How to tell when capex will be rewarding and when it won't be
06-Mar-2023 •Dhirendra Kumar
Equity researchers and investors use many simple, straightforward metrics based on revenue, profits, costs, growth, etc. For these, it's pretty clear which direction is good or bad. For example, if revenue and profits grow at a healthy rate, that must be good. It's hard to think of any exceptions to this. For investors, these are open-and-shut cases of drawing conclusions about a stock.
Other corporate metrics are most ambiguous. Debt is the biggest example that 'Wealth Insight' has tackled in the past. We consider it axiomatic that high debt is bad but it's often ambiguous in the case of an individual company. Certainly, there are many businesses whose success is based on using debt well.
The intensity of capital expenditure, which we have tackled in the cover story of 'Wealth Insight' March 2023 issue, is another example. On the face of it, just like debt is nominally bad, capex is nominally good. You invest capital and if you do that well, then you build the resources with which you get greater and greater profits. That's the heart of the entire system and that's why the system is called capitalism.
However, there are many pitfalls along the way. As equity analysts and investors, we are generally aware of these pitfalls. For many years, large amounts of capex often mean large amounts of debt. The rock-bottom global interest rates and huge liquidity in the global financial system have made this the rule rather than the exception. The standard way for overambitious businesses to destroy themselves is to overborrow and overspend. For a certain type of business personality, the easy liquidity conditions have had the same mental effect as a parent's credit card has on a teenager.
There's good capex and there's bad capex. How should the investor distinguish between the two? Our team has developed a model for the cover story 'Spend more, grow rich'. After an elaborate analytical process, we formulated a set of questions (or filter conditions) designed to elicit intelligence about the prospects of companies with high capex. Based on these, we arrived upon a set of companies that we believe have a high probability of making a success out of a high-capex situation.
Just like debt, capex too might look difficult to analyse but offers a great tool for the equity investor and the analyst. As our cover story will show you, in the context of modern businesses, high capex is an analyst's friend. For anyone trying to evaluate a company, it makes a nice indicator that tells you a lot of things about a company, its management and its prospects, especially in combination with the other filters we have devised. These questions are like a stethoscope or an MRI scan in the hands of a doctor. They tell you a lot that would otherwise be hidden. In all these, capex analysis is like debt analysis. However, there's an important caveat. Debt-related analysis of a stock can, at best, be a negative indicator. It can tell you whether a stock should be avoided. It cannot, by itself, tell you whether a stock is worthy of investing. Capex is different. Done well and done with the right balance and for the right purpose, capex is a force multiplier.
That's exactly what we are trying to discover in our cover story of 'Wealth Insight' March 2023 issue. As always, our filtered lists of companies are intended as a learning tool and not as investment advice. The ultimate goal is to learn how to evaluate companies because running and growing a capex-intensive business is more art than science. Some can do it; many can't. And as investors and analysts, we aim to learn which business management falls into which group.
This editorial appeared in Wealth Insight March 2023 issue. To read the cover story and other insightful analyses, columns and articles