February 2011
Resources trump technology for cash generation
Long term studies of returns from the stock market consistently demonstrate that the bulk of the returns, about 90% according to the Barclays Equity Gilt study, come from dividends and reinvested dividends. On this basis it makes sense to seek out the highest dividend payers and focus portfolios on the strongest cash generators.
It might be logical to think that companies that generate the most cash would be modern, high margin technology businesses. After all, these are the ones politicians and commentators are saying will provide the jobs and the income for the future and offer the most potential for growth. This argument reaches its apogee when it comes to green technology. According to its advocates this sector can provide us with industrial nirvana with an endless demand for workers and throwing off prodigious amounts of cash. The reality is rather different.
If we look at exactly where the cash comes from in today’s economy we see a very different picture; and one that is more low-tech than high-tech. Taking the FTSE 350 as a broad measure of the UK economy (although it isn’t but it has the data we need) the massive amount of cash generated by resource exploitation is immediately apparent. Oil extraction and mining together account for over a quarter, 27.5% to be exact, of the cash that analysts forecast will be paid out as dividends this year. Anyone who has worked in or understands these industries will know that they are in fact anything but “basic”. The geophysics and geochemistry needed to find new deposits is highly developed and the engineering required to build and operate an oil rig, a mine, a refinery or a processing plant is immense and is only possible through the extensive use of technology.
Finance is the next biggest source of cash flow for the market with a contribution estimated at 18.3%. Although it is less than the 25% it used to provide in 2007 before several large banks collapsed it is still a sizeable chunk. Although aided enormously by computers the business of lending money is as old as human civilisation.
It isn’t until we get to the third largest sector, telecoms, that we come across an industry that can rightly be called new and high tech. Mobile and fixed communications together supply 9.0% of the cash, and the bulk of that these days comes from mobile telephony and not fixed line services. These of course are just operators, not the manufacturers of handsets and networks where the real technology lies.
The fourth sector is almost as big. Pharmaceutical’s provides 8.0% of the cash and is even newer than telecoms. It does have high gross margins and massive research and development spend, although there are questions as to how sustainable those margins are as governments seek to drive down health care costs.
Growing and making food and drink has always been man’s first priority and that still generates 5.7% of the cash flow. Next on the list is the need to keep us warm and serviced. Utilities account for 5.5% of the cash generation. Much of the technology deployed here is rather stale but the challenges of modern society are triggering large capital expenditure on new kit to deal with the changes in how electricity will be generated and used in the future.
Right behind this sector is tobacco providing 5.3% of the cash and definitely on the low tech side. Staying with entertainment Travel, Leisure and Media provide a substantial 4.3% of the cash flow. While a lot of technology might be deployed in aircraft, trains, communication systems and films they are a means to an end, not an end in themselves. The Aerospace sector itself only makes up 1.6% of the cash into the market and software an almost irrelevant 0.3%. Needless to say green technology does not even rate an entry.
Constructing a portfolio around this distribution of cash flow might seem rather backward looking. After all it rather ignores the growth opportunities in new industries. In practice securing commanding positions in mature businesses is usually an excellent way creating of a prodigious amount of cash flow than can be passed back to shareholders for them to invest in the next big thing.
While the theory of investing in companies that have strong cash flows is well proven the last few years have not been very rewarding for such an approach. In the wake of the Global Financial Crisis interest rates were slashed and then huge amounts of cash were injected through Quantitative Easing. This had the effect of making higher risk assets, such as small capitalisation and growth shares much more attractive. That is the main reason the FTSE 250 and the FTSE Small Cap indices, home to many technology companies, have outperformed the FTSE 100 by 42% and 40% respectively since the beginning of 2009. Other high risk assets such as commodities and emerging markets have also benefited from this wall of cheap money. While the valuations of these assets might have risen over that time frame their fundamental cash generation capabilities have not changed significantly.
At some point more normal monetary conditions will prevail. That will be when the importance of cash flow will once again be the dominant factor in stock and asset selection. It will come; we just don’t know when.