Thursday, October 30, 2014

Returns to capital aren't high.

I've been seeing talk regarding returns to capital, corporate share buybacks, profits, etc., including this post by Paul Krugman.  Krugman writes that we are seeing high profits and low investment because corporations are exhibiting monopoly power.  Brad DeLong responds to Krugman here, saying that profits are high because labor compensation is low and that investment is low because we are now permanently below the previous trend in GDP.

Krugman uses this graph, which I think might be causing some confusion:

One bit of confusion is the use of corporate profit as a measure of returns to capital.  From a finance perspective, this would proxy Free Cash Flow to Equity (FCFE), but the more comprehensive measurement is Free Cash Flow to the Firm (FCFF).  Capital comes in the form of debt and equity.  For any firm there is a broad set of factors that might determine the right balance.  But, in terms of measuring the returns on the assets of the firm or the return to capital in general, that balance is fairly arbitrary.  FCFE is a residual, partial measure of returns to capital.  FCFF is the appropriate measure.

Monopoly Doesn't Explain Current High Profits

What if Krugman's assertion was correct, that monopolist tendencies have pushed up the profit margins of American corporations, and that barriers to competitive investments keep investment low while those profits remain high?

In that case, we should expect risk premiums to equity to be low, since profits would be protected by competitive barriers.  Usually, firms within this context are expected to use higher leverage.  Partly, this is because firms with high and stable cash flows tend to have high fixed capital levels.  But, also, from a capital supply standpoint, creditors are more willing to provide a higher portion of the capital base because stable profits create lower default risks.

But, currently, equity risk premiums are very high.  If we had a large amount of capital chasing monopolist corporate profits, equity risk premiums would be bid down, and equities would be trading at much higher valuations.

As I have pointed out in several previous posts, total real returns to capital, implied by the Federal Reserve's Z.1 report, currently are pretty close to the surprisingly stable long term average of about 8%.  If we use something like Damodaran's estimates of risk premiums for the S&P500, the required return runs a little lower, understandably, but, they are still pretty stable over time, especially when adjusted for leverage.  Here is my rough estimate of real total required returns implied from the Z.1 report over time.  Total required returns to non-financial corporate capital here are Real Risk Free Rates (RRFR) + Unlevered Equity Risk Premium (UERP).  Nominal returns include inflation (GDP deflator used here).

It is common, and understandable, to assume that firms have high profits because low interest rates allow them to leverage up on cheap debt, keeping more of the returns for equity holders.  If this was the case, we would expect to see firm leverage increasing when rates are low and equity values would soar.  However, what we find instead is that firms deleverage when interest rates are low.  Here is a comparison of the 10 year nominal treasury rate and debt/Enterprise Value from the Z.1 report.  The next graph is from JP Morgan, showing Debt to Equity levels among the S&P 500.

So, the high profit levels aren't due to low rates in the way we normally think of it.  High profits simply reflect the current balance of capital - debt vs. equity.  Firms are using more equity to fund operations, so more of the operating profits are flowing to the bottom line, simply as a matter of accounting.  This is, indeed, the opposite of what we would see in an economy of monopolists.

High ERP suggests risk aversion.  In fact, equity risk premiums and risk free interest rates tend to move inversely.  The fact that rates are low and risk premiums are high could suggest that, as Krugman puts it, "business are holding back because Obama is looking at them funny".  While that is a more plausible explanation of interest rates and risk premiums than Krugman's monopolist conjecture, it is hard to say how much.  Regulatory and tax threats and uncertainties generally affect potential competitors at least as strongly as existing firms.  A common way to become one of Krugman's monopolists would, in fact, be to have the government look at your potential competitors "funny".  So, it's not clear that the monopolist context and the unfriendly regime context create distinctly different signatures in required returns.

Current risk premiums are probably mostly the product of capital supply.  Well known demographic trends mean that millions of households are preparing for decades where they will be unproductive, and thus don't have the stomache for potential financial losses.  I have also argued that the exchange of high risk and low risk capital between the developed world and the developing world is highly beneficial to both sides of the trade.  Low risk free rates also reflect this influx of developing world capital that lacks avenues for local low-risk returns.*

Low interest rates and low corporate leverage both reflect this demand for low risk.  Here is Krugman's original graph, with additional information regarding returns to capital.

We start with Profit (the blue line at the bottom).  I have extended the time frame further back.  The green line represents all returns to corporate capital, both to debt and equity.  The debt portion peaked in the early 1980's when corporate leverage was at its highest.  When we make this correction, we find that corporate returns to capital have been flat for 40 or 50 years.  If we add in proprietors' income, we find that returns to capital have been flat or declining for a century.  From 1929 to about 1985, there was a trend of profit claims moving from proprietors to creditors.  From 1985 to the present, there was a trend of profit claims moving from creditors to equity owners.  But, there is no trend of increasing total returns to capital over the past 30 years.

And, when we take the longer view, there really isn't so much of a trend in private fixed investment either, especially considering that investment continues to recover from the recent recession.  Investment is well above the levels of the 1950s.  Investment as a share of GDP ranged from 10-12% until the 1970s.  Since then, the range has moved up to 11-14% and is currently 12.3%.

There is nothing to see here.  Which casts doubt on DeLong's reply, also.

But, if that is the case, then what is causing compensation to decline as a share of GDI?  I'll tackle that in the next post.


* I would put this in the "We are the 100%" file.  Developing world laborers may have a depressing effect on unskilled wages in the developed world.  Developing world capital may have a depressing effect on risk-free returns in the developed world.  This creates higher relative returns to skill for laborers in the developed world and higher relative returns to risk for capital in the developed world.  The context we see in labor and in capital is parallel.

This is a product of the opportunities global capitalism presents to developing economies.  Without these opportunities, developing world laborers would have lower wages or would simply live outside the wage-based economy, and developing world capital that lacked foreign low-risk outlets might seek local low-risk returns through limited-access land ownership and governance.  Access to global financial markets allows for both labor and capital in developing economies to jump up to a much more productive and universally applied economic system.


  1. Excellent post. One possibility you didn't mention that is (only) slightly more sympathetic to Krugman as an alternative or supplement to the demographic/developing world demand for future safety argument: Temporary monopolies. The argument is that technology has produced (1) a greater proportion of winner take all businesses than usual, but many of those businesses are seen as ephemeral monopolies; i.e. risky and (2) generally increased the risk of volatility from incremental investment for many conventional industries (e.g. retailing). This would lead to high apparent returns to equity but also high risk premiums pushing down equity valuations. The speed at which an entrepreneur can convert her labor into a new network that in large part steals or threatens value from existing business (Whatsapp!, Uber) does seem to have accelerated in more than one or two areas, and has started to put more risk in the teeth of supposedly staid businesses.

    Of course, more temporary monopolies and greater threat of obsolescence would actually imply higher overall returns and capital, and you argue they don't really exist. But it could well be that capital structure has corrected to reflect these risks, with the lower debt-equity ratios resulting in a barbell, with the very low returns on (lesser and more selectively placed) debt more protected from the increased competitive risk, with averaged returns on equity bearing most of the burden slash gaining most of the fruits.

    It's interesting that real returns on equity in the industries that seem least affected by an increasing pace of world change, especially financial businesses whose equilibrium competitive returns are mostly based on market-to-market asset values, have not in fact increased. On the other hand, their required returns on capital don't appear to have decreased either (in the case of financials), but there could be other reasons for that.

    1. Thanks for the input, dlr. Excellent comment. Welcome to the IW conversation! Don't be a stranger.

      I think your observation does explain some of what is going on. There is an unusual amount of survivorship bias. So, I think market values to book values are high, but market values to cash flows are pretty normal, which I think is what we would expect to see in the scenario you describe.

      Your last paragraph is interesting. I suspect, especially regarding financials, that the recent extreme volatility in the business cycle might be overwhelming other factors.