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Holly LaFon
Holly LaFon
Articles (8057) 

Markets in Perspective: The Gannon Report Capex Revival - Royce Funds Commentary

March 13, 2013 | About:
Principal and Portfolio Manager Francis Gannon provides thoughts regarding the economy, the markets, and small-cap investing. Francis, a former panelist on Louis Rukeyser's Wall Street, has 19 years of investment management experience and joined our team in 2006."We continue to believe the U.S. is on the verge of an early capex recovery, one that is likely to have some considerable legs in our view given the fundamental and economic stability the U.S. offers its global partners. This is due to the defensive nature of corporate America over the past few years, driven in part by their general reluctance to invest cash into the business—aside from share buybacks and dividends. Unfortunately, many investors remain extremely skeptical in this regard given what has proven to be a challenging economic environment."

—Brian Belski, Chief Investment Strategist, BMO Capital Markets, [i]U.S. Strategy Weekly, February 1, 2013[/i]

For some time now, we have been noting the defensive nature of the investment environment, one in which fear and uncertainty continue to be the major forces driving markets. Interestingly, this trend has held true for both investors and corporations alike of late.

Even after a powerful move from the low of last November, for example, investors remain fearful about cyclical or economically sensitive sectors while at the same time embracing those very sectors that benefit from easy money, are defensive by nature, and are supposedly riskless.

It should not be surprising, then, that Real Estate Investment Trusts (REITs) and Health Care have been the best performing sectors year-to-date through the end of February, both advancing north of 9% while the Russell 2000 Index advanced 7.4%.

At the same time, corporate America, flush with cash, remains reluctant to invest that cash into their own businesses, aside from share buybacks and dividends. In fact, capital expenditures ("Capex") as a percent of U.S. nominal GDP stands at only 10.2%, up from the approximately 9% low in the recent recession but well below the prior peak of 14% and under the historic average of 11% (Source: ISI).

The average age of industrial equipment and manufacturing plants in the United States, according to ISI, are 5.8 and 15.5 years, respectively, the oldest since 1965.

More than five years after the Great Recession, there are several catalysts in place for the acceleration of capital expenditures that we believe could have a meaningful impact on many more cyclical businesses.

Corporate balance sheets are in generally excellent condition today and in many cases cash abundant. Yet while corporate profits are at record highs, top-line growth is being pressured by the lack of robust economic expansion.

As Brian Belski points out in his recent research report, "Sooner or later companies will need to invest in their businesses to provide themselves and investors with future growth opportunities." This search for growth, coupled with low interest rates and easing bank lending standards, is the perfect backdrop for Capex growth.

At the same time, the critical secular driver of Capex is what observers have called the U.S. "manufacturing renaissance" which is being fueled by a revival in U.S. energy production.

This aggressive investment in extracting oil and gas from shale formations has driven down natural gas prices to among the lowest levels in the world, giving the U.S. a significant competitive advantage that is leading many corporations, both foreign and domestic, to shift an increasing portion of production to the U.S.

Low natural gas prices are a boon to industries for which natural gas is a key feedstock—e.g., chemical producers—while all manufacturers are benefiting from lower electricity prices as a rising percentage of domestic electricity is generated by burning natural gas.

Billions of dollars in new or expanded chemical plants have been announced here in the U.S. We are also seeing utility plant conversions and Capex from companies building factories in the U.S. rather than abroad. In addition, more efficient energy exploration and production should also spur capital investment in energy transport infrastructure such as pipelines, rail track, and railcars, roads, housing, and the related capital equipment and construction materials—steel, cement, etc.—needed for these build-outs.

Perhaps Nancy Lazar, an economist at ISI, best sums up the opportunity: "Middle America is my favorite emerging market…"

Understanding a company's capital allocation decisions plays a key role in our investment process. To be sure, today's anemic economic growth environment is pressuring many corporations to invest in future growth.

The need for companies to hoard cash has passed. Prudent capital allocation should be the catalyst to a powerful investment cycle, one that we think will have a meaningful impact on many of the more economically sensitive areas of the market, sectors, and industries that investors are currently ignoring.

Stay tuned…


Important Disclosure Information

Francis Gannon is a portfolio manager of Royce & Associates, LLC. Mr. Gannon's thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above, will continue in the future. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements.

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