The global financial crisis was largely confined to a bloated and increasingly reckless financial sector. Yes, government debt positions worsened and excessive household debt was exposed. But non-financial corporations are in pretty good shape. Unlike the 1990 and 2000 economic downturns, business gearing was kept low. The top 100 American corporates have almost $US2 trillion in cash balances; it was only a banking crisis.
A report by Deutsche Bank makes a similar point about Australian corporates, making the point that gearing is now down to “historically low levels”. Returning capital is likely to become common. It will probably be one of the big investment themes of 2011: how will capital returns affect share prices?
The report says net debt to equity is below 20% and that the low debt emphasis is likely to stay:
Previous gearing levels may well be unattainable, for two reasons. Firstly, there is still caution towards debt amongst corporate, given the recent financial crisis, and conditions are not yet that strong in all sectors. Secondly, while market gearing has declined from 50% to 20-25%, resources have been a key driver of this. For industrials, the decline in gearing has been a little less pronounced, from ~50% to ~30%. While still a reasonable fall, when we look at individual stocks it is not obvious that there is a wide range of under-geared companies. For many companies, it is more the case that gearing was quite high earlier in the decade, rather than current gearing being low. And for banks, we see a preference to hold on to capital given impending regulatory changes. In sum, it seems that the aggregate picture of under-geared corporates is less compelling when we look at the individual company level. As a result, the market may see a solid, rather than strong, pick up in capital management and acquisition activity over the course of 2011.
The Deutsche report, which gives an overview of the likely stocks to be affected, says that many companies are interested in organic growth or acquisitions:
While most resource stocks fall into this category, there are also gaming, chemicals and utility companies with large planned capex, and other stocks like TOL, BLD, ANN, CSR, who seem more interested in acquisitions.
This situation creates many investment puzzles. If companies return capital, that might be expected to reduce the beta of the stock (its tendency to underperform or overperform the wider market). That is, returning capital should reduce a stock’s volatility, which may not be good news for short term traders. It may also not be good news for longer term holders. If cash is being returned, it could be concluded that management lacks growth ideas. The whole point of investing in equities is to get higher returns (plus higher risk), not for it to be handed back. Still, capital returns might be preferable to a dodgy acquisition.
The suspicion is that the market is becoming relatively low risk, but has only modest growth potential. The lack of M&As does imply that valuations are pretty full. All a bit boring. But boring may be far better than what is likely to be the exciting times that lie ahead in the Australian property market.