Follow the Money...

September 2016

 

Developed economies (the U.S., Europe, Japan, and Canada) are experiencing lower growth than in past economic expansions. This is partly due to demographics as populations are aging and birth rates have dropped, leading to limited labour force growth. But another factor has been weak capital spending, with the result that there have been fewer jobs created and a lower level of productivity gains achieved (Capital Group, Investment Insights; A. Gary Shilling's INSIGHT).

Instead of investing in further growth, we see large international companies (e.g. Apple) hoarding cash offshore to avoid paying taxes that would be due if the money was brought back to America and invested. As well, many corporations are buying back stock or paying out large dividends instead of investing in new capacity. Of course, it is always a good thing when cash is returned to shareholders, but the concern is that boards of directors do not see opportunities within their own companies for investment of additional capital that would create jobs and help to grow the economy.

For the first 50 years or so after WWII, there was strong secular growth across most sectors of the economy. Since 2000, however, growth has been focused in just a few sectors while others, like manufacturing, have stagnated. Housing boomed until 2007 and then went bust in the financial crisis. Next, energy investment soared as oil and gas shale plays were developed but spending then was slashed in the past two years as prices for oil and gas dropped. Since 2011, resources in general have been impacted by the slowdown in China, along with demand for many industrial products.

The question now is how to find companies that can still succeed and grow in a lacklustre economy, These are what I call "businesses with a future" (BWAF). I have never been a "growth" investor per se. Instead, I have generally focused on "value" stocks, following the teachings of Benjamin Graham and Warren Buffett. But, in the current environment, companies that are doing well, are profitable, have pricing power, and can make attractive returns on investment are those that still foresee growth opportunities for their businesses. Meanwhile, many well-known blue chips of the past are struggling to grow and often boost their earnings per share by buying back stock instead of investing further in their business. This may be due to the slow-growth economy, or perhaps their business models are no longer viable given new competing technologies, foreign competition, or changing consumer preferences.

However, there is a way to find companies that still have good future prospects. I will credit one of Canada's fund management companies (Front Street Capital) for developing this approach and making it the theme of a recent presentation called "Follow the Money".

The point of the presentation was simple, but powerful. If you search for companies and industries where serious amounts of additional capital are being invested to develop new products or to expand capacity, you will find businesses that are succeeding in today's economy, whose managements expect future growth and healthy returns on investment. You can follow the money and invest where this new capital is being deployed.

Some examples of growth related to cutting-edge technologies are obvious, like Biotech or the Internet of Things. But there are predictable cash flows available as well from new investments in infrastructure, such as real estate, highways, airports, power plants, etc. The art is in finding the best ways to participate in sectors of the economy that still offer growth and reasonable investment returns. The first step is to see who is putting new money to work. Perhaps they have identified a worthwhile investment opportunity.

 

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