Tuesday, November 27, 2012

Jeremy Grantham's 3Q 2012 Letter: The Decline in U.S. Net Capital Formation

From Jeremy Grantham's latest letter:

"Typically I see less significance than others in debt and monetary factors and more in real factors. When someone says that China is building its trains and houses on debt I think, "No, they are built by real people with real bricks, cement, and steel and whatever happens to the debt, these assets will still be there." (They may fall down but that's a separate story; you can build a bad high rise with or without debt). So I take the quality and quantity of capital and people very seriously: they are the keys to growth and a healthy economy. A badly trained, badly educated workforce is a problem...but reduced, abnormally low capital investment, particularly in the U.S., is the current topic."

Grantham sees the emergence of the "Bonus Culture" as a contributor to the problem (check out the letter for Grantham's explanation) of reduced capital investment. He later added:

"When I was a young analyst, companies like International Paper and International Harvester would drive us all crazy, for just as the supply/demand situation was getting tight and fat profits seemed around the corner, they and their competitors would all build new plants and everyone would drown in excess capacity. The CEOs were all obsessed with market share and would throw capital spending at everything. It might not have been the way to maximize an individual company's profit but it was great for jobs and growth. Now, in the bonus culture, new capacity is regarded with great suspicion. It tends to lower profitability in the near term and, occasionally these days, exposes the investing company to a raider. It is far safer to hold tight to the money and, when the stock needs a little push, buy some of your own stock back. This is going on today as I write, and on a big scale (approximately $500 billion this year). Do this enough, though, and we will begin to see disappointing top-line revenues and a slower growing general economy, such as we may be seeing right now."

In my view, the buybacks themselves aren't a problem, they're a symptom. As a shareholder of a good business, I'm enthusiastic about buybacks when the stock is cheap. When done the right way for the right reasons, buybacks are an important part of disciplined capital allocation.
(Unfortunately, they're frequently executed with too little discipline.)

Still, Grantham is very right that buybacks require capital that could be put to work elsewhere. For increased economic activity to occur, healthy capital investment is needed to fund good ideas and build useful things. Why, in the current environment, are buybacks the more attractive alternative for so many companies? It's worth understanding the real reasons. Maybe the "Bonus Culture" is a contributor to the problem, but I doubt it comes down to just one thing.* I'm guessing there are many reasons companies are choosing buybacks over other capital investments that might lead to economic expansion.

Understanding the root cause(s) of this might not be an easy thing to do, but incredibly important. Even if a business is not buying back stock, it may just hunker down, remain conservative with its capital expenditures, and avoid other forms of risk until there's more certainty.

Compared to historical norms, we are no where near a healthy level of capital formation. Exhibit 5 in Grantham's letter (see page 8) shows this. Check it out. The chart in that exhibit reveals capital formation as a percent of GDP at levels compared to U.S. historical norms that should make no one comfortable.**

Of course, it's not just how much but how smart the investments end up being. It's, as Grantham says, both "the quality and quantity of capital" that matters, but going from where capital formation was a bit more than 50 years ago to where it's at now can hardly be seen as a good thing.

You'll have a hard time convincing me this can't be fixed once it's more fully understood with some smart policy moves and changes to the system. I'm guessing that increased certainty and confidence will eventually lead to more healthy levels of capital formation and investment.

One can only hope that the best ideas will be considered carefully and turned into action.

There's plenty of capital sitting on the sidelines that eventually can be put to good use.

Adam

* Though increased certainty/confidence for businesses and consumers might be cheapest form of economic stimulus.
** Though no measure is perfect, Fixed Private Investment (FPI) as a percent of GDP, points to a similar dynamic. The following chart shows how FPI as a percent of GDP has looked in the U.S. since 1947:

Based upon that chart, it sure looks as if FPI/GDP was closer to the historic average, it would materially improve recent U.S. GDP growth.
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