This is a long-standing Wall Street belief. The basic idea is that as companies expand and mature, their leadership gradually turns from entrepreneurs into bureaucrats. The ultimate warning bell that rough waters are ahead for corporate profits is the announcement that a firm will spend huge amounts of money on a grandiose new corporate headquarters.
An odd article in the Wall Street Journal reminded me of this a couple of days ago. The company coming into question in it is Amazon, which has just initiated a search for the site of a second corporate HQ.
–why no comment on Apple’s new over-the-top $5 billion HQ building?
–the headquarters idea was followed by a discussion of research results from a finance professor from Dartmouth, Kenneth French, which show that publicly traded firms with the highest levels of capital spending tend to have underperforming stocks.
I’ve looked on the internet for Prof. French’s work, much of which has been done in collaboration with Eugene Fama. I couldn’t find the paper in question, although I did come across an interesting, and humorous, one that argues the lack of predictive value of the capital asset pricing model (CAPM)–despite it’s being the staple of the finance theory taught to MBAs. (The business school idea is apparently that reality is too complicated for non-PhD students to understand so let’s teach them something that’s simple, even though it’s wrong.)
–money for creating/customizing computer software, which is one of the largest uses of corporate funds in the US, is typically written off as an expense. From a financial accounting point of view, it doesn’t show up as capital spending.
–same thing with brand creation through advertising and public relations. I’m not sure how Prof. French deals with this issue.
Over the past quarter-century, there’s been a tendency for companies to decrease their capital intensity. In the semiconductor industry, this was the child of necessity, since each generation of fabs seems to be hugely more expensive than its predecessor. Hence the rise of third-party fabs like TSMC.
For hotel companies, it has been a deliberate choice to divest their physical locations, while taking back management contracts. For light manufacturing, it has been outsourcing to the developing world, but retaining marketing and distribution.
What’s left as capital-intensive, then? Mining, oil and gas, ship transport, autos, steel, cement, public utilities… Not exactly the cream of the capital appreciation crop.
At the very beginning of my investment career, the common belief was that high minimum effective plant size and correspondingly large spending requirements formed an anti-competitive “moat” for the industries in question. But technological change, from the 1970s steel mini-mill that cost a tenth the price of a blast furnace onward, has shown capital spending to be more Maginot Line than effective defense.
So it may well be that the underperformance pointed to by Prof. French has less to do with profligate management, as the WSJ suggests, than simply the nature of today’s capital-intensive businesses–namely, the ones that have no other option.