Yesterday, Bill Gross was once again pounding on his bottom-line solution for rebuilding a healthy, growing U.S. economy: Companies must invest in “making things and making them better.”
From the founder of Pacific Investment Management Co. (Pimco), one of the most powerful and sophisticated investors in the world, it’s an enticingly common-sense solution – innovation fuels growth.
Too bad the stock market doesn’t buy it.
A new study from global securities firm UBS AG found that over the past 15 years, companies worldwide that invested the least in innovation (defined as research-and-development spending as a proportion of sales) significantly outperformed industry peers that spent more on innovation. Indeed, they found that in most sectors, investors favoured higher-than-average dividend payers over higher-than-average R&D spenders.
Rather than viewing innovation as a positive, investors appear to view high innovation spending as an additional risk – and discount the stock accordingly. “The pursuit of innovation is risky, costly and time-consuming – and the results are certainly not guaranteed,” the report said.
The findings dovetail with a recent study from Standard & Poor’s, showing that S&P 500 companies paying dividends or instituting stock buybacks outperformed the overall market over the past three years. The best performances came from those with the biggest and most frequent buyback programs, and those with the highest dividend payouts.
S&P equity analyst Stewart Glickman, the co-author of the report, said this points to a fundamental dilemma for investors. They must choose long-term growth potential versus quick, reliable returns on their investments.
“The stock market is generally going to value companies based on their free-cash-flow generating capacity. A lot of that depends on growth,” he said. “At the same time, roughly 40 to 45 per cent of the returns on the S&P 500 over the past 80 years have been generated by dividend reinvestment. You can’t dismiss that.”
Cash Distributions vs. Long-Term Growth
The balancing act between growth and immediate returns was at the heart of the income-trust debate that led the federal government four years ago to change the tax law for these high-cash-paying investment vehicles, essentially declaring an end to trusts when the new law takes effect Jan. 1, 2011. Policy makers had grown concerned that the boom in conversions to the trust structure was discouraging reinvestments in business that would fuel innovation and productivity growth.
As a result of the tax change, many companies are now testing the market’s appetite for investments less focused on cash distributions and rededicated to investing in their long-term growth. One such trust is Penn West which intends to convert to a traditional corporate structure at the start of next year.
Penn West sees the conversion as an opportunity to reinvent itself as an oil and gas growth company – and to leverage technological innovation to do it. The company has cut its cash payouts by 74 per cent in the past two years while ramping up its capital spending on oil and natural gas exploration and development, using horizontal drilling innovations.
The company started cutting its distributions in mid-January of 2009, and by early March the price of its trust units had sunk 42 per cent – although the company is quick to point out that this coincided with the depths of the bear market. As investors have developed a greater understanding of the company’s new direction in recent months, its price has rebounded and is up nearly 30 per cent in the past year.
“I believe that the market embraces innovation and an aggressive posture,” Penn West chief executive officer Bill Andrew said in an e-mail interview. However, he also noted that the shift away from the high-payout trust structure has attracted a different kind of investor – and increasingly, it’s a foreign investor, rather than the Canadian retail investor who used to favour trusts.
“I believe we take for granted the truly innovative and positive side of many Canadian companies inside Canada, and that it takes the less familiar eye outside Canada to see the potential that exists for many Canadian companies,” he said.