At the half-way point in the capital expenditure cycle, companies still have a lot of cash to spend on expanding their business, creating investment opportunities across several sectors.
An extended business cycle is under way, with favourable prospects for a range of riskier assets. Company cashflows stand at extraordinarily high levels, with ample cash in hand and low external financing needs. Companies are increasingly putting their high cash balances to work with business expansion in mind. But how can investors best play these themes?
Robust fundamentals have enabled equity markets to navigate successfully through temporary slowdowns or exogenous shocks. This is likely to be further supported by a continued commitment to self-help from the corporate sector as profits growth continues to slow.
One increasingly prominent corporate strategy is to increase capital expenditure to boost sales, and hence earnings. Corporate earnings growth has decelerated in recent years as higher input costs, particularly oil, have acted as a constraint. Sales growth rates have also stagnated as weak underlying inflation, and global competition from China, India and other emerging markets, has constrained corporate pricing power for western companies.
Given the length of the economic expansion in America, how much upside is there in the Capex cycle in that economy? The chart right puts the current American Capex cycle, measured here as non-defence sector capital goods orders, into a long-term historical context. Over the past 50 years, the Capex cycle has typically been seven years in length. Given that the current investment cycle has lasted three years, history suggests America has barely reached the halfway point of the typical cycle.
Data from global manufacturing surveys suggests orders for manufacturing goods are increasing. The biggest beneficiaries of this trend have been Japanese and European companies who are big exporters of capital goods. For example, huge power shortfalls in China, India and other emerging economies mean that the earnings growth outlook for European power suppliers is encouraging. Our portfolios are exposed to this theme through ABB, which, along with Siemens, controls 100% of the market share in high-voltage direct current.
An interesting feature about this surge in export activity is its impact on German banks. Although the large-cap exporters are dominating the headlines, many smaller exporters are joining this trend. In many cases, these companies are heading for the banks to secure capital to meet increased orders. The result is that Commerzbank, IKB, Deutsche Bank, Dresdner Bank and HVB are reporting strong new business lending.
The situation is not quite so straightforward in Britain. Although British companies are enjoying historically high profit levels, the level of domestic capital expenditure has been disappointing (see chart below). Rather than investing, British companies have found other uses for their capital: paying down debt, retiring equity, increasing dividends, putting more cash into their pension funds, and engaging in merger and acquisitions activity.
However, our “Focus on change” philosophy includes the question, “what is changing?”. In recent months, it has become more evident that there is a strong upturn in global activity, including a noticeable improvement in several of Britain’s main trading partners in Europe. Signs that British companies are starting to spend are emerging, with the ratio of capital expenditure to sales rising modestly. In particular, the price of manufactured goods has come down, while the cost for companies of investing in productivity improvements has also fallen. Firms are spending more effectively and more cheaply than previously.
It is possible to play this upturn in domestic and global capital spending on several levels. The first is where companies are investing to make a tangible saving, particularly against a background of higher energy costs. Invensys, a controls and process solutions company, is benefiting from the corporate sector’s efforts to secure efficiency gains.
It is also worth obtaining exposure to companies that are benefiting from expansionary capital expenditure. One example is Enodis, a commercial catering equipment company that supplies most of the fast-food chains. It is benefiting from food retailers’ investment in new kitchen equipment. This trend has been particularly noticeable in America, where food outlets like McDonald’s are expanding.
Finally, the higher levels of business activity, and the subsequent pull this has on raw materials, are benefiting mining companies like Kazakhmys and Xstrata. Both companies are profiting from increased demand for copper, a commodity that is in high demand for plumbing and wiring when business activity picks up.
The business and investment cycles are likely to remain intact. This will result in a number of important drivers for equities over the next few years. One of these developing themes is the capital expenditure cycle, which is still immature but likely to continue to benefit exporters, particularly in Japan, Europe and, to some extent, Britain.