Wealth Management & Financial Planning

Wealth Management & Financial Planning

Examining the Performance of Stocks Based on How They Use Their Cash

Benjamin Franklin once said, “Many people die at twenty-five and aren’t buried until they are seventy-five.” His point was that most of our good thinking and learning ends very early in life. We then simply apply what we believe to be true without question the extreme majority of the time. This appears very accurate in the financial world where we witness families believing old rules or principles that are long outdated. This week one of my own beliefs was challenged and worthy of sharing.

When a business has excess cash at the end of the year they can choose to do several things with those dollars. They can send shareholders a dividend, buy back outstanding shares of stock, or reinvest in their business, which is often referred to as “cap-ex” or capital expenditures.

On the company balance sheet is a list of assets they own. Each year, depreciation is taken against the value of the assets. Our hope is that a company is adding more assets than the amount they are depreciating! That means the CEO and the board of directors think the company is worth investing in and is ostensibly growing. We like cap-ex spending and the economy likes cap-ex spending!

This year the companies investing in capital expenditures have actually underperformed companies paying dividends or buying back stock. According to data from S&P Dow Jones, the 20 companies spending the most on cap-ex in the first quarter grew 0.5% versus the broad index being up 1.4% at the time. Our firm’s allocation team is less focused on results of a short-term market variance, viewing it more as “noise” as my engineering friends would say.

The challenge is this is apparently no short-term trend. According to Bank of America, since 1986, companies with the highest capex-to-sales ratios have underperformed the S&P 500 by more than 2 percentage points on average each calendar year. Color me shocked and surprised!

The data would suggest that you clearly want to invest in companies that believe in themselves and yet not expect to collect the bounty until later. Stepping back from the evidence it does make some sense.  Investors feel comfortable investing where companies have free cash flow. The more cap-ex spending, there will be less free cash flow. Still the 2% per year for the last 32 years is shocking.

When you build a portfolio, many look toward companies that are both value and growth oriented. Just as you diversify among stocks and bonds, international and domestic, large cap and small cap, you should also think growth or value. Growth stocks tend to appear to have very little earnings today based on what investors feel the future company will look like. They are willing to pay more for the future. Value investors tend to find companies where the current stock price is comparable to the current business value. Both methods have purpose and should be examined closely.

 

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see our Disclosure page for the full disclaimer.

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