For a number of quarters now, we have been among those investors waiting for private-sector spending to replace government stimulus as the primary driver of economic growth. While the wait may not be over just yet, it appears that we are getting closer to that point. With the Federal Reserve’s second round of quantitative easing (QE2) scheduled to be completed in June 2011, capital deployment by cash-rich businesses is on the upswing, spawning potentially attractive investment opportunities across multiple market segments.

Not surprisingly, capital deployment plummeted during the latest recession. Nearly two years later, corporate balance sheets remain fairly laden with cash, suggesting that companies in general are still being somewhat cautious with their capital allocations. However, as many firms have grown more confident in the sustainability of the recovery, they have demonstrated a greater willingness to deploy capital. As shown in the chart, capital expenditures by nonfinancial companies in the Russell 3000^® Index have steadily increased in recent quarters after an extended period in which their free cash flows rose dramatically. Merger and acquisition (M&A) activity has also picked up, with the total value of takeouts by U.S. companies more than doubling in the first quarter of 2011 as compared with the same period a year earlier.

The evidence gleaned from our own fundamental research paints a similarly encouraging picture. Some of the companies we follow have begun to step up their capital spending in spite of the still-challenging economy, while others have undertaken M&As as a way to put their idle cash to work. Unlike some of their shorter-sighted competitors, we believe these companies have correctly recognized the need to make sound business investments now in order to better position themselves for long-term growth as the business environment continues to improve. Naturally, more robust capital deployment can also directly benefit select companies in sectors with strengthening end demand—such as industrials, energy, and information technology—as well as companies that become strategic acquisition targets.

Concluding observations
The recent uptick in capital deployment signals that the handoff from government stimulus to business spending may finally be underway. After anticipating this trend for months, we expect it to gain further traction in the period ahead, creating a potential tailwind for a variety of stocks. The task for investors, of course, will be to identify which ones look most likely to emerge as “winners” going forward. As always, we think a rigorous, bottom-up stock selection approach is well suited to that task.