Over the past 4 years, US corporations have returned over $1.4 Trillion to investors through share buybacks and dividend payments. These companies have used a combination of free-cash flow, asset sales, and debt borrowings to fund these capital returns. Their actions have resulted in strong share price performance across US markets, particularly vs. their peers in Asia, Japan, and Europe. With valuations approaching excessive levels, any slowdown in share buybacks or dividend payments may result in a drop in US corporate share prices.
We have analysed the financial statements from 2015 to 2018 for all Dow Jones 30 listed companies, as well as the Top 10 companies by market capitalisation across Asia, Japan, and Europe. The purpose of this analysis is to:
The highly accommodative policies implemented by the Federal Reserve following the 2008 global financial crisis provided large US companies with the ability to borrow enormously, as low interest rates and strong investment demand for yield resulted in US corporate bonds trading at record levels.
From 2015 to 2018, US corporations began to aggressively buy back their own shares and pay higher dividends to shareholders as a means of driving continued share price appreciation. During this 4-year period, the 30 members of the Dow Jones Index returned over US$1.35 Trillion direct to shareholders, funded by the difference between operating and investing cash flows (net US$850bn), asset sales, plus additional new debt borrowing of ~US$300bn.
By spending their own cash holdings and borrowing debt to buy back their own shares, these companies are effectively converting a large portion of higher quality tangible assets (including cash and PPE) into lower quality intangible assets, given that intangible and goodwill assets now make up 60c in every $1 of assets. With additional capital returns of up to $400-500bn planned for 2019, the composition of intangibles is likely to surpass 75% in early 2020.
Corporate actions had a very strong impact on the Dow Jones 30 Index, resulting in ~25% cumulative price growth since 2015, driven by share buybacks of US$740 billion plus US$610 billion of dividend payments over this period. With expectations of an additional US$1 Trillion to be returned to shareholders in 2019, US corporate balance sheet quality (measured on an NTA basis) is likely to weaken further into 2020.
Share prices were also boosted in 2018 following the corporate tax reduction policy implemented by President Trump that lowered corporate tax rates from 30% to 25%. This reduced the total tax payments for the Dow Jones 30 Index members in 2018 by ~US$25 billion.
Financial market commentators have in general looked favourably upon the increased return of capital to shareholders over the past 4 years, and have for most parts, failed to address the impact of these actions on overall balance sheet health for large US corporations.
The combined balance sheet size of the 30 Dow Jones Index companies have shown a steady decline in net asset quality since 2015, with lower-quality assets such as goodwill and intangibles now approaching US$1 Trillion, representing almost 60% of their entire net asset base.
Long-term value investors usually subtract these intangible assets first to adequately determine the value of higher quality net tangible assets (NTA) held by a company. If we undertake this exercise for the Dow Jones 30 listed companies, total shareholders’ equity (assets less liabilities) suddenly falls by 60%, from US$1.7 Trillion to US$750 Billion, with NTA down by over 20% over the last 4 years.
The next step is to compare NTA to the current market capitalisation of each company, providing us with a market multiple for the company’s higher-quality net tangible assets. The current market capitalisation for all of the Dow Jones 30 Index stocks is US$7.3 Trillion, resulting in an FY 2018 P/NTA of 9.6x. Another way of looking at this P/NTA value is that an investor is currently only purchasing 10.4 cents of net tangible assets for every $1 invested in the Dow Jones Index.
Of particular note is that 14 of the 30 Dow companies produce a negative NTA result after subtracting intangibles and goodwill. These 14 include world-leading companies such as United Technologies (US$34bn), IBM (-US$22bn), Proctor & Gamble (-US$18bn) and Pfizer (-US$25bn). Many of these companies have made sizeable acquisitions over the past 3 years, and in most cases a large portion of the acquisition costs have been recorded as goodwill and intangible assets on their balance sheets.
Having a negative NTA balance should not necessarily impact a company’s ability to continue to operate and meet current debt payment schedules. However, it does pose concerns about management teams and boards who continue to aggressively buy back their own shares at expensive valuations whilst the share of intangible assets continues to be concentrated on their balance sheets. As we will see later in this report, acquisition targets at highly attractive NTA multiples are abundant in Asia and Europe, offering alternative value-accretive investment opportunities for US based companies.
Turning our attention to the income statement multiples, we see the combined US Dow Jones 30 companies trade on a market capitalisation weighted multiple of 17x market cap/pre-tax profit (PTP) with the 10 largest Dow companies trading slightly higher at 17.4x (we have used PTP to remove the impact of different tax rates across the 30 companies). When comparing this result to European and Asian companies, we see that the US trades at much richer multiples than other regions, possibly due to the sizable share buybacks they have undertaken over the past few years. With the ability to buy back further shares is likely limited to annual free cash flow from 2020 onwards, large US corporations are at risk of substantial P/PTP derating if they are forced to slow down share buybacks.
For example, when we take a closer look at the management of Microsoft’s balance sheet over the period from 2015 to 2018, we see that the company has returned ~US$100 Billion to shareholders through both share buybacks (US$53bn) and dividend payments (US$43bn). These capital returns to investors were funded through operating cash flows (net +US$40bn after subtracting investing cash flow), as well as through adding additional “leverage” to its balance sheet by borrowing US$53bn over the period.
With US$42bn of NTA remaining on their balance sheet in early 2019, Microsoft’s NTA has fallen almost 30% since 2015. Investors have driven Microsoft’s market capitalisation above US$900bn, resulting in a current valuation of almost 22x P/NTA. This means an investor looking to acquire shares in Microsoft today will receive less than 5c of NTA backing for each $1 invested.
Compare this to buying shares in Korean technology giant Samsung, and we find an immense difference, with Samsung currently trading at 1.25x P/NTA. Investors are able to acquire 80c for each $1 invested in Samsung, an almost 16-fold improvement in NTA backing over Microsoft.
A review of the income statements of both companies reveals that Microsoft made US$36.5 Billion in 2018 FY pre-tax profit (PTP), resulting in a P/PTP multiple of 24.8x (US$905bn market cap/US$36.5bn PTP). By comparison, Samsung’s US$55.8bn PTP and market capitalisation of US$235bn produce a P/PTP valuation of only 4.2x.
Once again, this highlights the enormous value offered in Asia vs. the US, with Samsung trading at an 83% discount to Microsoft on a P/PTP basis, and a 94% discount on a P/NTA basis.
With technology likely to be the strongest business sector over the next decade,, Samsung’s excellent balance sheet and significantly cheaper market valuation will likely result in them outperforming Microsoft over the next decade, particularly given Samsung’s strong branding in Asia, the largest consumer growth region.
If we undertake the same valuation exercise for the 10 largest companies listed in the greater Asian region (including Japan), we see a polar opposite to the US corporate balance sheet actions over the past 4 years. Asian corporations have strengthened their balance sheets, showing discipline by keeping debt balances low and cash balances high. With Asia expected to continue to drive global growth over the next decade, Asian companies are well positioned to participate in regional infrastructure projects that will deliver strong long-term growth.
The table below shows that the combined market capitalisation of the 10 largest listed companies across Asia and Japan is US$2.9 Trillion. These companies have a combined NTA approaching US$1.55 Trillion, more than 2x the NTA size of the entire US Dow Jones 30. Asian balance sheets offer tremendous value to investors, who are able to pay only 1.9x P/NTA, an 80% discount to the P/NTA multiples offered by the Dow Jones 30 companies. This allows investors to acquire 53c of tangible assets for each 1$ invested in the combined balance sheets of these companies.
Reviewing the income statements of the top 10 Asian companies, we can see in the table above that earnings multiples are slightly higher than the US at 18x market cap/Pre-tax profits (P/PTP). This however is heavily influenced by TenCent and Alibaba, both of whom trade at high market multiples that are similar to their US-based technology competitors. If we remove these 2 companies from our analysis, we see the P/PTP multiple fall to 10.3x, a 40% discount to US Dow Jones 30 companies.
Samsung, Toyota, and the Chinese banks offer investors the best regional opportunities on a P/PTP basis, providing a high level of exposure to the Chinese and Asian consumer growth story.
Turning to the broader European region, we can see in the table below that the 10 largest European listed companies have a combined NTA of US$597bn, 20% smaller than the entire Dow Jones 30. With a combined market capitalisation of US$1.54 Trillion, these 10 companies offer value for investors, trading at 2.57x P/NTA multiples. This is a discount of 73% to the Dow 30 stocks on a P/NTA basis.
The significant difference with the US can partially be explained by five of the Top 10 European companies being asset-heavy financial services and oil majors (HSBC, Allianz, BP, Shell, and Total). Four of the remaining five companies (LVMH, Unilever, SAP and Sanofi) are the exact opposite, choosing to instead to operate with very low negative net tangible asset bases, principally due to high intangible and goodwill asset balances.
As with Price/NTA valuations, some of the Top 10 European companies offer attractive investment valuations can also be seen when reviewing the income statements, particularly HSBC, Shell, BP, Total, Volkswagen and Allianz. The overall group average however is skewed to the upside due to extreme P/PTP valuations for LVMH, SAP and Sanofi. This results in a combined P/PTP of 10.6x, which is is a 37% discount to US markets, but in-line with the P/PTP multiples of the top 10 Asian companies (excluding TenCent and Alibaba).
The ongoing debt problems in the wider European region, coupled with the train wreck that is Brexit, will however likely exert a negative impact on market multiples until the UK and Europe reach a final conclusion on their Brexit separation plans.
Finally, if we look at the combined financial statements of the top 10 Japanese companies detailed below, we identify almost US$530bn of NTA, 30% less than the NTA value of the Dow Jones 30. With a combined market capitalisation of US$830bn, investors seeking “value” are able to acquire large Japanese companies at an attractive P/NTA multiple of 1.55x. These companies in Japan trade at an 84% discount to the Dow Jones 30 stocks on a P/NTA basis, and a 40% discount to the top 10 European peers.
Turning to the income statement, we see that the top 10 Japanese companies trade at a P/PTP multiple of 11.5x, a 32% discount to the Dow Jones 30, and slightly above Europe at 10.6x P/PTP.
This data is heavily influenced by 2 companies, Keyence Corp and Takeda Pharmaceutical, which, if removed from our analysis, results in a much cheaper P/PTP valuation of only 7.6x. This widens the discount to 55% vs. the US group, and also results in a 28% discount to Europe.
The graph below illustrates our research outlined above. Here we can clearly see the vast difference in Price/NTA valuations for large US corporations (Dark Blue and Light Blue), alongside European (Green), Asian (Red), and Japanese (Yellow) competitors.
With European, Japanese, and Asian markets trading at substantial valuation discounts to US markets, we are beginning to see net foreign selling of US corporate stocks. The graph below shows the monthly movement in foreign holdings of US stocks. We can see that the consistent buying through much of 2017 has begun to reverse, with foreigners selling a net US$205bn over the past 12 months, the largest liquidation of US equities by foreigners on record.
An August 2018 article in the Financial Times highlighted the work of research house Bernstein, which
“estimates that the total value of buybacks in western Europe, Canada, Japan and the developed countries of Asia totalled $248bn by the end of July—double the volume over the same period last year.” According to Inigo Fraser-Jenkins, a senior analyst at Bernstein, “The boom in US buybacks this year is widely known and commonly reported. Less well known, however, is the elevated net purchases by corporations occurring in developed markets outside of the US.”
The Financial Times article also mentioned that Société Générale analyst Andrew Lapthorne has warned investors that with cash balances being drawn down to finance the repurchases, they have to end eventually. “Yes, the overall payout ratio is high when you add buybacks to dividend payments, but a large chunk of this increase is being funded by cash from the balance sheet and the selling of liquid investment,” Lapthorne said. “Net debt is therefore on the rise.”
We have also seen ~US$15bn of foreign investments flow into Japanese equities over the past month, as shown in the chart below. Further analysis over the next 1-2 quarters is required to identify clear evidence of foreigners buying Japanese equities again.
The following chart shows the level of buybacks or stock issuance (capital raise) in Europe over the past 15 years. Net positive issuance across European equity markets has been consistent since 2007. This appears to be ending, with European companies starting to buy back their own shares since early 2018. With stronger balance sheets (on an NTA basis) and attractive valuations vs. their US peers, European boards and management teams may be looking to replicate the share price appreciation success achieved by their US competitors through a sustained period of share buybacks. This could be a catalyst to start closing the 73% and 37% discount to US valuations on a P/NTA and P/PTP basis, respectively.
We can reach the following conclusions from this research report:
Whilst the US has embraced a more aggressive business model with respect to large capital distributions through holding less shareholders’ equity, the other regions covered in this report have adopted a more conservative stance. If the US model of holding smaller balance sheet assets proves to be more relevant in the current low interest rate world, we could see a sharp increase in the volume of share buybacks and increased dividend distribution across European, Asian, and Japanese markets, given the level of excess assets currently held on their largest corporate balance sheets. With US balance sheet capacity limited from 2020 onwards, the acceleration of capital returns across other global markets could trigger capital flows out of the US markets into Europe, Asia, and Japan.
Chief Investment Officer
DigitalX Asset Management
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