I am in the process of writing a series of articles addressing concerns expressed by Eric Parnell based on S&P 500 statistics for the period 2011 to 2016 (see here, here, here, here, here and here). These statistics suggest: (1) companies in the S&P 500 have borrowed excessively to fund buybacks; and (2) share prices have doubled while earnings have remained flat (see Eric Parnell’s article, “The Beginning Of The End“. The Heisenberg has added further concerns based on S&P 500 averages, as per this extract from this article, “There appears to be no direct relationship between a company’s ROIC/WACC and its weight in the S&P 500. ROIC/WACC for the top 10 companies in the S&P 500 (20% of the index), on average, is lower than that of the next 70 companies.” He goes on to suggest that passive S&P ETFs are creating an enormous misallocation of investor capital and causing investors to misallocate their own capital by funneling it to companies which are (relatively) bad capital allocators, and when huge amounts of money goes stomping around indiscriminately in markets, bad things (or at the very least “distortions”) are inevitable.
MR. HEISENBERG, YOU CANNOT USE ROIC/WACC AVERAGES TO COME TO MEANINGFUL CONCLUSIONS
The WACC denominator
I will explain about the averages, but firstly, let us look at the WACC denominator. The lower that cost is, the higher and more favorable the ROIC/WACC ratio will be. The way to get that cost lower is to borrow heavily at the current low interest rates. In a simple example – a firm’s cost of equity is 15% and its borrowing cost is 5% and it has the opportunity to invest in a new project returning 20%. If the firm chooses not to borrow, its WACC will be 15% and its ROIC/WACC ratio will be 1.33 for this project (20%/15%). If the firm chooses to fund half the project with borrowings, the WACC will be 10% ((15%+5%)/2) and its ROIC/WACC ratio will be 2.0 for this project (20%/10%). I have already established the top 20% of companies in the S&P 500 have been very conservative in their borrowings, and for the most part have increased cash net of debt and have no net borrowings (see here and here). Could it be those 70 companies, immediately below the top 20 companies, have borrowed heavily in the current low interest rate environment, and that is why the top 10 companies have a lower ROIC/WACC ratio?
The ROIC numerator
To calculate the ROIC, only funds/assets that are actually employed/invested in income producing activities are counted. So cash reserves and business assets that are not in use are excluded. The Heisenberg suggests a misallocation of funds to projects that do not earn sufficiently above the WACC is the likely cause of the top 20% of companies having a lower ROIC/WACC ratio than the next 70 companies in the S&P 500. Given the levels of buybacks by large and small companies it is fairly obvious there is a shortage of investment opportunities that meet ROIC criteria. But that appears to be the case…