditure is a hindrance rather than a help. But such groups are also benefiting from the caution of those they are buying from. As Mr McVey says, “Whereas in the past, [leveraged buy-out] firms actually had to know something about the business they were buying, today they can earn huge returns by merely getting rid of the excess cash on the balance sheet.” In theory, investors ought to be wise to this. They should be urging companies to borrow money to enhance returns and they should be resisting buy-outs, because they understate the potential value of the companies in question. In practice, however, Mr McVey argues that investors, particularly fund managers, are only too happy to accept a bid premium from a private-equity group. The lift such bids give a portfolio help them to beat the index, and possibly their competitors, keeping clients happy for a while. This is good news for stockmarkets in the short term, in that profits may remain high—or at least will not be undermined by the folly of executives. But the bad news is that underinvestment will weaken companies' long-term health. The conglomerates behind the takeover booms of the 1970s and the 1980s resembled today's private-equity groups. They aimed to use their financial expertise to improve returns across a range of industries. But they tended to run subsidiaries to maximise cashflow, and the businesses slowly deteriorated, like a poorly maintained house. Today's skinflints may do the same.