29/10/06
US Market Outlook
At a time when many companies are facing a slow down in growth it is imperative for investors to keep a close eye on how company managements are reacting. More shareholder friendly managements will deploy the company's cash flow in investments or acquisitions that truly add to shareholder value in contrast to some who desperately attempt to keep earnings growth going by spending on internal projects or acquisitions that do not add shareholder value. In many instances a company can spend cash that is sitting almost idle on its balance sheet on acquisitions that will not earn returns that most investors would consider adequate. The company's management teams will tout that a particular acquisition is accretive to earnings, meaning that post the acquisition, future years earnings per share will be higher than previously expected. While earnings levels and growth rates are very powerful in determining the relative performance of share prices, managements often assume with a higher quantity of earnings that the company's price to earnings multiple will remain constant, propelling the share price higher. If the acquired business does not fit well with the company's existing business or if it requires management expertise that the new owners lack, the price earnings multiple may contract leaving the shareholder no better off than before. In the current environment when growth opportunities are limited and corporate balance sheets are strong it is important the management teams invest the company's cash flow appropriately or give it back to shareholders in the form of dividends or share repurchases.
Precisions Castparts, a manufacturer of complex metal products, is a company that has demonstrated it can repeatedly use its cash flows and its balance sheet to make acquisitions that enhance shareholder value. In August of 2005, Precision Castparts announced that it was spending $540 million to acquire Specialty Metals Corporation, a producer of higher performance nickel alloys and super alloys. Since the acquisition closed in May of 2006, Precision Castparts has been able to improve performance of the acquired business faster than anticipated with its stock price reflecting the increased value of the acquired business. Shareholder value is created as the management team applies its expertise to the acquired company, generating returns investors could not likely create for themselves.
As important to knowing how to spend cash is when to give the cash back to shareholders. Large companies such as Bank of America can't effectively spend all the cash coming in the door. While a bank can lend money quickly, competent management teams will recognise that there is a limited amount of good loans to be made and the excess cash should go back to shareholders. While Bank of America has been an active acquirer, the company has also returned a significant portion of cash flows to shareholders. Bank of America currently generates a dividend yield over 4% and has grown its dividend at a 13% annual growth rate over the last 5 years while also actively repurchasing its own stock.
How a company's management uses its cash flow is imperative to long term stock price performance. Often the market will be comfortable that a company's management can run its existing business well but at the same time be concerned if that same management team has a significant amount of cash or borrowing capacity at its disposal. This fear is often well founded, as many acquisitions are made that increase the size of the company's earnings stream but not necessarily adding value to shareholders. At a time when growth rates are slowing for many companies, it is important for shareholders to be wary of actions a management may take in an attempt to keep growth going.
Jeff Morris, Vice President, Standard Life Investments USA
First published in International Investment in December 2006
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