Monday, May 5, 2014

Financial engineering as a CapEx substitute?

In my last post (see The bearish verdict from market cycle analysis), I pointed out that the relative performance of capital equipment sensitive sectors like Technology and Industrials were not behaving well. I further lamented the lack of sales growth visibility of capital equipment companies during the latest Earnings Season  (see What the equity bulls need for the next phase and CapEx: Still waiting for Godot).

As per Business Insider points out, loan standards are being relaxed and loan demand is rising, so these conditions "should" be conducive to higher business investment. But higher capex has yet to appear.

Zero Hedge confirmed the long awaited capital expenditure acceleration has yet to arrive, though I always read their analysis with a grain of salt:

One explanation for the lack of capital expenditures this cycle came from Drew Matus and Julian Emanuel of UBS. Matus and Emanuel postulated that companies are engaged in so-called "corporate QE" (via Bloomberg).

Companies that engage in corporate QE are characterized by a reasonable dividend yield, a history of dividend growth and share buybacks. The UBS analysts went on to explain that companies feel pressured to engage in this form of financial engineering in the current low return environment (emphasis added):
The strategy is understandable in an environment where gross domestic product is expanding at an anemic rate of 0.1 percent. Companies hard-pressed to grow their businesses organically are paying dividends and reducing share count in order to maintain 5 percent to 7 percent cash-on-cash returns for investors.

The concern, as Mssrs. Matus and Emanuel indicate, is the substitution effect where companies "give away" money rather than reinvest in the form of capital expenditures. Ultimately, top-line growth will justify investment and companies will generate higher returns. Until then, investors must acknowledge the slow-growth reality of PIMCO's "new normal" and take growth where they can find it... even if that means settling for corporate QE.
Is this what happened in this cycle? Are ROIs so low that companies turning to financial engineering instead of investing the money back in their own businesses?

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.


Anonymous said...

Financial engineering must include effective equity tips to reduce risks in Capital Expenditure or CapEx

Rik said...

It doesnot necessarily have to replace it the 2 could well be combined. Especially now when borrowing costs are so low (including for Junk).

It looks to me a way to keep EPS look well on one side (the buy back side).
But still not seeing possibilities for real growth (on the CapEx side), even when it could easily be financed very cheaply.
That from the corporate side.

Likely as well that investors donot see 'CapEx growth' potential. Which will have its influence on the cies as well.

AE said...

Anti-growth policies in the White House means less investment.