Capital Markets: The Paradigm Shift

This year’s return of persistent inflation has been damning for investors. After decades of subdued price pressures, we are experiencing the pernicious effects of this difficult-to-control phenomenon. The question on everyone’s mind is: when will inflation be under control?

As investors, we believe the better question is what will the capital markets environment be like in the next era, and who will prosper in such an environment?

Capital has been abundant and cheap for a decade. This potent amalgamation gave rise to an era of capital superabundance, which led to an avoidance of the lessons taught in Corporate Finance 101 classes. Namely, conservative hurdle rates, rationale NPV calculations, and the pursuit of allocating company resources only toward opportunities capable of generating the highest returns were replaced with a mindset favoring growth opportunities supported by cheap and readily available funding.

With interest rates rising and the tide of capital receding, the capital-as-a-scarce-resource concept is returning. The next generation of top performers will adapt to a capital scarce environment, making the pursuit of growth at all costs unsustainable. This will require the CEO to return to her ultimate duty of skillful capital allocation - investing scarce company resources in pursuit of opportunities providing the highest return

Background

The Federal Reserve's scope, as stated in the “The Federal Reserve System Purposes & Functions” is such:

The Federal Reserve conducts the nation’s monetary policy by managing the level of short-term interest rates and influencing the availability and cost of credit in the economy. Monetary policy directly affects interest rates; it indirectly affects stock prices, wealth, and currency exchange rates. Through these channels, monetary policy influences spending, investment, production, employment, and inflation in the United States. Effective monetary policy complements fiscal policy to support economic growth.

Following the Great Financial Crisis (“GFC”) of 2007 - 2008, the U.S. entered a period of tepid economic growth while monetary policy remained accommodative and inflation subdued. The Fed’s policy kept rates historically low for a longer period than any other time in its history.

The chart below shows the Fed rate policy over a longer time horizon and various economic cycles. This helps us understand not only the gravity of the low-rate environment - how far we have been from more normal times - but also where a potential reversion of these measures may lead.

Federal Funds Effective Rate: 1955 – 2022

Additionally, the Federal Reserve instituted Quantitative Easing (QE) to increase the money supply and further stimulate economic activity. QE is a GFC innovation, and while there is less history, the data in the chart below makes clear that the Federal Reserve has been persistent in expanding its balance sheet, which accelerated dramatically during Covid.

Federal Reserve – Total Assets

These policies led to lower and lower bond yields across the risk spectrum – i.e., borrowing costs dropped over the decade - as shown in the Aaa Corporate Bond Yield and US High Yield Index charts below.

Moody’s Seasoned Aaa Corporate Bond Yield: 50-Year History [1]

Comparing the period “Before 2012” to “After 2018”, the capital markets landscape has been markedly different. At no point between 1972 and 2012 were high-grade rates below 3% and rarely below 5%. Since 2018, high-grade rates were always below 5% and most of the time below 4%!

ICE BofA US High Yield Index Effective Yield [2]

The same story is told through the High Yield Index data. After 2018, lower credit borrowers accessed capital at sub-7.5%, rates rarely seen before 2012. Additionally, the notional amount of high-yield issuance was high over the past decade, peaking in 2020 – 2021. This indicates that cheap capital was available to a broad range of lower credit borrowers.

The point is to recognize we have not been in a steady-state environment for more than a decade. Instead, the economy has been operating in an environment supported by artificially low bond yields. This created a set of learned behaviors, including reliance on readily available and low-cost funding, that likely won’t persist.

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Prolonged low interest rates have had a two-sided effect. First, they provide borrowers access to cheap capital. These low-cost funds are then used for organic growth opportunities – like capital expenditures, research & development, pursuit of new ventures, general working capital needs – or inorganic growth like acquisitions. Additionally, businesses can use cheap funding for financial activities like retiring costly debt or share buybacks and dividends.

The combination of low-cost funding and market incentives to pursue growth motivated management to relax historical return hurdles in pursuit of top line growth opportunities. The days of pursuing only “sure bets'' were replaced with “scale-as-fast-as possible.” Slow-moving companies invited fast-moving entrants backed by seemingly endless sources of funding from venture capital firms, commercial banks, or sophisticated funds.

This created feedback loops as business leaders were compelled to tap the same cheap capital to pursue expansion and compete with new market entrants. It was competition for not only market share, but also talent retention.

Investors, on the other hand, were forced up the risk spectrum in pursuit of higher yields. As more capital moved into riskier assets, yields across the risk spectrum were further suppressed.

This occurred on a grand scale, from pensions and endowments, to private equity and hedge funds, to individual investors. Investors balked at money market funds and bank accounts providing no yield on deposits, while CDs offered only a few basis points of improvement. Treasuries offered a slight improvement, and safe corporate bonds a bit more – but not enough to make a pensioner happy.

For investors, the cost of borrowing through leverage, margin accounts or outright bond issuances - as in the case of pensions – declined. These low-cost funds could be used to pursue higher-returning (risky) investments. So investors went further out on the risk spectrum seeking higher returns.

The media even created a new investing acronym to describe the environment - TINA – for “There Is No Alternative” to stocks.

Equity Markets Created Reinforcing Behavior

The low capital cost environment supported higher equity valuations. For the C-Suite, a new game developed: show big growth numbers and the pursuit of a huge market opportunity or Total Addressable Market (“TAM”). Many firms embraced this framework, ranging from early-stage ventures to more mature companies. A simplistic graphic representation in corporate presentations would look something like this:

Building on the TAM in support of its future opportunity, a company would show huge growth rates from the preceding few years. Yet the cost of such growth mattered not, partially because, the cost of growth was naught!

Investors salivated over opportunities for exceptional growth in pursuit of TAM dominance. The logic held that by owning and dominating a particular market, scale benefits would emerge and profits would follow. The days of conservative capital allocation seemed antiquated.

Valuations were conjured based on the following logic: if “X” company can dominate an industry like:

1. Google dominates search

2. Microsoft dominates business tools

3. Amazon dominates ecommerce and cloud services

4. Facebook dominates social media

Then the company will be worth “x” billions. The implied market cap could be backed into by engineering a TAM, determining a “winner-takes-all” portion of the TAM and applying scale benefits to show extraordinary future cash flows.

In a world with abundant cheap capital, where investors known as “APES” buy “STONKS” (not stocks) under a “YOLO” mentality, who’s to say that this wasn’t the right approach?

A relatable yet more subdued example is Netflix. The company pursues a large TAM that is supported by global scale and strong paid-streaming subscriber growth.

How did Netflix accomplish this remarkable growth? Take a look at the bond issuance table below covering the previous decade.

Source: Netflix, Inc. - 2021 10-K

To attract subscribers, Netflix needed to grow its content library. That required funding beyond cash flow generated from operations. Despite Netflix’s assertion that “Since 2013, we've been at a scale where we can economically create original content for Netflix …”, the company has tapped the debt markets every year since 2013. The cheap capital supplied by lenders allowed the firm to expand its content library, which in turn increased its value proposition and attracted more customers.

Netflix’s strategy was clear – be the dominant player in content streaming. The thinking was once the company has scale it will generate enough subscriber cash flow to pay off the debt and grow free cash-flow-per-share for the shareholders.

However, a funny thing happened. Netflix still hasn’t generated sustained positive operating cash flow. Since “content is king,” the company continues to invest additional capital in “content assets” to attract and retain subscribers. Competition offering viewers more options has ramped up, creating further challenges for the company. Once viewed as an affordable form of entertainment, it appears that customers are price sensitive and churn has increased. Netflix realizes that tapping capital markets ad infinitum is unsustainable, and the company has changed its monetization strategy to include advertisements, something CEO Reed Hastings has long disdained.

All of this to say that Netflix isn’t a bad case study. Stockholders have compounded over 20,000% since IPO, and Netflix’s ad monetization strategy should unlock a gusher of near-perfect margin revenue (save for Microsoft’s cut). The point is Netflix’s mentality reflects the behavior of the prior decade – grow as fast as possible fueled by low-cost and abundant capital without worry about profitability since “scale benefits” will eventually kick in, driving extraordinary future profits. While this super-charged growth strategy may end up working for Netflix, given the rapid rise in the cost of capital, it’s not likely to work for the company or others going forward. It also highlights an important realization by management that a change in business strategy was needed to open new revenue sources and achieve positive free cash flow.

The Netflix case can be widely applied to the capital markets ecosystem. The search for large growth opportunities eventually led to valuation metrics not based upon profitability or cash flow but on sales or TAM. In COVID-stimulated 2020 - 2021, even companies that had zero revenue may have been awarded high valuations. The frothy environment led to the re-emergence of SPACs, special purpose companies, that raise capital in public equity markets by luring investors seeking a return in an otherwise low-yielding environment with the hope of acquiring a company in the future. Unfortunately, it’s the sponsor who benefits the most.

Investors, eager to gobble up anything with future promise, sent valuations to nosebleed levels and pushed the IPO market into hyperdrive. The IPOs in 2020 and 2021 earned record-high valuations yet had record low profitability and, unsurprisingly, were mostly funded by financial investors.

Source: Initial Public Offerings: Updated Statistics Jay R. Ritter

Behaviorally, sky-high valuations awarded to a rosy future changed the game for the C-Suite. Profitability became a secondary concern. The focus was growth, even if it was unprofitable growth. When a company was in danger of running out of money, the fix was simple – raise cheap capital and keep the game going.

As Charlie Munger said: “Show me the incentive, and I will show you the outcome.” With Total Stock Return being the most favored metric for long-term incentive plans, the C-Suite pursued a short-term game that drove incentive compensation – boosting the stock price.

However, as the Fed fights inflation and pursues a more restrictive monetary policy, capital availability will diminish and cost of funding will rise. With rising capital costs, the low-cost playbook won’t be possible.

For investors, this presents a difficult challenge – identifying which corporate leaders were simply being opportunistic versus those using the accommodative conditions to mask underlying issues. With abundant capital, almost any plan – acquisition, pivot, or anything in between – could be approved.

The era of capital superabundance is over, for now (…or forever?). Inflation and interest rates have ended the party even if the partygoers don’t know it yet. The pursuit of growth-at-all-cost, with an increasingly expensive cost, is unsustainable.

Capital Allocation – Reversion to the Mean

Creating long-term value on a per-share basis is management’s ultimate objective. Management must decide how to deploy the firm’s resources; and that decision must seek the most attractive opportunities out of all those available to the company. Capital allocation decisions are core to every business. If the CEO focuses on thoughtful capital allocation and long-term value creation, the stock will do well over time.

A CEO has four main uses for cash flow: (1) reinvest into the business in pursuit of organic growth, (2) acquire another firm or assets in pursuit of inorganic growth, (3) pay down debt, and (4) return capital to shareholders through (a) dividends or (b) share repurchases. When returning capital to shareholders, repurchases are favored because of tax efficiency and increases in the per-share value of the firm.

Rational capital allocation acknowledges that each dollar has a cost associated with it. Simply, rational capital allocation requires that every investment - whether in the labor force, working capital needs, new projects, capital expenditure, or acquisition - has a positive net present value of cash flows.

• This means the return on the investment must be higher than the firm’s cost of capital.

• The investment should be made if it earns a higher return than the cost of capital, i.e., generates an economic profit.

• If the investment does not meet those objectives, it should not be made. Management teams that pursue growth opportunities earning less than the required hurdle destroy shareholder value – not all growth creates per share value

• With limited resources for investment, management should focus only on opportunities generating the highest returns. This allows talent to be focused as opposed to being spread too thin on various projects.

• If no investment opportunities can earn a return above the firm’s cost of capital exist, then cash should be returned to shareholders.

• Most importantly, capital allocation decisions should always align with a singular goal – long-term growth in free cash flow per share.

Amazon founder Jeff Bezos’ brilliant 2004 Annual Letter provides a simple, albeit counterintuitive, example of how a company can “impair shareholder value in certain circumstances by growing earnings. This happens when the capital investments required for growth exceed the present value of the cash flow derived from those investments.” He provides an example of a transportation business that can rapidly grow both sales and earnings, but requiring significant ongoing CAPEX. The income statement suggests the business is healthy with remarkable top- and bottom-line growth of 100% each year. Cash flows, however, tell a different story of high cash burn. It turns out the no growth scenario was the only one to generate some cash, but the NPV of this cash flow stream was still negative. The investment should not have been made under any scenario, and the business is fundamentally flawed.

Bezos then leaves us with what is important for him at Amazon:

Our Most Important Financial Measure: Free Cash Flow Per Share

Amazon.com’s financial focus is on long-term growth in free cash flow per share.

Amazon.com’s free cash flow is driven primarily by increasing operating profit dollars and efficiently managing both working capital and capital expenditures. We work to increase operating profit by focusing on improving all aspects of the customer experience to grow sales and by maintaining a lean cost structure.

The Conundrum of Capital Allocation

In a sense, allocating capital to pursue rapid growth may have been rational since the cost of capital was de minimis. However, those costs are real today. In an era where capital costs were distorted, few CEOs acquired the necessary skills to operate in a higher-cost environment. Therefore, there will be an adjustment period while CEOs learn to reconsider the opportunity cost of capital and how to allocate wisely.

In 1987, Warren Buffett detailed the conundrum of capital allocation.

This point can be important because the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.

Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.

The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.

CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie [Munger] and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.

In the end, plenty of unintelligent capital allocation takes place in corporate America. (That's why you hear so much about “restructuring.”)

Fast forward 35 years and the issues are super-charged.

Many executives won’t learn the lessons of capital scarcity until it’s too late. Chasing growth has been ingrained for too long for a quick about-face. Eventually the market will respond and take care of them. As capital costs rise and scarcity increases, CEOs looking for cheap capital to keep the growth plans intact will soon realize the hard truth.

In some cases, this will lead to a death spiral. Managers will face the unenviable position of deciding between the lesser of two evils. The first is taking on high-cost debt, which may have no chance of being serviced in its entirety. The second is a share issuance whose dilution is exacerbated because the share price fell and valuation compressed. These are tough pills to swallow.

However, there will be opportunities for wise capital allocators. In a zero-sum game, stronger entities stand to benefit as weak competitors are forced to sell at discounted prices. Additionally, savvy management teams understand that a bear market may push shares well below intrinsic value and create opportunity to repurchase shares cheaply and increase the value of the firm on a per-share basis. In William Thornedike’s, “The Outsiders,” a book worth revisiting given the era, he states:

“At the core of their [the Outsider CEO’s ] shared worldview was the belief that the primary goal for any CEO was to optimize long term value per share, not organizational growth. This may seem like an obvious objective, however, in American business, there is a deeply ingrained urge to get bigger. Larger companies get more attention in the press, the executives of those companies tend to earn higher salaries and are more likely to be asked to join prestigious boards. As a result, it is very rare to see a company pro-actively shrink itself. And yet virtually all of these CEO’s shrank their share bases significantly through repurchases.”

This passage lays it out. The North Star for CEO’s has always been optimizing long-term value (read: cash flow) per share. Paradoxically, growth and the allure of being larger – without being tied to growth in intrinsic value per share - has a magnetic pull on many managers. Counterintuitively, optimizing long-term value per share has often meant shrinking, specifically the share count (i.e., denominator) not always growing, specifically, cash flow (i.e., numerator). In an ideal world, we shrink the share count while growing FCF.

While growth is the lifeblood for any company, it must be pursued with discipline and in a manner that maximizes long-term value per share. There is plenty of evidence that opportunistic acquisitions, capex spend, R&D spend and investment in working capital help a business grow long-term value. But these cannot be done for the sake of growth – management teams must avoid the institutional imperative. Capital allocation must be disciplined and follow the North Star – maximizing intrinsic value on a per share basis.

[1] Moody’s, Moody's Seasoned Aaa Corporate Bond Yield [AAA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/AAA, October 17, 2022 [2] Ice Data Indices, LLC, ICE BofA US High Yield Index Effective Yield [BAMLH0A0HYM2EY], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY, October 18, 2022

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