According to data from S&P Capital IQ presented in The Wall Street Journal, corporate profits are increasingly being directed back to shareholders as dividends or stock buybacks instead of being reinvested into the businesses as capital spending. In 2013, the most recent year in the study, companies in the S&P 500 sent a median of 36% of their cash flow back to shareholders with only 28.7% being devoted to capital spending.
Is this a positive or negative phenomenon? Like most things in the world of economics, the answer is not straightforward. Let us dig a little deeper into the reasons and effects.
Corporate priorities have cycled between capital spending and capital returns. In 2003, capital spending far surpassed capital returns, 33.3% to 17.7%. However, the rates crossed over in 2006, reaching a differential of nearly 13% of capital returns higher than capital spending. The Great Recession immediately reversed that ratio, and it took until 2011 to reverse the trend back toward higher capital returns.
Why is the current trend toward capital returns? There are a few major reasons.
- Activist Investors – Hedge fund leaders and other activist investors see themselves as fighters against wasteful corporate spending. They argue that internal spending should be limited to what is required by manufacturing demand and necessary R&D investment to sustain product lines, and that the remaining cash should be returned to shareholders via dividends or stock buybacks.
This is a healthy debate that — companies should be able to justify their internal capital investments and R&D efforts — but some argue that the activists are focused purely on making money in the short term without considering the long-term health of the companies in which they invest.
Meanwhile, companies are going to put their cash to the best use possible, and if they cannot get sufficient returns, they will simply sit on it until better opportunities come along (or activist investors pry it out of them). They will not overfund R&D facilities and factories just to keep people busy.
- Stock Prices – In a slow economy like the current one, stock buybacks are a useful method of improving a company's earnings per share (EPS) ratio by reducing the number of outstanding shares. Higher EPS values in turn keep stock prices high — although some have argued that too much current growth is due to buybacks and the trend is not sustainable.
Interest rates also play a role. Since the Fed is still keeping interest rates near historic lows, it is unusually cheap to borrow money right now to buy back shares and potentially end up in a stronger position from the subsequent boost in stock prices.
- Demand – Businesses simply are not going to invest in factories without some indication that demand is going to increase to justify that investment. However, companies that skimp on their R&D investments, especially in the tech sectors, are unlikely to generate new demand for their products, and a focus on shorter-term returns can come at R&D's expense.
Ironically, both sides can point to Apple to bolster their case. Spurred by activists, Apple has returned over $64 billion to shareholders since mid-2013, according to the Wall Street Journal. However, Apple has not spared on R&D spending which has propelled them far ahead of the competition.
The real question is which path makes better use of the money. Advocates of capital spending argue it is the engine that drives economic growth by providing business expansion and new jobs. In turn, those new jobs boost consumer spending and overall economic health. Hedge fund managers and other activists suggest that they reallocate the money to enterprises that can use it more efficiently and raise overall wealth by keeping companies efficient and stock prices high. Investors see the benefits through their 401(k) programs.
It is not our place to say which path is correct. Each company has to find their own balance between capital investment and shareholder returns that satisfies shareholders (even the activists) while serving their companies' needs. However, it is worth noting the last large imbalance toward higher shareholder returns peaked in 2008 as we tumbled into the Great Recession.