2020 Corporate Investment Outlook

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Heading into 2020, many companies are sitting on large amounts of cash to invest. They’ve been investing in share buybacks, which has the potential to artificially boost share prices. This can explain why the markets continue to break record highs despite earnings growth slowing down. Share buybacks have been such a widely used tool that companies are even taking out debt in order to invest in their own shares. Given the global uncertainties that are beginning to clear up, I suggest that companies look more towards long-term investments through attractive M&A deals as well as putting cash towards R&D and their operations. In this post, I will elaborate on the impact of share buybacks and explain why I see M&A as a better strategy for free cash flow allocation in the new year.

With an emphasis on liquidity and with corporate cash stockpiles growing under the Fed’s “easy money” policies, companies are putting their cash towards buying back their own shares. In a share buyback, a company buys its shares to decrease the number of shares outstanding, therefore decreasing its capital structure’s proportion of equity to debt. This has an effect on a company’s EPS (earning per share) and can explain why so many companies beat their EPS expectations despite a slowdown in earnings growth. According to an article in the Wall Street Journal, “Companies on the S&P 500 have poured more than $5.3 trillion into repurchasing their own shares since 2010” (WSJ). This number helps explain why the market has been thriving despite looming macro uncertainty. Along with the EPS boost, stock prices have already priced in earnings growth for the coming year which will help keep the market trending upwards (Barron’s).

Share buybacks are a way for companies to give back to their shareholders by helping to increase the share price. However, given the context of the market in the past year, it seems as though buybacks are a defensive measure taken against uncertainty. It is difficult for companies to make large and risky investments when the future is tough to forecast. As confidence grows and uncertainty continues to clear up, companies should be investing their free cash flow holdings into capital expenditures, R&D, and M&A activity (especially with share prices so high, companies can implement stock deals as a way to fund their transactions). M&A transactions help companies add value to their business in an attempt to gain a competitive advantage by increasing in scale, expanding, and eliminating competitors.

Long-term sustainability is important when it comes to the strategies that companies decide to implement in 2020 because they are being held more accountable through the increase in activist investors. Activist investors have played a big role in influencing a company’s organizational structure and the way in which it invest its resources. This is a proponent that will continue to drive trends in capital allocation and strategy. With these activists keeping a close eye on corporate behavior, companies will have to move away from short-term investments and decision making, which could suggest that buybacks won’t be as popular. This means that companies should look to pursue M&A strategies, specifically focusing on their core competencies in order to increase the size and quality of their operations instead of diversifying into industries that don’t necessarily make sense for that business. M&A transactions that veer too far from a company’s business model could serve to create a complex conglomerate that would be exposed to risks that would have otherwise been avoided. Especially with regulatory reform in mind and the increased scrutiny on mega-corporations, companies should use M&A as a means of strengthening what they do best.

As 2020 begins, the concerns investors face should begin to resolve. Brexit was one of the biggest factors standing in the way of long-term investment, especially in England. With the process seeming to come towards its eventual conclusion, confidence will be restored. The phase one deal between the US and China will also boost sentiment by promoting international trade and engagement. It is yet to be seen what the tensions in Iran will culminate to, but 2020 does look to be more encouraging for investors looking to take on more risk. On a corporate level, this means engaging in more frequent M&A transactions (as in more volume instead of being driven by mega-deals) while putting money into growth through PPE (property, plant, and equipment) and other R&D projects. Share buybacks will continue to be a widely used tool, especially during earnings season, but given the outlook for the upcoming year, it should not be the first place companies look to invest their free cash flow in.

– S.F

References

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