Michael Mauboussin, Dan Callahan 2022
The article can be found here
This 85 pages article published by Morgan Stanley research is about how the evaluation of companies' efficiency. It illustrates its views with accounting data from 1980 to 2021.
Internal Financing is the main source of funds
According to the Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of Funds Accounts Table F.103. Internal financing tends to account for 80% to 100% of new investment, whereas new debt issuance represents only 20% and gross equity buyback is between 0% and 20%. Gross equity buyback includes Stock Based Compensation - SBC - net equity issuance which excludes SBC is arguably much lower, but it was not required to be reported until 2006.
Debt to total capital ratio went down from 40% to 15%
Debt to total capital ratio - defined as ST+LT debt/(ST+LT debt + eq mktcap) - has gone down from 40% to 15% from 1985 to 2021 according to Factset data.
Capex is reduced and more buybacks, R&D and SG&A spending
- M&A spending is the largest item, with 9% on average, going from 3% during crises to 22% during booms. M&A market timing is bad
- Capex went from 9% to 5% of sales from 1985 to 2021
- SG&A and R&D went from 7.1% to 9.4% during the period, it seems that part of the intangible investment gets expensed instead of capitalized.
- gross share buyback increased substantially from 1.5% sales to 5.4% of sales, this is a mix of stock based compensation and money returned to shareholders
The authors note that this change is partially due to technology and healthcare stocks making up a larger part, and industrials and energy making a smaller part, of the stock universe.
ROI, IC and Cash position
ROIC averaged at 8.5%, invested capital has grown at a real rate of 4%.
Companies have accumulated in aggregate a substantial stash of cash going from 2% to 10% of assets, though it seems to be concentrated in a few FAAMG.
M&A business ebbs and flows, with average at 7% of total market cap and trending down as market cap goes up. Average deal premium is 45% and companies that overpay for acquisition do not find value.
Capitalizing vs Expensing: R&D and other SG&A and Capex
Mauboussin quotes Value of Internally Generated Intangible Capital as a reference for the case to capitalize R&D and typically 30% of the SG&A. This adjustment causes firms net margins and assets to be increased by an amount around 1% of sales.
SG&D has risen from 5.8% of sales to 7.1% of sales from 1985 to 2021. However, these figures are subject to a lot of annual noise.
Capex has gone from 9% to 6% from 1985 to 2021, while capex net of depreciation has gone from 4% to 1%. The author notes that depreciation underestimates maintenance capex by an estimated 20% due to inflation and technological obsolescence. This amount is expected to vary greatly by industry and firm.
R&D has gone from 1.3% to 2.3% of sales.
Working Capital, Divestiture
Net working capital (current assets minus non interest bearing current liab) has gone down from 30% of asset to less than 10% of assets from 1985 to 2021. The amount of cash invested in net working capital has gone down.
Median cash conversion cycle goes from 33 days for Energy to 120 days for healthcare. The CCC are highly company dependent.
Divestiture represents only 3% of sales, where M&A represented 9%. It is less popular due to the CEO having a propensity to grow the company to become more important.
Dividends and Buybacks
Dividend payout ratio has gone down from 50% to 40% from 1985 to 2021.
The SEC had rules against market manipulation since 1934 that created potential legal liabilities for firms doing buybacks. In 1982, the SEC adopted Rule 10b-18 which provides safe harbor and paved the way to more buybacks.
The taxation for the shareholder is different, as the buybacks are taxed as capital gains and the dividends as portfolio income. While there is much discussion whether the buybacks are done at too high a price, they are actually equivalent to dividends if the market price does not fall down later.
The author explains there are 3 schools of thought justifying buybacks:
- fair value: buying back when the stock is undervalued or overvalued does not change much.
- intrinsic value: buyback should only occur if the return on investment available to the firm are no better than its wacc
- accounting: buybacks could be done to ensure that EPS increases and offset dilution from SBC
It should be noted that the payout ratio shown in this study shows gross buyback, which have not been netted with the SBC dilution effect.