Chapter 25
Business Investment—What People Watch and Should Watch
Increases in business investment are generally viewed as a positive sign for the economy. Investments in human capital, out-sourcing partnerships, peer-to-peer businesses, and intellectual property are all less tangible and harder to track than many traditional business capital expenditures such as a physical plant or media content. These dynamics limit the usefulness of using traditional business investment figures as a measure of economic activity or potential future growth. In the United States, gross domestic product (GDP) report there is a break-out of “private nonresidential fixed investment,” which includes structures, equipment and intellectual property. This data can give some color on business spending trends. There are at least two dangers in using this historical data. One is the dramatic changes in the last few years in the composition of non-residential fixed investment. Intellectual property investments increased to the second biggest category, moving from 27% of the total to 33%. When the composition of data is changing meaningfully you must be cautious how you use historical data. The second danger is that with the significant changes in how some of the most dynamic companies in the economy invest in their business, you must question if the data is truly capturing the actual level of business investment activity.
A factor that could also be distorting the impact of business investment is that technology is often allowing corporations to get more out or each dollar spent than once was achieved. For example, a copy machine can still copy but can also scan a document and simultaneously send it to thousands of people, while also sending a personal fax to a different person. The cost increase to buy such a machine is less than what it would be to purchase the three separate machines. This also results in derivative savings, such as the employee hours involved to accomplish the tasks. Simply counting the dollars spent on business investment is not capturing all of these factors. It is also worth considering that theoretically increased business investment in the latest technologies is also making all the existing assets that companies own worth less as they are less efficient and less attractive on a relative basis to the newest assets.
New media companies are investing in their businesses very differently than traditional media corporations have. Social media and gaming communities invest capital in the design of their service, but much of their value really comes from having more users that create a community. The users are often creating a large part of the “content” and enhancing the experience. Growing and maintaining this type of unique business requires a different type of investment. In a traditional movie or television studio the investment in the product is much more defined. The value of the product (e.g. a movie or a television show) increases if it is popular but the value is not enhanced by who is sitting next to you in the theater (it is often actually a negative experience). In the case of a video game community the experience might well be enhanced by who you are playing with. Social media sites are more popular if people post more content on them. Therefore new media companies often have to invest in making the experience of using their website easier and more attractive than having to invest in content.
Business investment figures also may miss some of the expenditures involved in developing an “asset-lite” business model utilizing outsourced vendors for much of the work. A new company at the center of a circle of third-party vendors may have engineering and design teams that will craft specifications for a product and then outsource the manufacturing and assembly as well as distribution and then have a separate team that coordinates marketing with an advertising agency. At the center of this circle is a company that will be investing in human capital for customer service and quality control but not that much in a physical plant. There will also be significant investment in legal and logistics planning and documentation involved in pulling this all together but this is a different type of investment. Perhaps 10 or 15 years ago all of this would have been done in-house for a company and it would have required significantly more capital to start up and build out these capabilities rather than just utilizing unused capacity of other companies. Much of this is possible because of technological improvements in logistics and communications. These changes are distorting capital investment figures relative to historical data. Investment in intellectual property, including design, brands, contracts, logistics, and so on, are not all easily captured in the traditional macro data.
Trying to capture true business investment is valuable for many reasons. From a macro thematic view increased investment by businesses should lead to growth and this activity can give a good sense of an economy’s direction. From a micro investment point of view understanding how well a company can monetize its invested capital is an incredibly valuable tool for investors to measure relative value. If you are analyzing companies in the same industry you can combine various line items in their financial statements and cobble together a reasonable view of true investment. If you are looking across industries, it gets more difficult.
Some newer economy companies have an advantage over their incumbent competitors, in that they do not have to answer to the same metrics, such as earnings per share or return on capital. If you read research reports and articles Amazon gets to benefit from a different valuation framework than many other traditional retailers. Theoretically, this gives Amazon an advantage over its peers, as they can attract capital without having to show profits, while most incumbent retailers do not get this benefit and their stock valuations are typically measured relative to earnings. By this measure start-ups can get rewarded for expensive launches into new arenas that add to revenue but not profit and can be aggresive on pricing, traditional companies would likely have to discuss the impact on earnings to any new venture. This can get carried to the extreme and allowing companies to avoid having to rationalize an investment by showing positive cash flow generation can eventually result in meaningful capital losses. The combination of easy money and bad business investments is clearly a risk to economic growth and can destroy capital. However, right now, capital seems to flow to companies that are innovative and can grow the revenue and market share line, with the promise of strong profits in the future.
Mergers and acquisitions are an important way in which corporations invest capital. Corporate combinations have increasingly resembled pieces of a puzzle being put together than vertical or horizontal expansion. Technology companies are often about products. These products will have a life cycle and often as top-line growth slows for a product line it will become a significant cash generator, though not as much of a growth vehicle. This cash can be used in the pursuit of acquisitions of new products that can fit its existing customer base. A company that provides customer relationship management tools, like Salesforce.com might add an e-commerce software company. This is not traditional horizontal integration but adds to a suite of services that can be marketed to an existing customer base. Part of Dell’s acquisition of EMC was rationalized by “revenue” synergies as Dell believed it could sell EMC’s storage and cloud computing services to its existing customers.
A high level of capital availability and a large amount of business investment have appeared to be prevalent during much of the technological revolution. How business investment needs to be allocated for a company’s success can be very different in start-ups than it has been for more traditional companies as asset-lite models utilize third-party vendors. This has made measuring the quality and the quantity of business investment more difficult and has changed the make-up of corporate asset value.