The return on capital drives that of equities. And US companies, which had learned to grow using less capital, have changed the trend; in emerging markets, the opposite is true
Text: Robert Almeida (MFS) •
Equity markets have a tendency to confuse results and causes. When stocks perform well, investors look for explanations such as economic growth or favourable policies. However, over time, equity returns have been related to the capital efficiency of companies rather than GDP.
Over the past few decades, equity in developed markets – particularly in the United States – outperformed that in emerging markets, not because their economies grew faster, but because their companies learned to grow using less capital, as balance sheets shrank relative to income statements. Software replaced hardware, intellectual property replaced factories, and global supply chains outsourced asset needs.
US companies led the pack in these aspects, resulting in a powerful and sustained surge in returns on invested capital. Valuations followed suit.
“Those who favoured emerging market equities learned that economic growth, by itself, is not what multiplies wealth”
Emerging markets have revealed a diametrically opposed trajectory. Growth was real and often turned out to be spectacular, although many companies in these markets required a lot of capital. Infrastructure, housing, manufacturing capacity, among other things, demand huge initial investments and require long periods to recoup that investment. While this contributed to economic growth, returns on capital remained modest compared to those of companies in developed markets. Investors who favoured emerging market equities over those in developed markets learned the lesson that economic growth, by itself, is not what multiplies wealth.
This distinction is somewhat relevant, as valuations do not respond to growth in isolation. As highlighted in Chart 1, valuations react to the efficiency with which capital is deployed.
For much of the last 30 years, developed markets have enjoyed a structural advantage in this respect. However, something may have changed.
TURN IN CAPITAL INTENSITY
In recent years, capital intensity in the United States has begun to rise. After decades of becoming less capital-intensive, US companies are again allocating large sums to support growth. The infrastructure of artificial intelligence – data centres, semiconductor manufacturing, energy generation, and supply chain redundancy – requires both substantial initial investment and ongoing reinvestment.
These investments could prove necessary from a strategic perspective and economically valuable. However, from a capital cycle perspective, increasing capital intensity has almost always resulted in a contraction of incremental returns. As capital flows into attractive opportunities, competition increases, depreciation rises, and the profitability of the next dollar invested decreases, although for a time the returns on existing assets may remain high.
“If capital flows into attractive opportunities, competition and depreciation grow, and the profitability of the next dollar invested decreases. High returns and abundant capital incentivise over-investment”
It is worth noting that this shift is occurring from a starting point where both returns and valuations are high in historical terms. High returns and abundant capital are precisely the conditions that incentivise over-investment, the consequences of which often emerge gradually and then appear suddenly.
At the end of the 1990s and the beginning of the 2000s, telecommunications were considered a revolutionary technology. Fibre networks promised exponential growth in data usage and disruptive business models. To a large extent, this thesis was correct, but what turned out to be disastrous for investors was not the technology itself, but rather the fact that the volume of capital – and the supply it brought with it – was more than society could absorb. The lesson learned was that the capital cycle can lead to oversupply and dilute returns.
The current investment cycle driven by AI is different in its details, although familiar in its structure. When a theme is interesting enough to attract vast volumes of capital, history suggests that future returns are likely to be more of a disappointment than a surprise.
EMERGING MARKETS: ANOTHER STARTING POINT
As we have seen before, capital intensity in emerging markets has long been higher than in developed markets. Many companies in emerging markets already operate in environments where capital is scarce, financing costs are high, and efficiency is insufficient. Although capital intensity has increased somewhat in developed markets, what matters is that the gap – which has been narrowing secularly – between emerging and developed markets is closing.
“The lesson learned in 2000 was that the capital cycle can lead to oversupply and dilute returns”
This is significant because the return on capital is determined by the return on additional investment. As companies in developed markets transition from a low capital-intensive growth model to a more capital-intensive one – while companies in emerging markets are no longer progressively becoming more "intensive" in capital – the gap in return on capital could narrow on the side of developed markets.
VALUATION GAP
It is also relevant what investors have discounted. The existing valuation gap between US equities and those of the rest of the world implies, in our opinion, that investors are not taking into account the impact of increasing capital intensity on the American giant.
This is not a call to abandon US stocks, nor does it imply that emerging markets will suddenly require less capital. The argument lies in the fact that the incremental shift in capital intensity determines the direction of change and, therefore, influences the different risk premiums that investors are willing to pay.
We believe this is why non-US equities outperformed US equities in 2025, a trend that could persist, as this situation may have begun to be discounted.
THE ROLE OF ACTIVE MANAGEMENT
Periods in which increasing capital intensity has been observed have generally translated into a reduction in aggregate returns and an increase in dispersion.
When capital is cheap and business models are low in asset intensity, many companies can appear good at the same time. When capital becomes expensive and growth requires larger investments, the difference between companies that allocate capital well and those that do not becomes critical.
Benchmark indices do not distinguish between efficient and inefficient use of capital. They reward size, not discipline. In contrast, active investors can assess where capital is being invested, what the expected return is, and in what competitive context.
In our view, in a world where returns on capital are no longer growing uniformly, understanding capital allocation becomes more important, not less. It is unlikely that the next phase of equity returns will be determined by a widespread expansion of multiples. It will be the ability to select that drives it.
Ultimately, as capital intensity increases, capital returns will experience adjustments... And markets will eventually reflect that reality. The opportunities for those willing to go beyond the theses and focus on the mechanics of value creation lie in identifying those who adapt to the situation and those who do not.
In this environment, we believe that non-US firms, particularly those from emerging markets, will be one step ahead. ♦
