The general thought process for senior managers running major corporations is how much return they will receive on their investment. Back to my previous article on “The Monthly Employment Report, CEO's, Game Theory, & the Government”, the general theory is that senior management does not have the incentive at this point to take on risk spending their excess cash on risk projects only to potentially lose their jobs, if the project doesn’t pan out.
Let’s take this concept one step further and consider the relationship between the US equity markets and the unemployment number, from a big-picture thematic viewpoint.
Given the historical precedence that is set when the Federal Reserve initiates open market operations to the tune that they have (0.0-0.25% overnight interest rates) for over 3 years now, one would think that the unemployment number would substantially decrease, even after the 6-9 month lag has been in effect. However, this has not happen and the pesky unemployment number has been hovering around 9% for over 2 years now and many economists are forecasting this to be more of a structural problem that a cyclical short-term issue.
If this is the case, where did all the money go since this liquid capital has not been used to hire employees and where should it go?
Well, if you look closer, the answer may be simple enough: Eventually, senior managers will have to deploy their excess cash to projects once shareholders start to demand for a return on investment.
When this time comes (who knows exactly when that will be), the less risky way to deploy capital will be through firm acquisitions to create revenue or cost synergies on the company’s income statement. In fact, recent M&A activity suggests that trends for buyouts were to increase in the coming quarters. Since mid-2009, total equity values of global buyouts have increased approximately 13% annually and the average sized deal has increase to $73 million in 2011 from $62 million in 2009. (Source: Thomson Financial)
So, a typical senior manager (CFO or CEO) of a company will analyze a project and determine whether or not to invest, depending upon what the likelihood a project will succeeds in production of its cash flows. Since there still are a ton of “known-unknowns” in the economy (US Gov’t deficit, Eurozone debt situation, Prospects of QE3, Future Monetary Policy, etc.), senior managers must apply a larger discount rate (cost of capital) to their projects, especially those that are organically grown (i.e. built from within the structure of the existing company).
With that in mind, the formula is quite simple: In finance terms, it’s ROIC minus WACC, which means what is the Return on Invested Capital above the Weighted Average Cost of Capital. If the ROIC is higher than WACC, then it makes sense to invest. Also note that the largest component in the WACC is the cost of equity since highly-levered deals to fund projects are a thing of past. If firms were allowed to use large amounts of leverage (projected over the long-term), we’d be having a different discussion, however, underwriting in the debt capital markets are back to non-insane levels like that of pre-2008.
So, when a senior manager determines whether or not to either (a) organically grow their firm and hire employees or (b) purchase an outside firm to solve that internal need, the answer will be a function of the cost of capital on organic projects and the valuation of firms to be acquired in the open market.
Currently, valuations in the US equity markets via P/E ratio are roughly trading at a 16x’s multiple which, in historical context, is slightly under the average (Source: Thomson Financial). It’s very difficult, from the standpoint on the historic mean, to determine where the P/E ratio should be trading at and how long this bull market will continue, however, game theory suggests that senior managers will find less risk to acquire (or outsource) instead of organically growing internal projects.
With this is mind, I am bullish on the micro and small capitalization stocks for the next 6-12 months, unless the concepts above dramatically change in the short-run. Unemployment will barely change greater than 1% over the next year since most senior managers will not take on the risk to hire at this point.
My next follow-up project to this paper will be to break down the specific sectors to determine which industries it will be more advantageous for senior managers to acquire than hire.
Take care and Avenge!
