Investing in capital projects is all about timing
Companies that spend on capital projects/asset purchases throughout the economic cycle (not just when profits peak) are likely to outperform their peers. An article from McKinsey explains why companies shouldn't invest in capital projects at points of peak liquidity. It argues that it's unwise to invest when profits are high and funding is readily available because this reinforces cyclicality in profit growth and companies also “also forgo opportunities to invest at lower prices when profits are down”.
By analysing data spanning back to 1972, McKinsey argues that the US's 500 biggest firms' capital expenditures have been “highly correlated with prior-year profitability”. The graph below shows how changes in return on invested capital (ROIC) seems to be closely mirrored by capital expenditure growth from 1972 to 2014. McKinsey's authors, Marc Goedhart and Jyotsna Goel, write: “This relationship has been remarkably consistent over time—even in the recent years of quantitative easing—with a surprisingly strong correlation of 55 percent since 1972.”
The findings are somewhat intuitive and it seems logical that companies would invest at times when liquidity is more readily available. But according to the article's authors, corporates would be better advised to hold off on large capital spends at the top of the economic cycle and instead build some financial flexibility so they can spend more when times are hard. The authors write: “Companies that can time their capital spending and asset purchases to invest counter-cyclically typically outperform their peers.”
CTMfile take: A little like eggs and baskets, the message is don't spend all your money when the economic cycle peaks – redistribute your spending power to see you through tough times. This could even enable you to take advantage of lower prices at less prosperous times and would certainly give the corporate treasurer and CFO greater flexibility and control of liquidity.
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