Watch out for any company whose chief executive has just remarried, and decided it is time to splash out on a huge and expensive new headquarters. It is one of the oldest dicta in investors’ books that companies that embark on showy and obvious over-investment are to be avoided.
This makes great anecdotal sense. Now it appears there is a rigorous quantitative basis for it, too. Without needing to take a trip around the company’s gleaming new facility, investors can spot the stocks that are over-investing shareholders’ capital, and avoid them.
And while this is not surprising, there also appears to be a rigorous basis for avoiding companies that systematically underinvest as well. After years in which executives have been rewarded for disgorging cash to their shareholders, cutting their cost base and increasing margins, this is a disquieting finding for the future of the market as a whole.
This at least is the provisional conclusion of some heavy-duty quantitative analysis by Andrew Lapthorne and his team at Societe Generale. It suggests that neither over- nor underinvestment is punished quickly; but that after a year, over-investing companies are already beginning to underperform (perhaps because overpayment for big acquisitions is swiftly apparent), while the effects of neglect take longer to make themselves felt, and underinvesting companies only begin to underperform after three years.
This trend is most clear cut in Europe, where over three years both under- and over-invested companies perform much the same, and both dramatically underperform the more normally invested companies.
In the US, the punishment of over-invested stocks is clear, but underinvested companies have fared somewhat better, even if they have underperformed the market during the current rally. This is perhaps a symptom of the enduring popularity of companies that pay out big dividends or make share buy-backs.
In Japan, the exception to many rules, Lapthorne admits that the model does not work at all. There is no discernible difference between how stocks behave based on how heavily they are invested.
How does the model work? There is no agreed measure for under- or over-investment. Different investment levels are appropriate for different companies at different times.
Thus it is necessary to take into account a company’s position using different measures, and to rank them using different measures of investment. This shows which companies, relative to peers, invest most or least.
Those in the “tails”, which differ most from the norm, can be called over- and under-investors, and their performance measured.
The mathematics soon grows complex. For level of investment, Lapthorne’s team used five measures: capital expenditure-to-sales; new investment-to-sales; total annual change in property, plant and equipment (scaled by a company’s total assets); annual change in total assets; and annual growth in total employees. Between them, these measures capture what we mean when we talk about over-investment.
As some industrial sectors naturally invest far more than others, the data are then screened for five factors: the ratio of free cash flow to net property, plant and equipment (which gives an idea of how much of its cash a company is investing); the ratio of total debt to total assets; Tobins’ Q — the classic valuation measure that compares a company’s market value to the total replacement value of its assets; the ratio of retained earnings to sales; and a company’s sector.
On this basis, the most over-invested US companies over one year are in consumer services while the most underinvested, over five years, are in oil and gas. In Europe, the greatest over- and under-investors are in telecoms, still roiled by the historic over-investment during the sector’s boom at the end of the 1990s.
None of this means under- and over-investment should become one of the first factors investors should look for. Lapthorne admits it remains far more important to look at whether a share price is cheap, or whether a company has a strong balance sheet.
It is only too easy to imagine that someone will try to launch an exchange traded fund to systematise these ideas into a “smart beta” investment strategy. However, it still has its uses.
If you are nervous that a company you hold seems to have an unnecessarily flashy new headquarters, a check to see whether it shows up on a screen for over-investment could be useful. More usefully still, anyone wildly excited about a stock should run a reality check if it shows up on an over-investment screen.
There are also some intriguing political implications. Policymakers across the world are angry that companies are hoarding cash, and want them to start investing. This research suggests anyone who starts investing again could soon be punished by the market.
— Financial Times
