Humans are a pattern-forming species. The present is confusing enough, but the future is terrifying. So we like to create mental paths that give us some confidence that tomorrow will be like today. Even today, the unexpected – typhoons, earthquakes, floods – can bring terror; in the past, unexplained natural phenomena such as eclipses could bring life to a standstill.
Cause and effect
It is only natural, then, that those two greatest puzzles – money and luck – should have the greatest appeal to those with computers and a yen to prove that luck is not luck alone, but a hidden pattern that, when identified, will produce instant and riskless fortunes. Detailed analysis of stock market movements is not new, but the development of the computer and the growth of universities after 1950 turned this speculators’ hobby into a mainstream academic profession.
The growth of pension fund investment financed this research, and within a few years there was enough theory to persuade hard-bitten businessmen that investment could be a science, and not a speculation. Ideas, once developed, prove difficult to change; so, despite experience to the contrary, most major investment houses still operate on the basis of the efficient market hypothesis (EMH).
This also helps to explain investment confidence today, when all ‘normal’ considerations suggest that investors should be running for cover. Management consultancy McKinsey has analysed recent investment returns, over both the past century and the more recent 50 and 30 years. These have been good, especially for those who bought and held equities, with year-on-year returns of 8 per cent over the past 30 years, both in Europe and in America. So ‘history’ proves that we are right to take stock market risk.
These returns are a lot higher – at 25 to 40 per cent – than those over the 50- or 100-year periods; and they represent, in McKinsey’s view, a ‘dreamtime’ that is unlikely to be repeated. The fall of the Iron Curtain and the emergence of China massively expanded world GDP; technology gains boosted corporate profitability from 7.6 per cent of GDP in 1980 to 10 per cent by 2013; inflation fell, bond yields declined, and equity revaluations led to massive capital gains to investors. So McKinsey concludes that future returns are almost certain to disappoint.
Economic growth – where is it?
Recently, both GDP and productivity figures have failed to show the improvements expected, and neither governments nor central bankers have any idea on how to boost them. Some central bankers have now moved from quantitative easing to reduce the cost of money to actual negative yields: surely free money should persuade companies and individuals to spend? This is the real question for investors. Does prosperity continue, but is it now hidden by the inaccuracies of GDP measurement?
This, after all, is a measure developed in the 1930s during the Great Depression, and for a world that made and traded ‘things’. Now we are in a world where much of what we offer and consume is ‘services’, some of which are now ‘free’, like social media and ‘online’ purchasing. Economists and statisticians are increasingly questioning the value of GDP as a measure of today’s economy, let alone as a test of ‘welfare’.
Many suggestions have been made for improving economic measurements, but the intellectual and political challenges are great. The exigencies of war made the development of GDP an urgent need; no such need exists to push for its replacement. If the measurement foundations of prosperity are to be doubted, what then are the certainties of the EMH?
The role of skill
Bloomberg calculates there are some 68,000 listed companies in the world. So, whatever the merits of mechanical investment, whether EMH or one of its market-balancing offshoots, judgment is needed to select those companies that will thrive and survive; the average life of a company is less than that of a man.
And costs are important. Government ministers as well as the FCA are worried about costs; this shows both are conscious that, with future returns likely to be lower than in the recent past, investors need to make something from their investments if they are to continue with them.
That McKinsey report concluded that a 30-year-old today will have to work seven years longer, or save twice as much, to have the equivalent pension to a baby-boomer.
For many of us, the answer is a portfolio of half a dozen investment trusts, as shown in last month’s Investment Spotlight. But perhaps these should be not UK equity income, as was the sample, but a wider mix of global equity and UK income, such as infrastructure and other specialised funds.
As for what the board and manager of such a fund should do, there is perhaps no better example than the views of the equity management of Sarasin, a long-proven example of the best of the Swiss and English investment tradition.
It said in a recent update, “We believe that stable dividends, dividend growth and above-market total returns are the output of our disciplined approach. We identify and invest in high-quality stocks with strong thematic drivers. Our preferred measure of quality is profitability, measured as cash return on invested capital (CROIC), as we suppose this to be the financial engine of long-term, persistent, shareholder value creation.
“Companies that are able to sustain high levels of profitability and cash generation are well equipped to out-invest less profitable peers for the benefit of long-term growth. Higher returns lead to financial surpluses over and above the reinvestment needs of the business, thus supporting the payment of generous and sustainable dividends. In this regard, we view dividend growth as a by-product of corporate success.”
CROIC is the key metric. All of us, in our lazy way, are inclined to think that little changes within our lives, but technology changes everything, and all the time. More cars are made today than 30 years ago – and those cars are bigger and better – but with only a fraction of the workforce of the 1980s. The same is true of steel, heavy engineering, and all those other blue-collar industries. It is technological change, just as much as globalisation, that creates rust belts.
Thinking of the future
So companies that need heavy investment in fixed assets give hostages to the future. Companies with low fixed assets (such as Apple, Coca Cola and Microsoft) that manufacture and distribute through franchise or digital means are less vulnerable to technology and competition. And large companies (all of which started out small) have many strengths but also weaknesses – of which a lack of imagination can be one of the greatest.
Not for nothing are small- and medium-sized enterprises the foundation of employment growth. These are the entrepreneurs that see the new opportunities, and take advantage of new markets. It is their companies that can increase sales faster than the average for an extended period. It is those increasing sales that enable their companies to invest faster than their competitors, but also to increase dividend payments at the same time.
Since life expectancies continue to increase, many who retire today at 60 will live well into their 90s. Maybe inflation is less of a threat today than deflation, but more than 30 years of prospective retirement makes a growing equity income a necessity, if retirement is to be stress-free and comfortable.
History is another good lesson for investors. The rich have always dominated the fashion of demand, but it is the middle classes, with their desire for aspirational lifestyles, that have driven economic growth.
According to McKinsey the emerging-markets’ ‘middle class consumers’ comprise almost 2bn people and spend almost $7tn annually. This market is expected to double in size by the end of the next decade. Your manager should be searching for companies exploiting these opportunities, not babbling endlessly about ‘balance’ and ‘smart beta’.
