Wednesday, October 24, 2012

Capital Markets and Economic Regulation

Tim Brown's, head of Infratil's "Capital Markets and Economic Regulation" area, thought provoking article in the Dominion Post's 24 October 2012 got me thinking about economic investment.  Tim's thesis was New Zealand companies reinvest too little of their current profit, to the detriment of theirs - and ultimately New Zealand's - long term success and opportunities.  The legacy of low New Zealand investment was low company capital growth, manifesting in low average returns from the New Zealand share market measured over an 18 year period. 


  • Accept Tim's statistics and metrics and forget about which is "the correct" start and end points to measure international and inter-temporal average return rates;
  • Accept Tim's analysis that low investment "caused" lower average returns to the New Zealand share market;
  • Extend Tim's analysis, what else might be occurring?


Investment / Dividend Decision Making in Choice Economics

At a micro-economic level - the individual's decision-maker's perspective - existing companies choose to reinvest or return profit to their shareholders according to the options they face and the consequences of their choice.  But the value of the reinvested profit generates only a likelihood or a probability that it increased profitability will result.  No current investment is certain of generating a future profit.  The expected, probable, "could be" or "may be likely" future profit increase (not the profit level) from reinvestment is the only benefit that could support a business reinvesting its now, known and certain current profit level

Against that "benefit", is the opportunity cost of reinvestment - the cost of not doing the next valuable alternative use of the profit, which is - in this instance - returning the profit to the shareholders.  On the New Zealand share market, a market traded internationally, where the company competes with others for the attention of financial investors, the cost of not paying a dividend is high.  The share price falls, the credibility of management is undermined, and investor attention shifts to alternative investment opportunities, all of which generate current and future issues for the company.

So Tim is absolutely right.  From the companies perspective it probably does make sense for it to return current profit to existing shareholders and reduce the current and future impact on its share price. as opposed to reinvest the same money for a potential, maybe / could be increase in future profits.  

An Alternative Thesis:  Sharemarket Trading Peverse Incentives

But let me suggest an alternative thesis: the low investment behaviour is the result of the public dog-eat-dog short term nature of the share market itself.  Where companies DON'T trade on the share market, then the need to return a dividend as high as your neighbouring stock exchange company isn't so great.  The expected net benefit from the could-be/may-be marginal profit from the reinvested returns less the opportunity cost of not paying a dividend is much more comparatively large.   

Consequently, with less downside to reinvestment, and a higher relative upside to reinvestment, then economic theory would suggest companies which DON'T trade on the share market might have a higher rate of reinvestment.  And if they did, than all of Tim's points follow: they have higher average rates of return, and they generate more economic value for their shareholders and New Zealand over time.

To illustrate my point, I've used Statistics New Zealand's Institutional Sector Accounts (ISA) from here. The ISA distinguish between "Private non-corporate producer enterprises" which I've labelled as "Small" and assume are not regularly traded on the stock exchange, and "Private corporate producer enterprises and producer boards" which are "Big" companies who either are, or are similar to traded share market companies.

Graph 1: Returns to Factors of Production - Large/Small Companies

From Graph 1, large companies pay more of their productive surplus to their employees than they retain in profits.  Over time, they have been paying comparatively more to employees, and comparatively less to business owners.  From Graph 2 below, large business have also not fundamentally changed their Total Income to Value Added rates.  If they were reinvesting, then they would be increasing the amount of income they receive from all of their investment relative to their value added.  And from Graph 2, they have not significantly altered the level of their total income to value added between 1999 - 2009.

All of this is entirely consistent with Tim's analysis.

Graph 2:Total Income - including Investment Income to Value Added - Large/Small Companies

The bit that differs from Tim's analysis is the comparative behaviour and investment outcomes of the Private non-corporate producers.  From Graph 1, a significantly higher proportion of economic surplus is returned to owners than is paid to employed labour.  From Graph 2, significantly more of that retained surplus has been reinvested, and led to high and increasing rates of total income to value added.

Small companies tend to perceive higher relative benefits of reinvesting and face lower opportunity costs of reinvestment compared to larger companies. And, from Graph 2, they are generating exactly the investment/wealth behaviour Tim wished for stock market traded companies.

Maybe share markets are not great investment-enhancing economic vehicles?

No comments:

Post a Comment