Our focus on credit cycles is to make sure there is availability of corporate credit for companies to invest in growth. It is equally important to see how much companies are actually investing in growth.
This one key metric shows us whether management teams are investing in asset growth, and such spending leads to Uniform earning growth for the vendors, suppliers, and employees.
Over the last few quarters, we’ve seen this metric signal accelerating commitment to investing in growth, and that’s a positive for the market.
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We spend a lot of time in our macro analysis focusing on credit cycles.
Earlier in January, we talked about the importance of credit crunches in causing deep bear markets and recessions. Anyone who is a subscriber for our macro Market Phase Cycle (to learn more about the “MPC,” read here) knows that the understanding of credit cycles is a core to our research.
There are two parts of how we think about credit cycles.
There’s availability of credit, which is whether banks want to lend–if it is easy to get access to borrow.
Then there is demand for credit, which is whether borrowers want to borrow in the first place.
Early in a cycle, like back in 2010-2011, we could see ample availability of credit, but no borrowers. Companies were still repairing their balance sheets, and were scared from the last pull back. They weren’t interested in investing in growth.
One way to understand if a company is interested in growing, and if there’s demand for credit, is to understand if companies are spending.
One key component is a great datapoint to monitor. Without this, manufacturing companies couldn’t manufacture, retail companies wouldn’t be able to manage their inventory, and technology companies would be unable to design, produce, and distribute their products.
This component is called Property, Plant, and Equipment.
Property, Plant, and Equipment (PP&E) are the hard assets a company uses to run their business, including office space, factories, production machinery, and vehicles.
Without a functional base of fixed assets, a company cannot operate to its full potential.
Imagine what US Steel would look like today if it was just a bunch of blacksmiths with a large fire, hammering away. How about Apple if they hadn’t updated their infrastructure since they were making the original Macintosh 128K?
While this may seem obvious, it highlights the importance of continued investment in PP&E.
As an investor, you need to look at how companies are currently investing to understand their future performance. When a company under-invests, it limits their future production capacity and increases the need to reinvest in the future.
Long-term assets like PP&E have a useful life before they become obsolete, begin breaking down, or need to be replaced. Companies depreciate the value of their PP&E to reflect the “aging” of their assets.
Comparing the value of a company’s PP&E when they purchased it (gross value) to the current, post-depreciation amount (net value) gives investors a sense for the relative age of a company’s assets.
Tracking the Net/Gross PP&E ratios over time tells us when companies need to spend more money to support operations and when the need to reinvest is less urgent. Looking at Net/Gross PP&E ratios for entire industries or countries can tell a larger story about larger investment trends.
That’s what Net/Gross PP&E ratio should be able to do.
In reality, it is important to remove noise in the financial statements before coming to any conclusions because GAAP numbers distort reality.
There are a lot of problems with the accounting for PP&E under GAAP. These include issues around acquisitions, the company artificially writing down their assets, and bankruptcy “fresh start” related accounting noise, to name a few.
Using Uniform Accounting, we remove the noise that GAAP creates. This lets us look at individual companies, overall macro, and capex cycles, and gain better insights on how it can impact the market.
When companies have recently invested in PP&E to replace old fixed assets, but they aren’t investing in growth, they can use their cash flows for other purposes (servicing debt, paying their shareholders). Because of this, they are more likely to slow their future investments.
On the other hand, as companies begin growing their cash flows and see growth opportunities on the horizon, they have more incentive to invest in their PP&E.
The chart below highlights the Net/Gross PP&E ratio for the S&P 1500 (1500 of the largest public US companies) since midway through 2001:
As mentioned above, trends in Net/Gross PP&E are indicative of management’s growth outlook and cash flow expectations.
For instance, when Net/Gross PP&E ratios rise dramatically (as they did beginning in 2005), management teams around the country were aggressively investing in their assets to drive growth.
Rising investment in assets generally leads revenue growth, and earnings growth. This is a positive signal for economic growth and for the market.
Following the beginning of the Great Recession, management teams halted their investments in PP&E in favor of managing their cash flows during a time of significant uncertainty.
Post-recession, Net/Gross PP&E bottomed out at 56.4% as companies began reinvesting to make up for lost productivity. Long-term Net/Gross PP&E across corporate America was in the 57%+ range. Companies tend to feel the pressure on their production when their ratio falls below this amount.
Companies continued investing until they reached 57% levels midway through 2013.
For the next 1.5 years or so, management teams converted to just spending on “maintenance capex.” That meant they were just spending enough for PP&E to not age further in aggregate.
Then in 2015, the energy crisis began to grow. Many companies that were aggressively investing in capex, especially in the energy space, stopped. Companies across the value chain similarly stopped investing. For about four years after, companies showed widespread reluctance towards further investment in PP&E, leading aggregate ratios to reach multi-decade lows in the first half of 2018.
But that appears to be changing. Management teams appear to be realizing this need for capex.
Since Net/Gross PP&E reached multi-decade lows in the second quarter of 2018, we have begun to see an uptick in net investment. This is a possible signal that management teams have returned to a growth mindset.
This is an important lever to our overall macroeconomic outlook. Continued asset growth has three positive signals embedded within.
- First, it confirms managements are anticipating future growth opportunities.
- Second, it indicates that there are quality investment opportunities for future growth.
- Third, and most importantly, it signals that corporations are sufficiently profitable to support investment activity, and management teams are not hoarding cash to prepare for economic turbulence; earnings growth is coming.
We’ve continued to see that spending accelerate since, even through the sell-off of late 2018, and through 2019.
As we continue to monitor the macroeconomic environment, it is critical to monitor corporate capex spending, and monitor it after GAAP accounting noise has been removed.
If we continue to see companies spending on capex, and don’t see credit availability tighten, that’s a recipe for asset growth and the earnings growth that follows it.
All the best, as always,
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research