Corporate Capex Fallacies and Why You Shouldn’t Rely on CNBC

We get experts on everything that sound like they’re scientific experts … They’ll sit at a typewriter and make up all this stuff as if it’s science and then become an expert … Now, I might be quite wrong, maybe they do know all these things. But I don’t think I’m wrong. You see I have the advantage of having found out how hard it is to get to really know something … how easy it is to make mistakes and fool yourself. I know what it means to know something. And therefore, I see how they get their information and I can’t believe that they know it. They haven’t done the work necessary. They haven’t done the checks necessary. They haven’t done the care necessary … and they’re intimidating people.

-Richard Feynman, Nobel Prize-winning physicist

The excerpt is from a 1981 BBC documentary about Richard Feynman that was linked in a Zero Hedge post several years ago. Unfortunately, Feynman passed away in 1988 and never had the chance to watch the “experts” on financial television. We would have particularly liked to hear the great physicist’s thoughts on economics punditry.

To understand economics experts in Feynman’s absence, the best analogy that we can think of is to the methods of a magician. Magicians operate by showing their audience a small window on reality, and then tricking people into mentally filling in the rest incorrectly. Because the economy has so many moving parts, a similar approach also works in economics. Pundits can draw our attention to a couple of indicators, ignore everything else, and make claims that sound realistic even though they make little sense in the bigger picture. One difference between economists and magicians, though, is that economists are often unaware of their trickery because they fool themselves before fooling others.

To be clear, we don’t claim to be immune to such deceptions, but we do try to root them out as best we can and will do that here.

We’ll look at capital expenditures (capex), in particular. You can’t take in much media commentary today before finding someone arguing that capex is lower than it should be. Crystal ball gazers predict a capex resurgence that lifts the economy into a robust recovery, while pundits with an activist bent implore businesses (and public officials) to ramp up their investments.

There’s usually some combination of four pieces to what we’ll call the “CNBC” story:

  1. Corporate cash is high
  2. Net investment is low
  3. Bond yields are low
  4. Corporate profits are high

These four observations are said to demonstrate that businesses are behaving irrationally or improperly by not pushing capex higher. And the story may sound reasonable on the surface, but is it really that simple?

To dig deeper, we’ll critique the proposition linked to each observation, while testing them with over 60 years of data.  Our results show that the CNBC story is yet another careless economic illusion.

Proposition 1: Corporate cash is high, and therefore, businesses should put that cash to work through capex.

Comments: This is the most obviously deceptive of the four propositions, hence Mark Spitznagel’s incredulous response when asked to address cash balances by Maria Bartiromo last week. As Spitznagel explained, it makes little sense to isolate the cash that sits on corporate balance sheets without netting the credit portions of both assets and liabilities. We last updated corporations’ net credit position here, showing that gradual increases in cash balances are dwarfed by rising debt.

A longer history further disproves the proposition; it shows that there’s no correlation between capex and corporate cash:

capex and cnbc 1

Proposition 2: Net investment (capex less depreciation) is unusually low and should be much higher at this point in the business cycle.

Comments: This argument implies that businesses should invest more when depreciation is higher, as that’s the only way to drive the net amount of investment towards “normal” levels. Our criticism is that it combines current capex with an accounting measure of depreciation on past capex. This is extremely misleading after periods of malinvestment, in particular, when the capital stock is too high for the level of demand. Unusually high depreciation after such periods is a sign that capex should be managed carefully to keep the capital stock from further outpacing fundamentals, not increased blindly to maintain an assumed margin over depreciation. Therefore, net investment fails to tell us anything about the “right” amount of capex.

Turning again to the last six decades, data confirms that the second proposition is just as faulty as the first:

capex and cnbc 2

Proposition 3: Low interest rates should encourage more capex.

Comments: This is a trickier proposition than the first two, since low rates should certainly spur higher spending when other factors are held constant. The problem is that other factors are never constant. On the contrary, low rates are typically associated with a challenging economy, and this is especially true in today’s highly manipulated markets. The Fed seems to be discouraging long-term investment in some respects by holding rates well below where they would otherwise be. As perceived by us and many others (including Spitznagel per the interview linked above), the Fed’s approach raises long-term risks while drawing capital into short-term financial strategies.

Needless to say, this isn’t the ideal environment for capex. It’s not that companies aren’t taking advantage of low rates; they’ve increased borrowing substantially as noted above. It’s just that the proceeds of that borrowing aren’t flowing into capex as much as they would in less manipulated markets.

Moreover, history once again refutes the proposition. Adjusting corporate bond yields for inflation, the chart below shows that capex has tended to be slightly lower than average when real yields are low:

capex and cnbc 3

Proposition 4: Record corporate profits should encourage more capex.

Comments: Here’s a proposition with empirical support, finally. Although the relationship isn’t especially strong, the chart below shows that high profits have tended to coincide with high capex, and visa-versa. We highlighted the latest figures to show that they sit below the regression line:

capex and cnbc 4

There are two reasons not to get too carried away, though. First, the surge in profits is explained mostly by extremely high margins and tight controls on expenses. When businesses boost profits though expense reductions instead of revenue growth, there’s more than a little circular logic in the idea that their success calls for higher spending.

Second, there are other, offsetting considerations suggesting that businesses are wise to limit capex growth to a modest pace. In “What Needs To Happen Before We See a Big Recovery,” we listed four reasons to doubt the capex boom that many pundits predict: ample unused capacity, tepid overseas growth, growing financial risks and President Obama’s bumbling incursions into private markets. Unfortunately, the financial risk and policy factors aren’t as testable as the propositions above. We tested capacity utilization, though, and here are our results:

capex and cnbc 5

Lo and behold, 2013 capex fell almost directly on top of the regression line. This shows that businesses may not be so irrational after all, in view of the excess capacity that still remains after the last decade’s overinvestment. And together with the first three charts above, it tells us that capex fundamentals aren’t as simple as “CNBC” would have you believe.

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2 Responses to Corporate Capex Fallacies and Why You Shouldn’t Rely on CNBC

  1. Mickeu says:

    College corp finance class taught me 40 years ago that when a growth company becomes a cash cow it is no longer a growth company.

    Further when we have 5 years of little growth and reduced capex,depreciation expense declines and voila, companies are more profitable.

    Just look at retail sales and housing. No growth. Tell me agian why does a company need to expand? Auto sales? Only if there is subprime financing. Then they count inventory build at dealers as a sale.

    We have a real mess on our hands. Stagflation might be our best case scenario.

  2. Anonymous says:

    Good article
    I recently wrote an article on low levels of capital investment / business startups since the last recession. The two most likely causes are low long-term confidence among business leaders from the anti-business sentiment (rhetoric, taxes and regulations) coming from the Obama Administration (especially a lawless President “making” laws without Congress acting) … and possibly eight years of Hillary Clinton … plus the fact that most CEO’s/executives of public corporations are rewarded for short term stock market / earnings performance (if they reduce capital spending, they increase short term earnings = higher bonuses for them.). (Andrew Smithers data)

    My research shows all net US jobs growth in the long run is from business startups (businesses up to one year old) — there is a net decline of jobs for businesses two or more years old. (Kaufmann Foundation data). So the capital investment that adds the most jobs must be the money spent on launching new businesses.
    ECONOMIC LOGIC

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