Is all investment about the future?

Buy back questionI was reading an article by Doug Collins on the “three wishes for the innovation practitioner for 2015” where he points out “2014 was the year for share buybacks and dividends“.

An article from Bloomberg reports that companies in the Standard & Poor’s 500 Index are “poised to spend $914 billion on share buybacks and dividends this year, or about 95 percent of earnings.”

95% of earnings – Doug rightly says “wow” and offers a thoughtful set of observations

“Every organization that enjoys free cash flow makes a decision on where to allocate that resource. If the opportunity available to the organization meets or exceeds the hurdle rate—the desired, expected rate of return—then, in theory, they invest in that opportunity. If not, then no: the organization returns the cash to the investors. Of course, earnings come after investments the organization makes in innovation—research & development expenses, for example. Many do invest a lot in R&D”

He then remarks “And yet…..and yet” ….

“This offers the implicit message from the firm to the investment community: “we do not have a better use for this cash (i.e., the ideas we might pursue do not seem as promising and as compelling as we would like).”

“We know that we cannot cut, or cost save, our way to growth. By extension, we know that we cannot grow a business for the long-term by returning all profits to the investors. Doing so suggests a lack of vision—a lack of acuity into what the customer wants and what the market demands”.

Then you begin to read through the Bloomberg article

“Companies in the Standard & Poor’s 500 Index really love their shareholders. Maybe too much!  Money returned to stock owners exceeded profits in the first quarter and may again in the third”

The Bloomberg article goes on “Buybacks have helped fuel one of the strongest rallies of the past 50 years as stocks with the most repurchases gained more than 300 percent since March 2009. Now, with returns slowing, investors say executives risk snuffing out the bull market unless they start ploughing money into their businesses”

Some further quotes from the Bloomberg article

“You can only go so far with financial engineering before you actually have to have a business with real growth,”

Buybacks are something corporations can take control of and at low borrowing costs, they’re a viable option,”

If management can’t unearth future opportunities for growth, as a shareholder, I lose confidence.”

Buybacks have become sort of the low-risk medicine in the C suite,”.

The reality is capital expenditure comes with risk, significant amount of risk, especially in a slow-growth world. Buybacks offer a lot of flexibility.

So you do have to ask the really hard question: where is the future REAL growth going to come from?

So why are our companies not ploughing additional money back into their business, partly it serves the interest of top management who are often compensated on EPS. Business today remain utterly reluctant to buy new equipment, build factories or hire more workers, while management regards the recovery as uneven, it has regarded the buyback strategy as the best bet. How totally wrong!

Clearly the view that your own stock is under-priced, you believe your strategy is the right one and you are certainly not going to sit on hordes of cash, it is perhaps value-destroying to “our” shareholders. Yeah right including mine!

This is where the whole compensation of management has gone off the rails. If tenure at the top is shortening- as it is- then pushing your stock price performance helps for a two to three-year period helps you as the manager. Yet it really is simply “kicking the future down the road” for others to deal with, if it is not too late. It is very unlikely these buybacks will help performance of the company over a decade but then again most management has ‘cashed in their chips’ by then.

Simply too much cash and buy-backs are stopping innovation and new growth

Now of course if this ‘bull market’ does come to the end of its run this year as many are predicting then the ‘game’ of improving financial ratio’s gets so much harder. Buybacks do reduce the assets on the balance sheet (cash is an asset), the return on assets (ROA) increases and if the shares bought back are ‘retired’ the return on equity (ROE) equally goes up.

Today our markets and the investors view higher ROA and ROE as the greater positive over the need to invest in the promise of a better future. Yet change is stirring, new business models are revolutionizing industries, crazy ideas will be creating new markets and this call of the unknown holds an interesting promise of future ‘higher’ returns. The Darwinian effect is raising its head and innovation holds one big key to evolving differently to manage in these changing times.

Are these prop-up ratio’s providing short-term relief, holding strategies to what would otherwise be an ailing stock from poor investment in innovation or new assets or helps them get out of excessive dilution. These signal a company struggling.

The reluctance to raise capital investment has left companies with the oldest plants and equipment in almost 60 years. The average age of fixed assets reached 22 years in 2013, the highest level since 1956, according to annual data compiled by the Commerce Department.

Do you recall the Capitalists Dilemma?

I am sure many of you can recall the article in the HBR “The Capitalist’s Dilemma” by Clayton M. Christensen and Derek van Bever from the June 2014 Issue. This is where they outline the three types of innovation 1) Performance-improving innovations replace old products with new and better models 2) Efficiency innovations help companies make and sell mature, established products or services to the same customers at lower prices and 3) Market-creating innovations, our third category; transforming more complicated or costly products so radically that they create a new class of consumers, or a new market.

We are today often failing to create the market-creating innovations. Market-creating innovations need capital to grow—sometimes a lot of capital and risk and this is deemed unhealthy in today’s more uncertain environment but you are ‘creating’ lots of cash by running lean. Buy backs are safer, the risks lower and top management’s projects their confidence that this is better for shareholder wealth. Shareholders take the money but over time I would certainly argue lose confidence in a lasting future and constantly switch shares to chase the cash! So shares get propped up even more and the circle starts again and the future gets sacrificed just that little bit more.

The Capital Dilemma article was suggesting the need for a New Orthodoxy of New Finance.

It does recommend the emancipating of management. “Many managers yearn to focus on the long-term but don’t think it’s an option. Because investors’ median holding period for shares is now about 10 months, executives feel pressure to maximize short-term returns. Many worry that if they don’t meet the numbers, they will be replaced by someone who will. The job of a manager is thus reduced to sourcing, assembling, and shipping the numbers that deliver short-term gains”

Re-evaluating differently

While we value innovation alongside non-innovation in the same way the demands for returns on investment place unfair demands on internal innovation projects. Investing in the future is so much harder and while there is this lack of confidence in new innovation, alongside this lack of external pressure for different judgements, we are looked into that diminishing short-term viewpoint dominating our boardrooms.

Hopefully if this present bull market does end, innovation, the sources for new growth, alongside greater mergers and acquisitions (M&A) suddenly gets its ‘growing’ voice back in the boardrooms. Suddenly corporate behaviour moves from financial prudence and cash becomes released for accelerating real expansion.

We have lacked the right type of investment in the future

I just wonder if those at the top really understand that it is not just cash that will ‘create’ innovation when they require it, when they have  that sudden need to chase for real growth if the stock markets turn mean? This acceleration comes from driving new innovation. If they have not been sustaining investments in their resources; their assets and their people and we know these have been far more diluted through this pursuit of lean management, dispersing most of the gains with the cash piles achieved, then the company is in real trouble.

They might soon realize that real innovation and the skills needed has been running on ’empty’ or just the past fumes of low-octane incremental fuel, with little sustaining power, apart from this propping up the short-term. This sudden realization might create a sheer sense of scrabbling. A scrabble just to regain those forgotten skills and bring real lasting health back into our companies where people are valued again for what they can bring.

It would be nice to see a pursuit of growth back on the agenda, through pushing all the buttons needed surrounding innovation, and to see top management really earning their place, unearthing future opportunities for real growth, something shareholders will be increasingly looking to see.

Risk Opportunity

Risk and opportunity are the ‘yin and yang’ for innovation and when you are looking to really grow to give really valuable shareholder return then top management is going to have to re-learn much.

“Recognizing the power of ‘yin and yang for innovation’ can give you the order of things and how and why they relate to each other. Complementary and conflicting opposites do contribute to a greater innovation understanding but they do need consistent attention to manage”

It is critically important to have this ‘flow and balance’ and allow it to constantly evolve. Lets get back to investments that are about the future and that needs a healthier appetite for innovation investments.

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4 thoughts on “Is all investment about the future?

  1. Hi Paul,

    I’ve been hearing this line about stock buybacks a lot and I don’t buy it. Companies in the US do stock buybacks because of the tax advantages over dividends. They have been doing more stock buybacks lately because they are sitting on a mountain of cash. R&D isn’t falling, it’s growing (except for basic research, which is a problem, but its mostly about public sector politics not private sector investment).

    Here’s an article showing that R&D growth is outpacing GDP growth in the US: http://news.sciencemag.org/funding/2014/01/business-gains-drive-higher-rd-spending-u.s.

    And here’s the World Bank Data: http://data.worldbank.org/indicator/GB.XPD.RSDV.GD.ZS

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    • Hi Greg, Thanks for the reply. You are partly right. I think organizations are struggling for real growth, they are leaner than for a long time, have not invested in assets as intensively as the past and sit on a lot of cash. As interest is low to non-existent where do you put the money- in buybacks and your stock. It keeps it on a high, it takes out surplus stock, some feel were diluting the share price ‘reasonable’ value. No argument that R&D stays constant or even gone up, depending on industry but it is not really the environment ‘chasing for growth’, it is one where companies feel are still too uncertain, a little volatile and risky. Yet risk goes hand in hand with innovation and growing markets, getting into new sectors but the safe to do action is to distribute that spare cash back into buying your stock. It raises the question on how do you judge innovation, and the type of approach you make towards it.

      If the bull market does finally run out of steam, stocks will be driven by more than cash alone, they will be driven by company prospects and that comes from making the right investments, in innovating what you have and what you see as risks worth taking to keep attracting investment. M&A’s will come back, as all the cash can help in this area but the premium of return from many of these M & A’s has been questionable.

      Each way there is a need for greater, bolder innovation. Most are ticking over waiting for the ‘fundamentals’ to change and put your spare cash in where you feel it is the safest, back in your hands and not in the banks. Things will change. As for the tax advantage then this becomes a political one to handle equally.

      We need greater growth worldwide, more jobs that are above minimum conditions, we need different wealth generating concepts. Buybacks give shorter-term gain at present and certainly valuable addition to managements own share holding. We become more short-term in these actions and that has a finite time before it needs changing to get all aspects of the economy firing, not just selected parts.

      It is interesting that the majority of the buybacks have been related to two industry sectors- pharmaceuticals were they need to hind behind there lack of pipeline and technology related with Apple, Cisco, Intel, Microsft all pushing prices up with substantial buybacks as the cash is piling in. Maybe this distorts or is enhancing, and the real dynamics of technology might be less appealing and other options might come back into fashion, again it can create a distorted economy.

      Buybacks are made for many reasons but they are not the friend of investment in assets or people that can build ‘greater’ innovation and thats the point.

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  2. To be honest, I think this is a case of affirming the consequent. The behavior you speak of is a perfectly good explanation for buybacks, but so are other things.

    The case of Apple is extreme, but instructive. Apple is throwing off roughly $50 billion in cash, more than it could ever invest in research (and that’s after it increased its famously stingy research budget). It has to do something with the money and dividends are very inefficient tax-wise. So they do buybacks.

    That’s not a function of the bull market, it is an efficient allocation of capital. (Apple’s PE is significantly lower than than the S&P, so any acquisitions would be more expensive than investing in its own stock). So, that’s something you like to see.

    Now, where does that money go? It goes back to investors who can spend it (which would create jobs) or invest it elsewhere. For the most part, they seem to be investing it, which is why the market for startup investments is so frothy.

    So I think there’s always a problem when you try to extrapolate a micro-phenomenon (like buybacks) to a macro trend. The purpose of a business is not to innovate or to create jobs, but as Peter Drucker put it, to create a customer.

    It would be difficult to argue that there aren’t enough new products or even product categories, so It’s hard to see how, with R&D at the corporate level healthy (although not at the public level), why managers should hold on to capital when there is likely a better use for it.

    That’s not to say that there aren’t problems. There’s a lot of evidence that technology, as well as policy, is contributing to income inequality, which is one reason consumer spending isn’t reviving as fast as it should, but that’s another story…

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  3. I would like to take Apple out of this, we could get into tax lost in other countries where the revenue was earned but loop holes allowed for ‘efficient’ tax management for Apple. No I don’t want to go there. While Apple customers are prepared to pay the price and they ‘enjoy’ the margin- fine. It has been distorting technology stocks for some time, hence why others have been forced to buyback to run in the pack. Not sure, you would know better.

    Does buybacks then “create a customer” as you are suggesting? I don’t think so.

    Distributing back to shareholders I don’t disagree with. All I am arguing here is that financial management is dominating to the detriment of innovation, investment in renewing assets and constantly pushing down on existing resources to make them ‘sweat’ even more.

    Is it generating long term wealth or pampering even more to the short-term craving?

    We continue to face volatile, economic cycles that are making many companies fiscally conservative. Are CEO’s or their CFO’s pursuing opportunities as much as they should? It is a combined position of their ability to capture growth, as well as show their financial strength and it is this balance that goes more out of kilter. We are in this cycle of cash accumulation as risk fundamentals are seen as not healthy for the better pursuit of going for growth or approving more innovation projects as these lack the same security of ROI.

    I just would like a more bullish attitude towards growth not propping up what you have through consistent buybacks.

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