There is a growing sense that corporations are no longer contributing much to the economy, either for short-term recovery or long-term renewal. What or who is to blame? Ben Hunt investigates.
A great proportion of world economic activity is organised through giant global corporations. How managers govern them, and allocate resources, should at least in theory be of interest. For investors, ‘corporate governance’ – although not the most exciting of terms – is of central importance for enjoying a return on investment.
A growing observation, however, is that many corporations are no longer ‘run for growth’.
At stake is not just recovery from today’s crisis, and the various problems that revolve around ‘cash-hoards’ and failure to invest. A growing discussion is that a failure to invest is a structural feature of a new ‘corporate model’ that has evolved especially in the US and UK over the last two to three decades.
Such a structural change is seen as a further problem because, as firmsexcessively save and run ‘structural surpluses’, states have to run ‘deficits’ – borrowing and spending beyond tax revenues – to prevent economies from sinking into depression. Yet states are more up against borrowing limits.
Excessive savings with nowhere to go can also be a destabilising influence in terms of financial markets and the economy. According to Michael Howell, founder of the hedge fund CrossBorderCapital, “one reason for the financial crisis in the first place was that money markets were flooded with surplus cash that corporations were keeping on deposit. This became a source of cheap funding for banks, who generally like to lend it out. And they lent it out a lot, but in unproductive areas.”
Corporations are currently under the spotlight because of their unwillingness to invest and kick-start a recovery. The cash-hoards (currently about $2tn in the US alone) have become a favourite discussion point. Investors have looked for new signs of life when it comes to an upturn in investment, but with the global economic outlook deteriorating of late, plus the fiscal cliff problem rearing its ugly head, they will probably remain disappointed.
In the background is the unusual path that business investment has taken during the recession and recovery.
In the US, it was cut back much more as a proportion of GDP compared with previous recessions. Likewise, in the recovery period, firms were slower to turn the taps back on compared with previous recoveries.
The response was initially viewed as a rational one in light of the burst credit bubble and banking crisis. Firms were responding to poor credit availability, poor consumer demand, and the political uncertainty over the eurozone.
According to Charles Cara, head of quantitative strategy at Absolute Strategy Research, back in 2008/09 “companies were put under pressure not to draw down agreed lines of credit. If you cannot rely on raising capital quickly in a crisis, corporates have to self-insure and to build up their buffers of cash. This is shown by the cash-to-short term debt ratio rising from 1.2 times before the crisis to 2.0 times now.”
With the fact that companies are currently issuing long-term debt and putting it on deposit as cash, “there is a negative carry or a cost of doing this, but companies think it is worth it, as they can no longer rely on banks for credit in a crisis,” he adds.
This year in particular, however, a new perception is that the behaviour is increasingly irrational.
Some make the point that even a 1 per cent return on new investment would instantly translate into billions of new profits, given the negative returns on cash.
For others the trend is now damaging long-term productivity and competitiveness. The Swiss bank UBS pointed out in the summer that the US capital stock, defined as American companies’ investment in new equipment and software, less the depreciation of existing equipment, is showing a decline for the first time in the post-war period. Economic growth and returns on assets are likely to slow going forward.
Similarly US bank Goldman Sachs also pointed out that the average age of assets – defined as property, plant and equipment – has hit record highs across the west, especially in Europe.
For investors, a rising concern is the durability of the model for generating profits going forward. Many are wondering whether the top of a longer-term profits cycle has been reached, especially with the new global economic slowdown entering the mix.
According to Peter Hensman, global strategist at Newton Asset Management, “given the high level of profit margins, the scope to achieve further increases via further cost cutting appears limited”.
For Alec Letchfield, chief investment officer, wealth, HSBC Global Asset Management, a possible scenario of profits falling, GDP falling and growth being affected going forward is a big concern.
“Corporations built resilience in a difficult period and that was probably the right thing to do,” he says.
“But now we need investment. There is a danger of companies eating into their fabric and infrastructure which will affect long-term competiveness.”
Hensman says that, with this changing environment, “we expect equity returns to remain lower and more volatile as growth prospects remain challenged and policy focussed on boosting asset prices undermines expected returns.”
However, he adds that “low growth rates in themselves need not imply lower equity returns.” The problem is “higher starting valuations”.
On the positive side, “innovative companies that are able to tap new markets, or gain share from competitors and those able to demonstrate stable returns should deliver reasonable equity returns, even against a challenging overall backdrop.”
As suggested above, however, a new line of enquiry is whether corporations will invest given a secular decline in investment. There is now more questioning of the entire model of governance.
Here, the issue with governance is not necessarily an operational one. For instance, global corporations in general are probably more professionally and efficiently run compared with say 30 years ago. Huge thinking has gone into management structures and organisational processes.
One might also say that there is an impressive range of next-generation products in everything from nuclear reactors, airplanes, machines, to robotics and consumer gadgets. Many Anglo-Saxon companies for their part are world-leaders in their industry.
What does appear to be far less positive is the overall financial governance of corporations from a resource allocation perspective, and the implications for overall economic renewal of national economies going forward.
The ‘corporate model’ especially in Anglo-Saxon parts of the world is based far more around short-term profits and cash hoarding, redistribution of profits to shareholders rather than investment in new productive assets, M&A over organic growth, and constant cost-cutting.
This behaviour seems to have become a generalised strategy, independent of the business cycle. It was first in the mid-1990s for example that corporations began to heavily ‘downsize’ in an economic upswing period, surprising many.
Another part of the model is that, when investment does take place, it is increasingly outside of the West. For a while now, large corporations have tended to shrink employment at home and expand abroad, understandably given that revenues and profits are much higher in the latter.
Many corporations have reported that sales to developing markets now make up perhaps two-thirds or three-quarters of the total, up from perhaps a quarter a decade ago, and they expect this to continue.
One caveat is that there may be an element of change here. Talk of ‘onshoring’ is on the up, especially around the new US energy boom. Producing in China, says Letchfield, is not the “slam-dunk” it used to be. “Wages in China have been rising. Companies may be more discerning in moving production there.”
A further feature of the corporate model, much commented on of late, is that over time wages for employees have typically been held down, but salaries and bonuses at the top have risen much faster.
These trends are easy to see in the data. In the US, business investment as a percentage of GDP declined from 13 per cent in the late 1990s to about 10.5 per cent today.
Cash hoarding in the US, as many have noted, began an upward curve since the early 1990s. Hoards were already at high levels by the mid-noughties, noted by many as a strange development given the period of economic upturn in which they were increasing.
Share repurchases increased markedly in the last decade. According to William Lazonick, a professor in the department of regional economic and social development at the University of Massachusetts Lowell, the 459 companies that were in the S&P 500 index from 2001-2010, almost all of which are US-based, returned a huge $2.7tn to shareholders over the period – about half of all net income.
In terms of hiring practices, the US Bureau of Economic Analysis says that between 1999 and 2009, the US parents of multinational companies cut a total of 864,000 jobs. Foreign affiliates in the meantime added 2.9m jobs.
UK data reveals a similar picture – although arguably the trend has gone further. Business investment as a share of GDP has dropped to its lowest level on record, to about 7.5 per cent of GDP, on a path of decline from the late 1990s, where it was about 13 per cent.
Share repurchases rose to record levels. According to William Lazonick ,for the period 2001-2010, 86 of the UK’s largest companies included in the S&P Europe 350 Index returned about €230bn to shareholders.
On another measure, according to Cara, “we have seen a structural decline in capex levels in the developed world over the past 20 years. One measure of this decline is the capex-to-depreciation ratio – effectively a measure of whether assets are being replenished by new investment. They have fallen in Europe from 1.8 times at the end of the 1990s to 1.2 times today (see graph).
Another measure is that capex was around 8 per cent of sales in the 1990s for Europe. Today, that has fallen to 6.5 per cent for the UK and 5.5 per cent for the eurozone.
It is not difficult to see the problem of this model for broad-based, long-term prosperity. A major paradox is that, just at a time when the developed world is coming under greater global competition, with the loss of manufacturing jobs and ‘hollowing out’ of the middle or working class, its resource allocation has been skewed away from the creation of higher-value jobs and economic renewal. The West is finding it hard moving onto a higher plane of economic development in general.
Another contradiction is that the West wants to apparently raise living standards but does not want to create new wealth with resources. It is perhaps that conflict that has led it down the road of borrowing others’ wealth – and creating new ‘wealth’ from thin air – credit – instead of generating real competitive edges through, say, innovation.
“If you do not get organic growth by corporations, you have to manufacture growth via credit”, says Howell of CrossBorderCapital.
“The problem there is that you are borrowing from the future, in terms of future growth. So the last decade, we saw a bout of growth with credit, the cost of which is slower growth later, which we see now.”
A natural development is a search for explanations – but it remains a complex and undeveloped field of study.The UK economist Andrew Smithers, Chairman, Smithers & Co, has been focussing on this problem in the last few years.
The problem is limited to quoted companies on the whole, he believes, although there are exceptions.
“The majority of UK and US quoted companies are run like limited-life oil wells, with management seeking to extract the maximum of short-term cash,” he says.
“This depresses growth, accentuates income inequality and causes large fiscal deficits to be necessary.”
Low growth rates in themselves need not imply lower equity returns
Smithers does, like many, believe that the German ‘Mittelstand’ group of unquoted private companies, many of which are world-leaders in niche manufacturing and industrial areas, does provide an example of alternative success.
Smithers has explored a range of possible reasons for lower investment. These include falling returns, lower trend growth in the economy, a change in the industrial structure away from capital intensive industries, overcapacity, and a greater tendency to do share buy-backs.
He argues in a recent report that it is really this last one – share buy-backs – that explains a slowdown, closely linked to ‘perverse incentive’ structures.
According to him, there has been “a dramatic change in the way in which corporate management is remunerated. Over the last two decades there has been a large rise in the proportion of senior management’s total pay which comes from bonuses. These bonuses are almost always linked to one of three metrics – earnings per share, return on corporate equity or the return to shareholders”.
In this thinking, it has been easier to achieve bonuses with share buy-backs and lower investment.
However, falling profit margins, in the UK since the late 1990s, may also play a role, although not so much in the US.
Cara says that managing for shareholder value may be playing a role in depressing investment.
“We currently see that companies which have cut investment are rewarded by the market, and have seen their PE ratings rise. Those with high capex have been de-rated. The stockmarket is currently rewarding high cash balances, stable margins, debt reduction, not capex,” he says.
In particular, measures such as return on assets (ROA) and return on equity (ROE) have driven share performance. Over the last five years, stocks with higher ROA outperform by 45 per cent, while those with higher ROE outperform by 40 per cent, he adds.
“If you are managing a company for shareholder value, then you are incentivised by these kinds of reward and one way of increasing ROA is by keeping down capex. If you invest in say a new factory, then the costs are capitalised which reduces return on assets. Similarly, if you reduce shareholder equity with share buy-backs and dividends, this boosts ROE, all other things being equal.”
However, he adds that the stockmarket is not against economic growth. The problem here could be characterised as ‘fallacy of composition’.
“The stockmarket is not making unreasonable demands, and it is not against the economic growth. But while for individual companies it makes sense to maximize profits, it is counter-productive for the whole economy if every company seeks to do so. “
Executives themselves acknowledge the problem. Surveys of CFOs find that they would happily defer long-term investments if they thought they would achieve short-term goals.
According to Ismail Erturk, a former banker and now lecturer at Manchester Business School, “with declining investment, there is a structural issue, not just cyclical. The big trend is the financialisation of firms,” he says.
Corporations can have unrealistic expectations with regards to returns and a performance that shareholders want. It then becomes quicker and easier to do acquisitions for example rather than long-term investment.
“A number of things have come together to create a corporate culture where investments for the long-term are discouraged. Financialisation has encouraged a rise of ‘story-telling’ where targets are set, executives have to manage the story and the share price, deal with equity analysts, and so on.”
Executives themselves increasingly have more of a financial background, rather than a background in the product.
“Corporations become more financially-driven rather than operationally-driven. In pharmaceuticals, that might mean that people with a science or product background have lesser say in where the company is going versus those with a financial background.”
An open question is the extent to which investors have contributed to this much-discussed ‘short-termism’.
According to Hensman of Newton, “investor demands have undoubtedly contributed to short-termism amongst corporations, as willingness to see companies miss forecast earnings has declined.”
Yet, this in turn is, in part, a “consequence of often regulatory and accounting requirements placed on investment managers to produce ‘index-like’ performance and the expectation that they are able to manage quarterly returns in line with performance benchmarks.”
Greater acceptance that investment returns might diverge from those of the market “would allow investment managers more scope to support corporate decisions that had longer-term paybacks,” he adds.
One irony, pointed out by many, is that investors overall might not have benefited from a change in the corporate model. For example, there is strong awareness that mergers & acquisitions often destroy value, and some studies suggest the same for share buy-backs.
The problem could be charact-erised as fallacy of composition
Yet overall, the focus on finance, or governance, may not tell the full story, as many probably suspect.
For example, there is also an industrial structure problem, connected to a cost structure problem. Some of the key service industries that have replaced older industrial ones have typically brought more costs than benefits. Health would be an example in the US, widely acknowledged. Finance always has the potential to add value by socialising capital for new ventures that otherwise would be held under people’s beds, but with the rise of debt, and the costs imposed by the crisis, it is difficult to see whether it is a valuable ‘service’ or a burden. Many within finance itself would probably not disagree.
Governments in modern economies set the legal and economic framework for how the private sector holds obligations to national economic development. Rather than think deeply about broad-based prosperity, however, governments have tended to be opportunistic and also ‘relativist’ when it comes to their approach to the private sector and economic development.
In a bid to raise living standards over the short-term, any ‘growth’ has been seen as good, and debt, consumption and speculation have been equated with more productive activities. Faulty economic thinking has tended to view deindustrialisation as something not to worry about – the market would allocate resources to new innovations and higher value jobs on a sufficient scale, it was thought. Government deregulation of finance created huge short-term profit opportunities versus industry, and capital flooded there. Share buy backs were deregulated further, yet in many countries, they are banned as a form of ‘market manipulation’.
The state told the private sector it would not interfere, but firms were effectively told they did not have obligations anymore to national economies. Overall there seems to have been a lack of leadership issue on the part of government. The resorting to narrower financial targets overall, a fairly new trend, is perhaps partly a product of an absence of proper economic targets.
The business culture of greater self-interest and short-termism perhaps has a lot to do with government action and inaction. Yet on the plus side there are many policy options to create a better economic development model.