Dispelling capex growth concerns
‘Capex’ has become finance's dirty word. But, as we enter the final leg of this business cycle, are investors too negative about companies redistributing profits to invest in growth?
It’s understandable why the market may be pessimistic on the prospects for 'capex' (capital expenditure) growth. The headlines suggest that corporate spending plans have softened in the face of deteriorating global growth, which is consistent with the direction purchasing manager indices (PMIs) have taken. There is now a considerable amount of market chatter about CEOs reigning capex in due to falling earnings expectations — which can become a self-fulfilling prophecy.
Surely, businesses defying this norm should be rewarded. However, we’ve seen multiple instances over the past twelve months where share prices of companies have been negatively affected by news of extra investment. Potential improvements in operational quality and returns have been overlooked by investors' negative perceptions of funding growth during this point of the market cycle.
Through all the doom and gloom, investors shouldn’t lose sight of the fact that using cash is even more important, especially as growth slows. For corporate management, important choices have to be made. Let’s not forget that cashflow characteristics of companies are still strong. So while a deceleration in earnings growth is problematic, it means the use of cash is all the more important as these businesses take a decision to invest for growth.
Importantly, if secular and structural shifts are to lead to sustainable economic growth, a rebound in capital spending will be felt more widely. At a time when GDP growth is moderating, these companies should benefit from increased investment. To us, investment plans from the likes of Ocado, Just Eat and Coca-Cola Hellenic represent the right growth strategy to be taking.
When it comes to broader corporate reinvestment trends, current data suggests that European capex investment looks set to be stable at best, though well below peak as a percentage of company revenues. This differs from the US, where a number of sectors show that capex trends are at historically high levels.
By sector, we can see that cyclical industries are clearly more reliant on continued capex for earnings expansion. Encouragingly, evidence suggests there remains pent-up demand in the global capital equipment and technology sectors. Based on our recent discussions with management during earnings season, the outlook for capital spending in these sectors remains robust, while more broadly, research and development commitment is on the rise. Investing in newer equipment and keeping pace with the rapid rate of new technological advancements (automation/electrification) are key trends for the investment cycle.
On this point, it’s important to clarify that different end-market cycle stages imply differing opportunities within industries. For example, within the mining industry, copper and gold are viewed as the main drivers of the expansion in capex investment in 2019, while a sustained uptick in brownfield and greenfield project investment would be a considerable catalyst for further growth. This reinforces my positive view on Weir Group, where we are still in the early stages of a recovery in the multi-year capex growth cycle in downstream mining.
Another cyclical name focused on investment is equipment rental business Ashtead. Early investment in their equipment fleet ahead of the cycle not only means they have the youngest age of equipment across the rental segment, but that incremental capex requirement and growth rates are now better aligned.
In general, there remains fundamental, structural rationale for capex spending. Investment ultimately reflects the structural growth opportunity that businesses see in their end markets, enabling them to broaden product offering and geographic reach, whilst being a key driver of future earnings and cash flows.
For bottom-up investors, as we are, a clearly outlined capital allocation strategy is an integral part of the investment case for a company. While the jury is out on whether stocks will be rewarded for capex growth plans that support the longer term outlook, we continue to support management teams that prioritise investment in the pursuit of generating future value and higher returns.