How Important Is Heavy Investment For The FTSE 100?

Here are some facts that FTSE 100 (INDEXFTSE:UKX) investors should consider, argues Alessandro Pasetti.

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Let’s have a quick catch-up on asset bubbles, unrealistic returns and the business cycle. 

Mr Minack

Investment strategist Gerard Minack has questioned the widely perceived notion that companies are underinvesting in a post published by Neil Woodford on Wednesday. 

Return on equity in developed markets has oscillated around a flat trend despite a 35 year trend decline in investment spending as a share of GDP.

Return on equity is a good performance metric, and is split into three “levers”: net margin, asset turnover and leverage. As far as many constituents of the FTSE 100 are concerned, net margin and asset turnover aren’t growing much, while leverage is under control, which means that return on equity is unlikely to capture the imagination of investors for some time, particularly once it’s adjusted by intangibles and goodwill. 

Capex matters, though. 

Blame Cyclicality  

The FTSE 100 hasn’t had a great stint over the last few years, having grown broadly in line with US inflation over the period, excluding dividends. 

In recent times, some of its key constituents (big oil, miners) have been under the spotlight following announcements regarding their heavy investment plans, which have been drastically reduced as oversupply of oil and other resources, such as iron ore, dominated the headlines.

Think of BP, BHP Billiton, and Rio Tinto, for instance. 

China — “Chinplosion” as a US source referred to it recently — isn’t doing much to boost confidence. 

Policymakers & More 

Mr Minack argues that corporations are investing, but most of them are receiving diminishing returns.

In turn, this is likely holding back the prospect of the significant increase in business investment that policymakers yearn for”, he argued. 

Despite declining corporate profitability, as gauged by return on equity, “investors have ironically been prepared to pay higher valuations for equities“.

That’s normal in a low-yield environment, I’d argue, and is likely to last into 2017 at least. 

Capital-allocation strategies should be revisited. 

Cash

Deloitte captured the problem, which has been widely debated ever since 2009, in research published in early 2014.

One and a half years later, the landscape has surely changed but some of those core issues remain. 

A handful of companies are holding significantly more cash than others and have markedly different spending patterns“, Deloitte said, adding that FTSE 100 companies are typical of this cash dilemma.

The same statement holds true these days. 

Large companies, which hold huge cash resources, have been spending much less than a decade ago as a percentage of their operating cash flow (net income plus non-cash items, such as depreciation and amortisation, and working capital adjustments).

This may have boosted their free cash flow yields (operating cash flow mins core capex divided by market cap), but when companies do not invest in growth, their revenue trajectories tend to disappoint investors, while core margins shrink and asset write-downs may ensue.

As I argued some time ago, a different approach to extraordinary corporate activity (acquisitions, buybacks) in the UK is also required. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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