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April 24, 2005

Underinvesting in UK PLC?

Bit of a woods and trees discussion going on here about the investment practices of UK companies:

UK plc is afflicted by a poverty of ambition. Many companies seem to have run out of ideas of how to grow. Capital expenditure among non-financial companies is now just 6 per cent of sales, according to Morgan Stanley - down from a more normal 8 per cent.

Many bosses can't think of anything more interesting to do than hand back cash to investors via dividends and share buybacks. Nearly 70 per cent of earnings are being distributed in this way, up from a more normal 50 per cent.

Many companies think an investment is only good if it generates returns of between 15 per cent and 20 per cent. But we are now living in a low-return world: 10-year gilts are yielding only 4.6 per cent. Investors in publicly quoted equities have gradually woken up to that. High single-digit returns are what rational investors expect now. It's not much use if companies forgo the chance to make, say, a 10 per cent return and hand them back the cash. Will they be able to reinvest it any better?

Private equity houses, too, have been adjusting to the lower return environment - by setting lower hurdle rates for the deals they do. Again, so long as public companies remain stuck in the past, that gives private equity an edge.

It is time that UK plc stopped whingeing and started investing.

Now I accept what’s being said about the ROI that is being demanded, it’s been a long term criticism that the internal targets are too high for this low interest rate/low return environment that we’re in.

However, I’m at odds with the idea that UK PLC are in fact the investors in UK PLC. Think of it this way, there’s a pool of savings and a pool of investment opportunities. We obviously want some method of allocating one to the other. What is being suggested above is that the returns from previous investments, those additions to the savings pool, should be allocated by  the management that made those previous returns. In a sense, yes we do want this to happen, we do want them to invest sufficiently to keep their business going.

Yet it is also quite clear that there are, in that pool of investment opportunities, things which do not neatly match up with the expertise and knowledge of already extant companies. New markets, new businesses, entreprenurial opportunities and so on. Again, quite obviously, these will be funded from the general savings pool.

Go a step further, where we think about what we really want from that pool of available investment. We want the best performance, of course, this being likely to come from the best of the new ideas being funded.

We would therefore want a system whereby companies that had made profitable investments to retain sufficient of those profits to keep their activities running and growing, and returning any excess over that back to the savings pool so that it can be allocated over all of the investment pool, not just those areas in which they themselves have expertise.

In effect, we’d hope to see what is actually happening, excess returns being paid out as dividends and share buybacks, available to be invested in the next TrafficMaster/White Nile/My Rhenium Plant. The fact that AIM is awash with new flotations, shells even, seems to show that the other side of the equation is also working.

In short, we want a system where the savings pool (including the returns from previous investments) is allocated impartially, without company level bias, across the available investment pool. That looks to be what we’re getting, and that’s a good thing.

April 24, 2005 in Economics | Permalink


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