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The Annoying Capex vs Buybacks Narrative

by: Lawrence Hamtil     
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The historical outperformance of companies that return capital to shareholders tax efficiently through buybacks is no mystery.  It is, in fact, a well-documented and thoroughly analyzed phenomenon.  However, there exists a tired but persistent narrative that says that CEOs who engage in buybacks are 'out of ideas,' and are content merely to cannibalize their future growth for "short-term" rewards.  The corollary to that narrative is that investors would instead be better off investing in companies that focus on investing in the future via large capital expenditures, or "capex" spending.

Supporting this narrative are data from Goldman Sachs, which seem to show that the market is cyclical in terms of how it rewards investors by alternately rewarding return of cash (via dividends and buybacks), and capital expenditures.  Below is a graphic from Business Insider which shows how these cycles have played out over time:

 

On the face of it, the graphic is convincing, and an investor could reasonably conclude that the current cycle has turned in favor of capex-heavy companies.  However, it would be incomplete to stop the analysis there.  According to the graphic above, prior to the current 'cycle,' the last time capex-heavy companies outperformed was from roughly 2003-2011.  A closer look at the data by sector reveals why.  

From 2002 through 2010, which is roughly the period of prior capex dominance, the capex-heavy energy sector was far and away the best performing sector in the market, averaging an annualized return of 16%, versus less than 7% for the market as a whole:

Propelled by a weak dollar, the price of oil soared, and energy stocks reaped a rich reward.  However, higher oil prices demand more exploration and more drilling, which of course means more capex spending, and it is therefore no surprise that the energy sector saw the greatest increase in capex spending over that period (table via Business Insider):

So while the historical composition of Goldman Sachs's proprietary "capex" basket is unknown, it seems safe to assume that from 2003-2011 it was heavy in energy-related companies.  

The other massive outlier in the table above is the consumer discretionary sector, which saw huge capital expenditures over the same period 2004 - 2008.  This was in large part due to the housing bubble (home builders are part of the consumer discretionary sector).  It is therefore reasonable to conclude that home builders, too, were featured within the capex basket during this time.

If such is the case, the reality seems to be, then, not that buybacks and dividends fell out of favor from 2003 to 2011 so much as two simultaneous bubbles in energy and housing distorted the performance of capex-intensive industries.  

On the contrary, far from falling out of favor with investors, companies that return cash to shareholders continue to do exceptionally well.  Consider that the S&P 500 Buyback Index has not lagged the market over any five-year period since the peak of the tech bubble...

...while the S&P 500 Dividend Aristocrat index has seen only mild and occasional underperformance over the same period:
 

Indeed, the evidence seems to suggest that aside from a handful of exceptional companies such as Amazon and Alphabet, which we are told populate the current iteration of the Goldman Sachs "capex basket," the bulk of capex-heavy performance, historically, has come during extraordinary cycles such as the telecommunications build-out in the late 1990s, housing from 2002 to 2007, and oil from 2002 to 2008, and again from 2009 through 2014.  On the other hand, companies that return cash via dividends, and especially via buybacks, tend to do well regardless of the cycle, as the return of cash to shareholders signals not a dearth of investment ideas, but profitability and healthy cash flows.  It seems unwise, then, to bet against these cash cows of the market.









The information provided above is obtained from publicly available sources and it is believed to be reliable. However, no representation or warranty is made as to its accuracy or completeness.


Lawrence Hamtil is a fourteen-year veteran of the financial services industry, having served clients in all aspects of the business during his career, which started in 2002. In 2005, he joined Dennis Wallace of Fortune Financial Services, LLC, becoming, at the time, one of Multi-Financial Securities, Inc's youngest registered representatives. In 2008, Dennis and Lawrence made the decision to become fully independent by founding their own Registered Investment Advisory (RIA), Fortune Financial Advisors, LLC. He serves clients in the United States and Europe. His financial commentary has been referenced in Barron’s online edition.

You can connect with Lawrence on Twitter ( @lhamtil) or via email, lawrence.hamtil@fortuneadv.com. 

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