Mark Martin

UK’s productivity threats and opportunities in three charts

Mark Martin

It’s well known that productivity in the UK has lagged behind most competitor countries in recent years. Indeed, productivity of British workers fell at the fastest pace for five years in the second quarter of 2019.

Given how important productivity is to general living standards and economic prosperity, this is clearly a concerning trend. Many of the reasons for this productivity lag are well-known – most obviously, perhaps, the reluctance of companies to invest given Brexit and trade uncertainty. Less well-known than the reasons for falling productivity, however, are the dangers – and opportunities – to investors at a sector and stock level.

Whilst this article focuses on the UK, recent comments from the Federal Reserve reflect an increasing global concern over falling levels of capital spending (CapEx) – the funds used by a business to maintain or increase its scope. So this is not just an issue for UK investors. Going back to the broad UK market, it is hardly surprising that capital investment as a percentage of net operating cash flow has been falling rapidly since 2015 and in 2019 is forecast to be at a 14-year low.

Capital investment as a % of net operating cash flow


Related to this, investors should be aware that operating margins – a percentage figure showing a company’s profitability once production costs are stripped out – in the UK are now at post-financial crisis highs, having rapidly increased since the time of the Brexit referendum.

UK operating margins


To some extent, at a global level, rising operating margins and falling capex can be explained by the increasing significance of the technology sector which tends to be higher margin and less capital intense. In the UK, however, the tech sector is notably small and does not seem to justify such a sea change in such a short period of time. Even in the US, with its preponderance of technology companies, there may be cause for concern – especially given the rate at which US companies are splurging cash on share buybacks, even as they reduce capital investment.

Quaterly buybacks and dividends for S&P 500 companies ($bn)


At some stage – and sooner rather than later should the macroeconomic picture improve – three things are likely:

1) Many companies will need to ramp up capex in order to catch up on deferred expenditure

2) Free cashflow generation and margins will fall as a result

3) Buybacks and other returns of capital will diminish. 

Clearly, this would be to the detriment of companies – especially indebted, capital intense companies – that have failed to perform necessary capex in recent years. Where companies have also been spending irresponsibly on uncovered dividends – as discussed in previous blogs – then the potential for shareholder disappointments would be all the greater. Should a tight labour market cause significant wage inflation, companies with high labour costs would obviously be hit harder too. Simultaneously, in a wage inflationary environment, the costs of financing catch-up capex (and existing debt) will likely rise from current low levels. All too often, I suspect, a company that is hit by one of these issues will be hit by several of them.

All is not doom and gloom however. Such an economic backdrop would be a boost to specific companies that have resisted the siren calls of short-term cost-cutting and sensibly re-invested in their businesses in recent years for example Morgan Advanced Materials, Synthomer and Volution. Such an environment should also boost companies that provide products and services related to general capital expenditure. These tend to be industrial or technology companies, such as Tyman, Ricardo or Spectris.

 

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Wednesday, December 11, 2019, 11:00 AM