One of the strongest symptoms of secularstagnation - the slowdown in longer-term western economic growth that has caused real interest rates to fall - has been companies’ reluctance to invest. In the US and UK, the share of business investment in GDP is lower now than it was for much of the 1980s and 90s. This poses the question: why aren’t firms investing?
In a new paper, Rene Stulz of Ohio State University points out an oddity here - that it is firms with the highest stock market valuations that are most loath to invest. He shows that firms with the highest Tobin’s q (the ratio of share prices to the replacement cost of capital) tend to buy back shares rather than invest.
This is a relatively new phenomenon: in the 70s and 80s, the more highly valued firms did indeed invest more than cheaper ones.
It also seems puzzling. Many people regard high equity valuations as a sign that a company has good growth options. To exercise those options the company should invest, so highly-valued firms should invest more than others.
Thomas Philippon and German Gutierrez at New York University have studied this puzzle. They show that the highly-valued firms that don’t invest tend to be those operating in less competitive conditions and whose shares tend to be heavily owned by passive investors.
This might be evidence of short-termism; investors demand quick payouts in the form of share buybacks, and value highly the companies that give them this.
But there’s another possibility. Take Coca-Cola. Its price-book ratio is well above the market average. But it would be odd to say that Coca-Cola has great growth prospects: unless we discover extraterrestrial life it cannot expand much.
The tech crash taught them that growth options are in part illusory and that investment in pursuit of such options often fails
What the company does offer, though, is the prospect of steady profits thanks to its near-monopoly position - profits which it returns to investors through share buybacks and dividends. Because investors are happy at this prospect, the company is highly rated.
What investors value, then, is not so much growth options as what Warren Buffett called economic moats – a source of monopoly power that will generate future profits: it’s no accident that Mr Buffett is a big investor in Coca-Cola. But a moat is not a growth option. There’s therefore no reason for Coca-Cola to invest heavily.
My story here, though, is not confined to Coca-Cola. Consider two big facts. One is that defensive stocks have done very well in recent years, with the result that firms such as BAT, Unilever and Reckitt Benckiser are now all on below-average dividend yields. The other is that the conjunction of high valuations and low investment is something we’ve seen since the tech crash: before then, it was indeed highly valued firms that invested a lot.
These two facts are consistent with the possibility that investors have wised up. The tech crash taught them that growth options are in part illusory and that investment in pursuit of such options often fails: as Salman Arif and Charles Lee have shown, high capital spending more often leads to earnings disappointments than to good growth. Instead, the more reliable source of future profits are moats: monopoly power. Stock market valuations now reflect this - or at least do so more now than they did in the 80s and 90s. So we have companies that are highly valued but which don’t invest. What looks like short-termism might instead be a realisation that uncertainty is huge.
This theory has a curious implication. It suggests that secular stagnationists might not be right to say that investment opportunities have declined. Maybe instead they’ve been scant for a very long time, but it is only recently that investors and firms have realised this.
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Chris blogs at http://stumblingandmumbling.typepad.com