Major investments - including increased capital expenditure (capex), expanding the business overseas, and acquisitions of adjacent businesses - are seen by many management teams as being a great way to increase shareholder returns.
However, the evidence in Australia is that capex-lite companies - those companies that invest less than 10 per cent of sales in capital expenditure - deliver higher shareholder returns (stock price increase, plus dividend income) than Australian capex heavy stocks.
In Australia, between 1989 and 2014 investors would have received a 600 per cent higher return if they had bought shares in the lowest capex to sales companies and sold shares in the highest capex to sales companies.
Basically, the additional returns on new capital expenditure in capex heavy stocks were insufficient.
Capital management strategies - whereby companies return capital to shareholders in the form of dividend increases or share buybacks - are associated with a better shareholder experience than major investment projects. Increased dividends and share buybacks provide a strong signalling impact to investors as companies have to be confident about future profitability to deliver on distribution guidance.
Importantly, dividends and share buybacks align management with shareholders and limit the quantum of capital available for management to grow for growth's sake. This forces the company's management to focus on the true owners of the company - shareholders.
Stock buybacks provide an important benchmark for company capital management. Buybacks should be considered in the same context as capital expenditure or growth by acquisition.
A buyback is essentially swapping debt for equity, which if implemented at appropriate stock prices increases earnings per share and enhances shareholder value.
Given the low debt levels on most New Zealand company balance sheets, and relatively high levels of debt availability, modest buybacks undertaken at appropriate share prices may provide a better earnings booster at lower risk than major expansion or acquisition projects.
Recently Contact Energy and Tower, both with modest growth, have taken different capital management paths - as have their stock price performances.
In mid-February this year Contact Energy announced its profit results for the half year to December 31.
As part of the announcement Contact declared a dividend that was below market expectations, and that the Contact board was undertaking a dividend policy review noting that "distribution of forecast free cashflow increase through dividends may not be efficient, requiring alternative distribution methods".
Management also stated that Contact may be considering international growth ambitions. Contact's share price fell 10.7 per cent from the day before the announcement to the end of February as investors considered governance and management investor alignment issues associated with these statements.
In contrast, Tower announced as part of its profit results at the end of November, for the full year to September 30, it would undertake $34 million of share buybacks funded from the release of capital from selling Tower Life (NZ). Over the following month the Tower share price rose 10.8 per cent, outperforming the NZX50 benchmark index by 10 per cent . The $34 million buyback announced in November came after Tower returned $56.7 million to shareholders via share buybacks in January 2014 and September 2014. Over the period from January 1 last year to March 31 this year Tower has delivered a 47.5 per cent return to shareholders, which compares well against a 23.2 per cent return for the NZX50 benchmark.
Investors also need to focus on the sustainability of capital returns. Running companies hard financially puts competitiveness and cashflows at risk. Investors need to ask some key questions surrounding increased shareholder distribution, including:
Is the company's existing asset base up to the task? Profitability deteriorates if assets are not productive.
Do short-term management decisions "steal" from the long-term capabilities of the firm? Is the business keeping up with new technology? Is the business investing enough in research and development to offset the maturing of existing products and services?
Does reduced investment expose the business to increased environmental, social or regulatory risk? Is the business investing enough in environmental, social and governance practices to create long-term societal value and higher profitability even if it means incurring some short-term profit pain?
Does the company have a significant comparative advantage that justifies increased investment in growth opportunities? True growth investments and companies are hard to find and tend to be the exception.
Investors should favour investing for growth over capital management where future returns are likely to exceed appropriate return hurdles, where returns are delivered within a reasonable period of time, and for risks that are manageable by company management.
Where companies invest for growth they arguably need to deliver higher returns on this higher risk investment when compared to investment required to support the company's existing business.
Investors will support companies with proven growth investment track records (for example, F&P Healthcare), barriers to entry (for example, Auckland Airport) or those with clear innovation (for example, Pacific Edge).
In a world where "unknown unknowns" can test even the best management teams, a considered approach to capital management provides a solid platform for future shareholder returns.
• Shane Solly is a director, portfolio manager and research analyst at Harbour Asset Management. This column is general in nature and should not be regarded as specific investment advice.
