Long read: Cost of Capital and Capital Allocation – Investment in the Era of “Easy Money”

For many of us, Michael Mauboussin remains a crucial bridge between theory and practice, with his books and essays all drawn from his background that straddles academics and industry (he has been a finance Professor Columbia Business School and a highly regarded strategist on Wall Street). This paper is no different.

It begins like: “There is an old saying that “in theory there is no difference between theory and practice, while in practice there is”

The paper looks to evaluate the effect of the ‘easy money era’ defined by low interest rates between 2009 and 2021 on businesses in terms of how they allocate capital given lower cost of capital. And the findings are startling suggesting why practice could be so different than theory.

Whilst businesses may not have reacted to the lower cost of capital, markets surely did.

“For this analysis, we examine two periods of equal duration: the phase of easy money (2009-2021) and the thirteen years preceding it (1996-2008). The label of easy money suggests some distinctions between the periods. We expect to see lower shortand long-term interest rates in the easy money period than in the one before it. That is the case. The average yield on the 10-year U.S. Treasury note, calculated monthly, was 2.3 percent from 2009-2021 versus 5.0 percent from 1996-2008.

All things being equal, declining interest rates are good for asset prices because future cash flows are worth more when they are discounted at a lower rate. Here again, the point is borne out. The compound annual growth rate (CAGR) for the S&P 500, an index of the largest public companies in the U.S., was 16.0 percent when there was easy money and 4.8 percent in the equivalent time before.”

But businesses surprised us:

• Returns on Invested Capital (RoIC) in the easy money era were actually marginally better (9.5% vs 9.2%) than in the previous period suggesting that businesses may not have reflected the lower cost of capital in their investing decisions not settling for investing in lower returning projects

• Indeed, capital expenditures or investments as a % of sales was lower in the easy money era at 24.5% vs 27.3%.

“Despite lower capital costs, companies invested at a slower rate and the spread between ROIC and the cost of capital widened. Aggregate invested capital grew at a 2.6 percent CAGR in the easy money era and 4.9 percent in the previous period.”

What might explain this?
“There are multiple potential explanations for this lack of investment, including decreased competition and heightened governance. Indeed, the aggregate ROIC for public companies in the U.S. rose to a level above the long-term average.

As John Graham says, “sticky hurdle rates make a lower cost of capital less relevant, and thus, imply that monetary policy (i.e., reducing interest rates) may not be able to spur corporate investment.” Companies are aware that the cost of capital is lower but do not change their investment patterns as a result. Over the long haul, investment growth shows little link to short- or long-term interest rates.”

Furthermore, one would expect companies to borrow more during periods of low interest rates. The paper shows that isn’t the case either with ‘Debt to Total Capital’ ratio falling from 32.7% to 21.6% and excess cash and marketable securities as a share of assets growing from 4.3% to 9%.

But share buybacks did go up as a % of market cap, suggesting reduced attraction of equity in the capital structure. There is an interesting explanation for this in the article with a model to show when buybacks are attractive and when they are not.

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