Macro Trends in Capital Productivity
The Value-Creation of Capital
This post covers macro trends of capital productivity, the cost of capital, and value-creation of capital. In my thesis I discuss the relevance of value-creation of capital in the context of investment. Value-Creation, or Economic Value Added (EVA), is defined as Return on Invested Capital (ROIC) in excess of the Cost of Capital or Weighted Average Cost of Capital (WACC) multiplied by the Invested Capital. The findings are of importance to society: the current trend is that firms that create relatively little value compared to their market-valuations outperform firms that create relatively a lot of value. The figure below shows that historically speaking for the majority of time the exact opposite occurs: firms that create a lot of value outperform firms that create relatively little value. Firms that create a lot of value relative to their market capitalization are labelled ‘Cheap’ (or ‘C’), firms that create little value are labelled ‘Expensive’ (‘E’).
Post 2008 financial crisis
Since the global financial crisis in 2008 expensive stocks start to gain ground relative to cheap stocks. Investors are altering their preferences: real productivity seems to be substituted for capital payouts as the main selection criterion. This can be confirmed by considering the following macro-trends (median) of the US stock market universe (data from 10-Q/K reports of SEC’s EDGAR, approximately 4000 firms):
Capital Productivity & Cost of Capital
(1) The capital productivity (Return on Invested Capital) is downward trending, (2) the costs of capital (Weighted Average Cost of Capital) are on the rise
Cost of Equity & Cost of Debt
(3) the cost of equity is increasing, while the cost of debt is dropping.
More Capital Intensive, Less Productive
At the same time the only way firms are still creating value is by deploying relatively more capital to compensate for a lower excess return on capital:
Share Buybacks & Leverage
Driven by low costs of debt, firms are actively substituting equity for debt by pursuing leveraged share buyback programs. However, as displayed by the excess return on capital this endeavor does not result in a increase of real capital productivity.
Underlying Operating Income
Operating income seems to be upward trending on the aggregate level (median), but only when considering the income-statement definition. When considering cash operating income (adjusted for accruals), profitability seems to be much more static since 2008.
Summarizing the findings, I see on the aggregate level, i.e. the median across all (US) firms, that (1) productivity is dropping, (2) the cost of capital is increasing, and (3) firms that are creating relatively little value currently have higher returns than firms that are creating a lot of value (in contrast to what historically happens).
I can think of three explanations for these findings: (1) monetary stimulus is providing an incentive to payout capital rather than to invest in the real economy, (2) investors are extremely risk averse and for this reason cheap stocks have unusually low returns relative to expensive stocks, (3) there is a bubble in expensive stocks – possibly due to a preference shift towards short-term capital payouts rather than economically sustainable investments in real productivity.