Over the last five years, as the U.S. economy has proven its resilient nature and climbed gradually out of recession, one thing has been particularly puzzling. Even as profitability has returned, firms in general have been reluctant to invest in their future. Relative to cash flow and profits, growth in capital expenditure (capex) has been weak.
We have all heard stories of corporations sitting on huge piles of cash, and the politicized reasons given for that. Depending on your bias of choice it is either the uncertain environment created by Obama, or that created by the Republican Congress, or it is because corporations are greedy, or scared of Obamacare, or because taxes are too high or because they are too low... you get the picture.
Whatever the reason, the last earnings season gave a suggestion that things were beginning to change. After bumping along at 1-1.5 percent growth, overall capex grew 6 percent in the first quarter of this year. Some see this as a coincidence and a statistical blip, but a good case can be made that conditions and sentiment have actually changed, and a sustained increase in business spending will drive another surge in the economy over the next couple of years.
Part of the problem has been that, for many companies, capital investment has simply not looked like the best use for the money they have accumulated. Ultimately, companies invest in their future when they see growing demand for their products or services, but consumers around the world continue to de-leverage and demand in general has remained weak. Little wonder then that boards have been seeking another use for all of that cash.
Share buy-backs have been popular, but as valuations have increased, so the potential return to existing shareholders of buying one’s own stock has diminished. For example, when Microsoft (MSFT) initiated a $40 billion share buy back in September of last year, their stock was at around $31. Now, with MSFT over 30% higher, buying their own stock looks significantly less attractive. From a shareholder’s perspective the results have been great, but most would rather see investment in long term growth from here.
Instead of ever more expensive stock buy backs then, over the last few months, attention has shifted to acquisitions in search of that growth. Several high profile deals and lots of smaller ones have grabbed the headlines. Once again though, valuations have, as is the way of the market, caught up with the trend. Buying out others is not as cheap as it used to be.
Almost by default, then, there is likely to be a surge in capital spending by U.S., and probably global, businesses over the next couple of years. Worries about slowing Chinese growth are receding following a couple of decent economic reports and consumers around the world seem to be gaining confidence and loosening the purse strings, according to a Nielsen report. Nobody wants to be left behind as growth accelerates.
For investors, as always, the next question is “how do I trade that belief?” In broad terms, technology, materials and industrials are the logical places to be. More specifically it seems logical that in a tech driven world technology will be the biggest beneficiary. Business to business tech will be the big winner and there are plenty of opportunities in a sector that has underperformed over the last year.
IBM (IBM), in particular, could be a huge beneficiary. Their global presence makes them somewhat inefficient when others are being nimble and jumping from one trend to the next, but if there is a basic, global increase in spending on technology and infrastructure by businesses, few are better placed to take advantage.
Moreover, in a world where value is increasingly hard to find, venerable old IBM actually looks cheap. Old tech names such as Intel (INTC) and Hewlett Packard (HPQ) have done well recently, but the giant of old tech has been left behind until a few weeks ago.
Despite that recent rally the stock is actually slightly down on a 1 year basis. That, combined with a forward P/E below 10, suggests that there is significant upside to IBM in a world where capital expenditure becomes sexy again.
I believe that world is imminent. Regardless of your politics, if you have ever run a business, you know that capital expenditure is always a response to growing demand, whether current or anticipated. If the Nielsen survey linked to above is to be believed, then that time is upon us and with other options for the use of cash looking less attractive by the day, growth in capex is coming and coming fast. Investors would be wise to position themselves for it.