Robert Buckland wrote a piece in the Financial Times on Tuesday exploring how we might go about “ridding markets of their bias against capex spending” when the average company has decided that they'd rather just hand the money directly to shareholders. Buckland, Citi's chief global equity strategist, doesn't think it'll be easy.
The piece presents some cogent points demonstrating how the landscape of capital allocation has tilted. “Back in 2000, US listed companies spent $2 on capex for every $1 they gave to shareholders,” Buckland writes. “Now they spend just $1.” He also notes that the emergence of free cash flow as a popular and useful metric underscores how little investors value capital expenditures, which depress free cash flow.
Buckland sees three reasons behind the trend: “subdued global growth, the legacy of previously bad capex decisions and investors’ desire for income.” Relatedly, low inflation indicates to executives that we haven't maxed out capacity, while low-capex models like Amazon's are ascendant. And then there's those dang shareholders:
CEOs have been reluctant to invest, partly because they know their shareholders prefer payouts. Those boards which defy the markets’ preferences might find themselves attracting the unwelcome attention of activist shareholders. Instead, bosses have used cheap debt to fund buybacks or M&A. Both do more to stimulate share prices than economic activity.
All of these seem to be perfectly valid explanations for why companies would rather shovel cash to shareholders (or more accurately, hand them de facto call options) than build new factories. But there's an omission here: the role of the CEOs themselves. All the talk of big shareholders demanding CEOs do this or that obscures the fact that CEOs are big shareholders themselves.
This might seem like a tangential point, but how executives are rewarded has a real impact on capital allocation. When a CEO's bonus is tied to earnings per share – a metric that can be juiced by gobbling up shares – that company will likely to do more and bigger buybacks. And when companies appear to buy back shares in order to avoid a negative earnings surprise, capex spending tends to be diminished in the following year. Executives whose personal wealth moves in tandem with their company's stock price show a particular preference for repurchases over capital expenditures. Larry Fink has a term for this.
One would think that all of this might be pertinent to a discussion of how industry might sway back toward building stuff. Apparently not:
What could drive a switch back towards capex? The best indication that companies have been underinvesting would be a rise in inflation. This would indicate that output gaps have closed and it is time to add meaningful new capacity. For now, that moment remains elusive. Alternatively, there could be a populist backlash against the shift towards investor payouts. Dividends might go down well with shareholders but capex is more popular in the ballot box. Finally, maybe policymakers should get more directly involved in capex, especially in much-needed infrastructure. After all, they could find a ready buyer.
Pay incentives present an oddly one-way discussion. When corporate boards stuff executive compensation packages with big chunks of equity, the stated purpose is to align incentives between CEOs and shareholders, as the agency theorists demanded. Yet when market observers discuss the reasons why shareholder payouts have ballooned so much, they neglect to mention those very same incentives. Perhaps it would be gauche.