Companies will soon change their strategy and start to invest to grow organically, rather than look towards mergers and acquisitions and buying back shares, a new research report shows.
Over the past five years, most businesses were operating below full capacity and saw little need to invest, Societe Generale’s North American economist Aneta Markowska wrote in the report.
The stock market was relatively cheap over the period, providing companies with an attractive way of distributing cash to shareholders by doing buybacks, which also served to boost earnings per share.
At the same time, mergers and acquisitions were a good way to grow fast as there were opportunities to find undervalued targets.
But this is all about to change.
Capacity utilization is nearing the levels before the crisis, while stock prices now look expensive relative to the replacement costs of corporate assets, Markowska argued.
The two charts above show that both economic and financial considerations support the case for increased investment by companies going forward, she added.
Another good sign for future investment is the fact that small businesses’ intentions to increase their capex are at their highest since 2008.
Obtaining financing for an increase in investment is “a valid concern.” There is a positive financing gap – the difference between capex and corporate cash flow – as cash flow generation flattened out an investment picked up.
“This means that corporate America is now reliant on external financing if it wants to merely maintain the current levels of investment, let alone boost capex further,” Markowska said.
However, “corporate America has both the access and the means to take on more debt,” she added.
Demand for corporate bonds is still very strong as the hunt for yield continues. The Federal Reserve has indicated numerous times that it intends to raise interest rates only very slowly, while the European Central Bank is in full easing mode, which means there will still be a lot of liquidity in the markets.
The majority of banks are easing their lending conditions for loans to companies for the fourth consecutive year, making lending standards look “quite friendly,” Markowska added.
And there are no immediate constraints on borrowing. Corporate debt by non-financial firms stands at 85% of gross value added (a national accounts measure similar to revenues), which is below the level reached in the last two cyclical peaks, she noted.
More importantly, only 3.2% of gross value added is spent on paying interest, which is below the average rate over the past few decades, meaning borrowing is much cheaper during this business cycle.
Societe Generale forecasts a pick-up in investment of about 6% this year and next year, which would still be below the levels seen in previous investment cycles.
“We believe that the fundamental case for capex is strong and various leading sentiment surveys suggest that our forecasts may ultimately prove too timid,” Markowska said.