11th March 2013
J.P. Morgan Asset Management’s latest note from global strategist Dan Morris says that corporations are spending more as evidenced by increasing M&A activity. Investors might however want companies to spend their on money on dividends.
“The latest indication that US corporations were perhaps becoming more willing to spend the significant amounts of cash they hold was the announcement of several large mergers in February (Virgin Media, Heinz). Activity has been strong, however, since October and the value of deals announced in 2013 is running 13 per cent ahead of 2012 year-to-date.
“The net benefit for investors of increased M&A activity is difficult to measure because if a company overpays, it is just a transfer of wealth from one set of shareholders to another and the aggregate market value does not increase unless the new entity is more profitable than the original components. Investors, therefore, may wish to see companies use their cash in other ways, either returning it to them via dividends and share buybacks, or investing it in the operations of the company.
“European equities have been considered a better alternative to US equities for those focused on dividends because the yield on European equities has generally been 1.5 per cent to 2.5 per cent greater. Using the MSCI High Dividend Yield indices as a benchmark, the European index currently generates a 3.9 per cent yield compared to just 2.3 per cent for the US. But this ignores the sustainability and growth of the income being paid to investors; clearly a company can have a high dividend simply because its stock price has fallen as it moves towards bankruptcy. Though yields are lower, it is US corporations that have provided the greatest dividend growth recently. Since March 2009, dividends per share for MSCI’s European index have increased by 20 per cent while those for the US index have grown by 50 per cent. This may explain why the total return of the US index has been greater than for the European one over the last several years.
Another way that companies can return cash to shareholders is through share buybacks. Theoretically share buybacks should peak when the company’s stock price is low or undervalued as then management would be serving existing shareholders by using the company’s cash to retire shares cheaply. Management, however, tends to behave like most investors and buy when prices are high — as markets rise share buybacks tend to as well. In the last quarter of 2012 this was not the case, however, probably because CEOs were reticent ahead of the fiscal cliff. Recent announcements of substantial share buyback programmes suggest that the trend is reverting to the norm this quarter.
A generous dividend or large share buybacks can indicate that the company has few profitable opportunities to invest in its own business. For those companies that believe they have room to grow, however, it would be better for them to direct at least some of their cash internally. Despite the economic recovery over the last few years in the US, business investment has been extremely low due to an uncertain outlook and excess capacity. Companies are devoting just 1.06x profits to internal investment compared to an average of 1.7x over the last 50+ years. The contribution to GDP growth from business investment has also been below average in this recovery. If, however, the increase in M&A and share buybacks indicates greater optimism, capital expenditure could increase dramatically. Given how long investment has been below trend, there is likely a substantial amount of expenditure that has been postponed as companies waited for greater clarity in the economic outlook.
The better-than-expected increase in US private non-farm payrolls announced last week shows that the labour market continues to recover. The unemployment rate fell to 7.7 per cent, but this is still far from the 6.5 per cent target the US Federal Reserve has set for an end to quantitative easing. At current rates it may not be until the summer of next year that the unemployment rate drops that low. The number of jobs in the economy should get back to pre-recession levels a few months before that. The worry for the Fed must be, however, that inflationary pressures arise elsewhere before the labour markets have fully recovered. Excess bank reserves are over $1.6 trillion and growing. Corporate and consumer credit growth is modest for now, but a sharp pickup could create problems for the Fed.