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The capital conundrum

Everybody knows company bosses will be hacking back costs with grim determination in the coming months. The process has started even if the effects aren’t much in evidence in the batch of results being released at this time of year. So, for example, farming supplies producer and engineer Carr’s Group (CARR), whose shares are in the Bearbull Income Fund, showed a 2 per cent drop in revenue for 2019-20, but, because costs adjust slower than sales, a 20 per cent drop in operating profit.

In the coming 12 months the process will go into reverse. Costs will slide more than revenue as so-called discretionary items are wiped from company budgets; labelled ‘discretionary’ because their absence brings immediate benefit to profits and cash flow while the detrimental effects are both remote and fuzzy.

Marketing is the archetypal discretionary item. The marketing team is always first out of the door when the going gets tough since marketing’s benefits are hard to quantify even at the best of times. In addition, mainstream costs, such as capital expenditure and research and development (R&D), also come under the cosh, especially for projects still far from being in commission.

Yet economists, academics and management consultants line up to say that, actually, these items are anything but discretionary since short-term gain will lead to longer-term pain. Earlier this month, management consultant McKinsey & Co was reminding clients that “now is not the time to slow down”; to apply the brakes on growth, even during lean periods, is usually a bad move.

On the logic that pursuing growth against a depressed backdrop is especially demanding, McKinsey served up eight guide lines that might help bosses. Most are common sense. Some are counter-intuitive, such as the notion that sometimes companies should aim to raise profit margins during a push for new sales; this counters the natural inclination to trade margins for new customers.

McKinsey’s suggestions are available via its web site. As investors, we may be less interested in how companies should secure profitable growth than examining the notion that spending on discretionary items, such as those mentioned, feeds through to superior investment returns. Hence the table, which shows data for two pairs of roughly comparable companies – Vesuvius (VSVS) and Morgan Advanced Materials (MGAM), which supply components and consumables to manufacturing industry, and instruments makers Renishaw (RSW) and Spectris (SXS).

Capital spending and share price returns
  Excess cap-ex (inc R&D as cap-ex)/Rev (%)Share price
CompanyCodeYr 0Yr -1Yr -2Yr -3Yr -4Latest (p)Change on 4 yrs (%)
Morgan Adv'd MaterialsMGAM3.
Source: FactSet        

First, we should ask: if spending on fixed assets (both tangible and intangible), on R&D and on marketing brings long-term rewards, then how should we quantify that? In practical terms, we can forget marketing spending. It is rarely identified separately in company accounts and only occasionally lumped into ‘sales and marketing expenditure’.

As for capital spending, not all is equal. There is the cap-ex that simply replaces what’s already there but wearing out. Then there is the spending specifically aimed at growth, which should add to a company’s value. Some companies are helpful enough to split their cap-ex into ‘maintenance’ and ‘growth’ categories. For the majority that don’t, the quick-and-easy way to estimate growth-led spending is to subtract the charge for depreciation and amortisation from capital spending while remembering to include the amount spent purchasing intangible assets as cap-ex. For simplicity’s sake, we can apply the same logic to R&D, labelling that a form of capital spending, which, in a sense, it is.

Take Renishaw, which – as the table shows – has been the one that commits the most to growth. Its latest accounts show £59m spent on cap-ex and £82m on R&D. From that, deduct a £49m charge for depreciation and amortisation, leaving £92m net, the amount the group devoted to growth. To put that into some context, that was 18.1 per cent of the group’s £509m revenue in 2019-20, though the amount could plausibly be compared with gross profit or even operating profit.

The important question is whether there is a link between the proportion of group resources devoted to stimulating growth and share-price returns. Given Renishaw’s share-price performance compared with the others in the table, it is tempting to think so. Yet we are not necessarily comparing like with like. For instance, historically, Renishaw has generated most of its growth internally. Meanwhile, Spectris has relied more on acquisitions; in the past nine years it has spent over £900m on them compared with £430m on conventional capital spending. In which case, the superiority of Renishaw’s share-price performance may be a reminder that internally-generated growth is often better quality than that sourced from risky acquisitions.

Similarly, we may wonder why Vesuvius and Morgan seem to devote such limited resources to capital spending and whether that is linked to their comparatively poor share-price returns. Of course, there is no simple answer and, as much as anything, the point of churning data in ways such as this is to get the thought processes moving. As capital spending comes under pressure in the coming months, it will help to gain insights into which spending is fruitful and which is a waste of money.