Co-CIO Francis Gannon explains why upward revisions to CapEx spending could be very good news for small-cap cyclicals.
We’ve recently heard quite a few mixed messages regarding the current health and the future prospects for both the stock market and the economy. Just a partial list:
- concerns over peak earnings, which first surfaced earlier in the year, versus earnings growth that in many cases continues to show improvement
- worries over tariffs and trade wars compared to a global economic picture that continues to be positive
- reservations about the health of the stock market juxtaposed against solidly positive returns for small-caps year-to-date (as well as a marked decline in volatility levels from earlier in the year).
This is another reason that—while we always keep the macro picture in mind—our attention is focused squarely on individual businesses.
And in addition to a strong-to-solid small-cap earnings picture, we are encouraged by the growing pace of CapEx (i.e. capital expenditure) spending throughout the U.S.
"CapEx has largely slumped in the years since the financial crisis, so any quickening of the pace is a positive."
Our friends at Furey Research Partners, for example, regularly track CapEx trends. To understand where spending stood at the end of May, they recently compared several years’ worth of CapEx revisions, in each year looking at the five-month period from 12/31 through 5/31.
Their study showed that estimates for S&P 500 CapEx spending this year have been revised higher by 7.9% since the beginning of the year. Partly due to tax reform and partly to accelerating economic growth, CapEx spending estimates are being revised higher at their fastest rate since 2012.
They also found that companies in the Russell 2000 are also seeing upward revisions to spending this year, though through the end of May 2018 they’ve not yet matched the pace of large-caps.
Even with the lag for small-caps, we still see this as good news—potentially very good news.
First, CapEx has largely slumped in the years since the Financial Crisis, so any quickening of the pace is a positive. Anxiety about the slow rate of U.S. economic growth made many businesses hesitant to do more than the bare minimum over the last several years—but the signs are pointing toward a welcome shift.
Additionally, Furey found two small-cap sectors among the biggest revisions through 5/31 were Industrials and Materials—two key cyclical areas for valuation-sensitive investors.
Equally important, if not more, is the fact that CapEx spending requires both small and large companies to buy from other businesses—most of them cyclicals, and many in the small-cap space.
Finally, Furey’s results are consistent with what company management teams have been telling us over the last year. Businesses are spending on new technology, automation, and related improvements. So far, these initiatives have been more common than larger-scale undertakings such as building new plants—though that could change.
What’s also interesting to us is that many of the companies we’ve talked to are increasing their CapEx spending based more on economic improvement than tax cuts.
We see this as another significant positive because of the longer-term optimism it indicates about growth. Stay tuned…
CapEx (Capital Expenditures), is spending by companies to acquire or upgrade productive assets (e,g, buildings, machinery, equipment and vehicles) in order to increase the capacity or efficiency of its operations for more than one accounting period.