Melting capex

Melting capex

24 Dec 2015

This seems to be a time in which people have a touching faith in the idea that progress can be achieved through international negotiations. Certainly, the mutual back-slapping following the Conference Of Parties (COP21) in Paris implied that a new era of cooperation has arrived.

COP21 had 25,000 official delegates and an estimated further 25,000 fellow travellers (doubtless all busily offsetting their air miles). The direct aim of this conference was to agree to a temperature target for the earth in the year 2100. With nearly 200 nations represented, it is understandable that everyone was pleased and relieved that everyone agreed that something had probably been achieved.

The obvious problem is that in 85 years (2100) almost none of the 50,000 attendees will be alive. COP21 is a group-hug endorsement of the contemporary notion that everything that is hard to face now can be flipped into the future.

The tendency to defer tough decisions is arguably human nature (though there must be some humans out there somewhere who prefer to face up to difficulties – where are they?) Certainly, putting off the evil hour has dominated central bank policy for nearly ten years to the point that markets were effectively begging Janet Yellen  to pull the trigger on the first rate rise of what might turn into the new current cycle.

Avoiding short-term unpleasantness has resulted in a massive build-up in off-balance sheet liabilities for future UK taxpayers through an expensive policy known as PFI. It has allowed students to be obliged to fund their own education on penal terms, using teaser rates to distract attention from the financial burden that will dog them in years ahead. The probable widespread default that will hit the Student Loans Company will be underwritten by all taxpayers in the future.

While much political capital is made out of trying to deny benefits to immigrants, nobody seems inclined to address the monumental unfunded liability that arises from the need to pay pensions to and healthcare costs for our dramatically aging population. We’re probably going to need a large number of working age, tax paying immigrants to help us out at some point.

The inevitable car crash that will hit property prices from the combination of downsizing oldies and impoverished super-taxed young adults is not only unaddressed but is worsened by a populist rallying cry to build, build, build. The last time this happened was just ten years ago and it wiped out a generation of family-owned building companies and pushed several larger businesses close to destruction.  

While COP21 was trundling on in Paris, Vienna hosted the 168th meeting of OPEC. OPEC was faced with an oil price that has fallen by 75% from its peak. But it turned out that not even OPEC could bring itself to act in its own longer term interest. The producers could agree nothing and the price of oil now implies that, with Iran being allowed back into international trade, they are going to pump and ship the black stuff like there’s no tomorrow (which may well be the case according to the delegates at COP21).

It is as if the world is being run by a committee of those flightless birds known by the common name of ostrich.

There is a financial point to my rant.

One of the most important decisions that the board of a large company has to take concerns capital expenditure (aka “capex”). Capital expenditure is a long term investment. Unfortunately, long term investment is not in keeping with the spirit of our times. It is like the quote attributed to Martina Navratilova about ham and eggs: the chicken is involved, the pig is committed. Everyone wants to be involved in decisions, but no one wants to commit.

I have analysed the capital expenditure plans of 80 of the FTSE 100 (excluding the banks and other service companies that are largely labour-intensive). I calculate that aggregate capex fell by 8% in 2015. I found 41 companies that have already indicated capex plans for 2016 and this indicates a further 8% decline.

I should mention that there are many international mining and resource companies included in the FTSE 100 and these cuts are certainly not a direct comment on the UK economy. Having said that, many FTSE 250 companies are suppliers to these multi-nationals and this reduced investment will be widely felt.

When businesses are uncertain about whether to invest they will, if they are sensible, prioritise cash preservation. If they are run by idiots they will spend this money on share buybacks. It is harsh to call managers who claim to be acting in their shareholders’ best interests “idiots” but I can’t think of another word. (Rolls Royce announced, when its shares were over £10 in mid-2014, that it would buy back 5% of itself. It suspended this programme when a new CEO arrived and its shares were well below £8. They are now below £6 and the company is, of course, reducing capex significantly).

Capital expenditure collapsed in 2009 and 2010 when the world was very alarmed by the fallout from the banking crisis. We will never know if this new capex freeze was a good idea (it might have delayed a recovery that is at best sluggish five years later) but it was certainly a big boost to free cash flow in 2010 and 2011 and as a result many companies, despite little or no revenue growth, began to look very cheap.  

So, a plan for 2016 is to look for companies that have surprisingly strong cash flow. Their outlook may be uncertain but it might mean that they are being run responsibly and it might mean that some big dividend yielders will be able to maintain their pay-outs. 

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