We calculated ROI and growth in invested capital for approximately 1,000 of the largest firms in Corporate America over the last several decades. We then computed the aggregate embedded expectations of ROI and growth that are necessary to deliver the valuations we see in U.S. equities today. Finally, we examine this in context of a proprietary Business Growth Confidence Index that measures trends in management guidance over 6,000 earnings calls over several years.
The results are consistent with an early stage of a bull market. U.S. corporates have been generating very high ROIs, however reinvesting in their businesses at low growth rates relative to history. Fortunately, to justify current market valuations, we only need forecasts for ROI and growth to continue at these levels. For significant market upside, we'd need to see more business growth, which overall, U.S. management teams are just not planning. Our proprietary index tracks management confidence in new growth opportunities. This index today is at multi-year lows.
The Rise and Fall of Invested Capital Growth Rates...
U.S. non-financial companies tend to grow faster than GDP, and the last three years have been consistent with that, including 2012. These recent growth rates have been below the higher growth rates of the rest of the decade, other than 2009.
In the Cash Flow Prime chart, the bottom panel bars for "IC Growth" represent growth in "invested capital prime" which is invested capital that has been adjusted for a host of financial reporting problems. These adjustments are made for inconsistent lease capitalizations, truly excess cash levels, research and development misclassifications, pension accounting nonsense, and others. In that second panel, we show an apples-to-apples comparison, in real terms not nominal, of the rate at which management teams have invested capital into their businesses year over year.
U.S. companies grew their balance sheets at an incredibly high clip from 2004 to 2007, well above U.S. GDP growth rates. They put more assets to work at high ROIs. This is the recipe for multiple expansion and thereby an amazing bull market. Unfortunately, much of that growth was financed by short-term debt at very low rates. When credit issues arose, the corporate growth engine did not shut off fast enough in 2008 to allow firms to service or restructure their debts as ROIs fell. The global slowdown and major recessions accompanied a collapse in both ROIs and invested capital growth rates into 2009, as the bars show.
… and Rise Again
In the years of rebound since 2009, we've seen average net new capital investment of about 5% per year in 2010, 2011, and 2012. Not at the 2004-07 rates, but not terrible by any means. Despite all the share buybacks, dividends, and cash build-up, companies have still managed real positive growth in investment in the businesses. The discipline management has exercised over ROIs has been sufficient to provide the cash to do it.
In other words, the expanding ROI and earnings growth we've seen has not been achieved on sheer cost cutting. There has actually been real underlying business investment. (Note: In this particular Cash Flow Prime chart, we leave out the banks and insurance industries of the financial services sector in order to get a cleaner picture of the rest of the 9.5 or so sectors.)
Examining growth in invested capital helps to show what management teams are doing with shareholders' money. Growth in top-line revenue does show if sales are rebounding, but doesn't tell us if the businesses are actually investing into that growth or simply using up excess capacity. A focus on corporate balance sheets requires not only debt analysis but a deep focus into the asset side of the firms.
"Market Implied" = Embedded Expectations
The new highs of the SPY and other market indexes imply a level of future performance neither low nor excessive. The market appears content to price in exactly what's being achieved in cash flow performance now. Nothing more, nothing less.
The red bars labeled "Mkt Imp" stand for "Market Implied ROI" and "Market Implied IC Growth." This is the performance that's required over the next several years in order to justify current market valuations. This also assumes that ROIs would fade to cost of capital levels after a period of time and any economic profit would fade away with it. Current market valuation levels do not require an aggressive perpetuity of these ROIs "into forever."
This suggests a market which is neither undervalued nor overvalued, and has been carried by the very high ROIs that firms have been generating. The ongoing improvement in business efficiencies and thereby higher ROI can take the market higher, albeit limited without higher growth rates.
With Limited Confidence in Growth, Limited Multiple Expansion
I had a conversation last week with two senior partners at a major management consulting firm. They've been managing their consulting business well, but brought a serious issue to light. They said simply, "Our consulting business has done well because we switched to doing exactly what management teams want… cost controls and business efficiencies." This story is anecdotal of how management teams appear reluctant to spend on growth at any higher rate than they already are. It's consistent with a comprehensive analysis of trends in over 6000 earnings calls over the last few years.
Our analyst team tracks certain "confidence markers" that appear in earnings calls that have historically proceeded increased business investment. We've tracked the accuracy of these markers from quarter to quarter. The results have been incredibly telling. This is not a poll of industry analysts. Lots of analysts and investors listen to earnings calls as any good, fundamental investor should. What's different here is the systematic, consistent methodology of which earnings calls are analyzed specifically for these markers across a large scale.
The chart below shows the result of this analysis. The index is at the lowest levels we've tracked in a few years.
The chart normalizes for call length, total calls in a period, and other factors. A score of "13" today suggests that we are seeing less than half of the markers that were seen in 2010 and early 2011 when the index displayed upwards to a "30" score. Managements' representations on earnings calls today are not in line with the patterns of companies who have historically grown their businesses at faster rates. While companies may have provided plenty of earnings surprises this quarter, signals for growth are missing. It reflects a strategy of continued cost cutting and a focus on ROI.
The comprehensiveness and consistency of the team's analysis is enough to lead me to believe that despite the wherewithal of firms to grow, they will grow at continued muted levels. Also, with such high ROIs generating so much operating cash flow, this lack of confidence in business growth suggests that we'll see more share buybacks, dividends, and cash buildup.
A Strong Case Against a Bear Case
Management has used cash flow to shore up their balance sheets and debt structure, creating a very safe foundation of low default risk, ROI expansion, and the opportunity for future growth. (Please see here.) Also, U.S. corporates have achieved truly amazing levels of cash flow generating ability, some of the highest ROIs observed in over 50 years. (Please see here.) These fundamentals limit the potential of a downside shock to growth and profitability. With low but stable investment growth, and the market pricing that in, the likelihood of a market collapse in U.S. equities is also low.
Buying Dips Until Signals Say Otherwise
Consistent with early stages of a bull market, companies focus on ROIs first and get comfortable with re-investing second. For now and foreseeable quarters, business growth may stay at currently reasonable, but historically muted levels. Current valuations embed just that level of performance.
Companies could drive ROI higher as the cost cutting and belt-tightening continues. With that, we could see the market continue to steadily edge higher. This favors riding the market with solid long positions if earnings continue to edge upward. It also suggests buying on dips if there are no other fundamental changes in corporate profitability and growth as they are now. In this light, a market correction would be an opportunity to take advantage on the long side.
When higher growth comes back, coupled with such high ROIs, we'll see the potential for sustained multiple expansion and the high-flying second stage of a bull market. For now, we're just waiting for management teams to give us that signal.