almost 3 years ago • 4 mins
A whole host of companies have announced major spending plans this year, pledging to ramp up expenditure on things like manufacturing expansion, mergers and acquisitions (M&A) activity, and shareholder returns. In fact, Goldman Sachs forecasts US firms will spend 19% more in 2021 than they did in 2020 – but that isn’t necessarily good for you as an investor.
M&A, reinvestment, cash return: all three spending strategies have worked out well for companies’ share prices recently. Historically, however, one of these approaches tends to prove more rewarding while the others lag behind – so it’s worth looking at things through a long-term lens.
Buying up other businesses in order to quickly grow earnings can be an effective use of a company’s cash. The hope is typically that synergies will increase revenue, reduce costs, and therefore boost profit – or that a “strategic” deal will give the company a leg-up in the long term. Yet investors often fret that deals won’t work out: combining the companies might be harder than thought, meaning fewer profit-driving synergies, and there’s always the risk of overpaying for an acquisition that never turns out to be worth it. Bigger acquisitions bring more transformational potential – but history’s shown they destroy more value over time than they create, while smaller deals simply don’t make much of an impact.
Capital expenditure and research and development are two sides of the same coin: spending cash on additional property, plant, and equipment, or on developing new and improved products and services, with the idea being that these investments should help a company generate higher profit in the future. Investors generally value such “organic” earnings growth more highly than inorganic M&A-based increases, as it suggests a virtuous cycle of reinvestment. But the risky thing about this use of cash is that it relies on effective execution and potentially out-innovating rivals, both of which can be difficult to predict.
A popular use of company cash is paying shareholders dividends and buying back some of their stock. A regular dividend is redolent of a mature company with stable earnings, while buybacks suggest self-confidence. One downside to this approach, however, is that it gives a company less of a financial cushion should things go wrong, and may indicate to investors that it’s unable to think of a way to spend its cash that could make even more money in the future.
When you invest in a company’s stock, you’re probably used to thinking about the operational risks attached: the effect that fewer sales or higher costs than expected might have on its price. But you may be less likely to consider the risks accompanying a company’s use of cash. Those risks are partly operational, sure – a company earning less than hoped will have less cash to begin with – but they’re also very non-operational.
Let’s take Microsoft as an example. On the one hand, you’re buying into a giant tech company with largely stable earnings and regular dividends. But you’re also buying into a business that’s spent billions of dollars on acquisitions in recent years that arguably haven’t worked out. The same is true of Apple: you’re potentially benefiting from buybacks galore – but you’re also hoping it’ll continue to innovate better than rivals when it comes to hard- and software.
Depending on the sorts of financial goals you’ve got, you might be more happy taking some risks over others. In any case, analyzing companies’ uses of cash gives you another angle on assessing exactly what kind of investment you’re actually making.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.