Living in an age of aging fixed assets
In edition 14 (30-Sep-16) of Investment Matters we concluded that we are at, or near, the bottom of the capital investment cycle in the mining sector.
In many instances, there are parallels with capital investment in other sectors although the extent of the upswing and subsequent downturn has not been as extreme, and different sectors are in different stages.
However, companies, including listed ones, across a variety of sectors have been 'sweating' assets. That is, delaying the replacement of an asset by maximising use beyond its usual replacement date. Qantas is a simple case in point; it is still running B-747s between Brisbane and Los Angeles (doable when the oil price is low). This also applies to the public sector (Melbourne's trains anyone!).
The graph above depicts the downturn in spending in machinery and equipment. (The impact of the mining sector capital investment upturn and downturn is evident in the green Engineering line.)
Dividends vs Reinvestment
Over the last few years, many listed companies have had a high dividend payout ratio. That is, paying out more of profit in dividends and reinvesting less in their businesses than in previous years. Reinvestment includes upgrade and replacement of assets and equipment.
This has been driven by two linked factors. Firstly, with low bank deposit rates investors have been chasing higher yielding stocks. Then, and secondly, management, always keen for a higher share price because of a matter called TSR, is happy to oblige and payout higher dividends. TSR is Total Shareholder Return. And is the return a stock pays to investors from both share price growth and dividends.
Many listed companies reward their senior executives and directors with bonuses based on TSR. Hence there is an incentive to pay higher dividends than might otherwise be the case. The more that is paid out in dividends the less that is available for reinvestment.
A company (or government) can 'sweat' an asset for an extended period. The extent will depend on the utilisation of the asset (assets operating at full capacity are harder and more risky to continue operating). It will also depend on the maintenance costs versus the replacement cost. Probability and consequence of breakdown are also crucial considerations. Productivity of the old versus new asset or piece of equipment is often of consideration too (usually newer assets are more productive).
Every piece of equipment or asset is different, and there isn't usually a specifically identifiable crunch point. But as assets are sweated for a longer period, the need to reinvest usually becomes more apparent.
Reinvestment good for shareholders in the long term
We view the focus on dividend payout and the lack of reinvestment as detrimental to longer term shareholder returns. An asset is what provides a return for shareholders in the future. Underinvesting in assets in effect provides a short term windfall benefit (via dividends) at the expense of generating ongoing future returns. Thus we view the turning tide on capital investment positively.
We like investing in things that are inevitable. An example is the aging population.
However, when the reinvestment tide will turn is not certain as different companies and sectors are at different stages regarding the age of their assets and the need for replacement and / or upgrade. But overall there is a need, and it is increasing and it is inevitable.
So how do we gain exposure to this reinvestment dynamic. Cardno is a case in point. The engineering, environmental and other services it provides offer a direct tap into to the need for governments and companies to invest in their fixed assets.
Another is Emeco. Emeco rents large scale mining capital machinery to the mining industry. With the mining downturn little investment in this class has occurred for many years. Emeco (after it completes its recently proposed acquisitions) has a relatively young fleet and will benefit significantly as the mining industries equipment continues to age and fail, and companies look for other alternatives (such as renting Emeco’s equipment!).
We are alert to other equity investment opportunities that provide exposure to this dynamic. However, we note that the timing of when such opportunities may arise is outside our control.