The undercurrents of the market in 2022 aren’t as strong as we would like, with the Federal Reserve expected to tighten soon and capital spending expected to increase materially, but we continue to like stocks for the long run and don’t see any reason to make any changes to the newsletter portfolios at this time in light of these observations.
By Brian Nelson, CFA
One of the biggest themes in 2022 is the amount of money companies will spend in capex (“capital expenditures”). A key reduction to net cash flow from operations to arrive at traditional free cash flow is capital expenditures, and we’re seeing some of the largest companies spend aggressively to the detriment of internal free cash flow generation. Though such spending may be necessary, in most cases, to enhance long-term revenue and earnings growth, the higher spending this year is a notable trend that we think may be posing a headwind to the broader equity markets so far in 2022.
The markets the past few years have been driven in part by high economic-return, asset-light entities. These companies are able to drive strong traditional free cash flow growth with little incremental net new investment as their operations become more efficient (scale) or become more digital in nature via traditional earnings/operating leverage. But this tailwind may be losing some momentum. According to a report from the Wall Street Journal, “companies in the S&P 500 allocated $528.4 billion toward capital projects during the first nine months of 2021, or 11% more than during the comparable months of 2020. According to S&P Global Ratings, in 2022, “capital expenditures by big companies worldwide are expected to increase 6.1% from 2021 levels.”
Big Spenders
For one, Amazon’s (AMZN) capital spending is simply out of control, and it is one of the biggest companies on the market. Intel (INTC), which reported fourth-quarter 2021 results January 26, noted in its prior quarterly report that it would spend as much as $25-$28 billion in 2022 when compared to just $18.7 billion in the most recently completed 2021, nearly a 50% increase in spending, and almost all of the operating cash flow generated during 2021. Intel’s $20 billion investment to build two chip factories in Ohio is quite the capital outlay, for example.
Though we believe the metaverse may live up to the hype, Facebook’s (FB) $10 billion investment in its metaverse division this year isn’t small potatoes and won’t translate into any meaningful returns for years. In total, the level of investment at Facebook to take a chance on the metaverse could be in the tens of billions, with considerable capital investment year after year. Look at the delta in capex spending as revealed in Facebook’s most recent quarterly report, for example: “We expect 2021 capital expenditures to be approximately $19 billion, updated from our prior estimate of $19-21 billion. For 2022, we expect capital expenditures to be in the range of $29-34 billion, driven by our investments in data centers, servers, network infrastructure, and office facilities.” That’s a huge jump.
Prudent Allocators
On the other hand, we’ve written extensively about how some of the largest companies in the energy sector (XLE) have scaled back their capital investments due to significantly lower energy resource pricing the past few years, leading to a much more benign environment both with respect to their cash-based sources of intrinsic value (i.e. free cash flow), but also in keeping excess energy resource supplies from flooding the market. For example, one of our favorite energy names, Chevron (CVX), which just raised its quarterly dividend 6%, to $1.42 per share January 26, has been keeping capital spending well under control.
Here’s what we wrote about this recently:
For 2022, Chevron aims to spend approximately $15.0 billion on its “organic capital and exploratory spending program” which is a proxy for its capital expenditure plans. While up from its 2021 budget, please note Chevron aggressively reduced its capital investment levels in the face of the COVID-19 pandemic to conserve cash, so a moderate recovery in spending does not mean it has abandoned its fiscal discipline (for reference, Chevron spent $14.1 billion on capital expenditures in 2019).
Back during previous boom years when raw energy resources pricing was elevated, Chevron found it quite difficult to generate free cash flow as it was pouring tens of billions of dollars towards its capital investments each year. For example, Chevron spent an average of ~$34.8 billion per year on its capital expenditures during the 2012-2014 period and generated just ~$0.3 billion in free cash flow per year on average during this period as capital expenditures consumed virtually all its net operating cash flows.
We’re witnessing the same kind of capital discipline at another one of our energy favorites, Exxon Mobil (XOM). Here’s the latest trends at that energy resource producing giant:
The company noted in its early-December update that its capital expenditures would come in around ~$20-$25 billion from 2022-2027. Its investments are focused on its operations in the Permian Basin, Guyana, Brazil, its liquefied natural gas (‘LNG’) business, and its petrochemical businesses. While up from ~$16-$19 billion versus expected 2021 capital expenditure levels (during Exxon Mobil’s third quarter of 2021 update, the firm noted that it would spend at the lower end of that range), please note that its 2022-2027 capital expenditure target is well below levels seen during previous periods of strong raw energy resources pricing. From 2010-2014, ExxonMobil’s annual capital expenditures averaged ~$33 billion.
Lower Economic Returns
Broad market economic returns on invested capital will likely take a hit, and while all eyes remain on the Federal Reserve and the 10-year Treasury rate, and perhaps rightly so, pressure on economic value added (EVA) or economic profit (returns), the difference between return on invested capital [ROIC] and a company’s cost of capital [WACC], may be starting to emerge. The dichotomy between those exhibiting capital discipline and those that aren’t is starting to become clearer and clearer as 2022 progresses. Technology, for example, is among the worst-performing sectors this year while energy is among the best-performing ones. Early last decade, the energy sector learned the importance of capital discipline the hard way–that overspending could be a recipe for disaster. The largest technology companies may be taking on that risk today, and it remains to be seen whether the same lesson will be taught.
That said, it’s far too early to say whether the broader markets will start to feel the weight of increased capital spending in 2022 as the year progresses, but many other research outfits are also starting to see what we’re seeing — signs of a new capex cycle ahead, with the consumer discretionary (XLY) and information technology (XLK) sectors leading the spending increases and the energy and mining (XME) sectors being as prudent as ever, revealing capital discipline late into the economic cycle. The undercurrents of the market in 2022 aren’t as strong as we would like, with the Federal Reserve expected to tighten soon and capital spending expected to increase materially, but we continue to like stocks for the long run and don’t see any reason to make any changes to the newsletter portfolios at this time in light of these observations.
Also tickerized for MCHP, HFC, MAR, RHI, ALXN, DISH, CZR, IFF, ODFL, FMC
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Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson’s household owns shares in HON, DIS, HAS, NKE. Some of the other securities written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.