Exponential growth and compounding returns (Part 1)

Introduction
Hyperion Asset Management (Hyperion) exists to help our clients protect and grow their capital over the long term. When we invest capital in listed companies on our clients’ behalf, we have the mindset of long-term business owners, not short-term traders. The average holding period for the companies in our portfolios is 10 years and long-term sustainability of the businesses we invest in is core to our philosophy. Sustainability is essential because over long time periods, the value proposition to all relevant parties associated with the business needs to be sufficiently attractive for the business to grow and thrive. In the very long term this includes the wider community, society and the environment. Long term capital preservation is a core part of our investment philosophy as we see risk as permanent loss of capital, not short-term market price volatility. Our mindset is centered on achieving attractive long-term absolute positive real (inflation adjusted) returns on our clients’ portfolios. Our investment philosophy and process are designed to compound our clients’ capital at rates of return that are not only positive in absolute (inflation adjusted) terms but also materially above the relevant passive benchmarks over long time horizons. Compounding returns on capital are core to how we invest and how we have been able to grow our clients’ capital. Since Hyperion was established in 1996, we have achieved our goal of producing attractive positive absolute real returns (preserving capital) whilst also achieving long-term returns significantly above the relevant benchmarks (after fees). These attractive returns have added significant long-term value to our clients’ portfolios not only in percentage terms but also in dollar terms. We estimate that total cumulative dollar alpha (the excess returns of our portfolios above the relevant passive benchmark) currently amounts to approximately $A1.3 billion. This cumulative dollar alpha currently represents 22 percent of our total funds under management (FUM) of $A5.8 billion.[1] We believe we are well positioned to continue to add value for our clients over the coming decades.

We have prepared a five-part series of thought pieces that are designed to explain how achieving attractive cumulative returns on capital over decades is key to building wealth.

This paper (part one) looks at the three components of capital accumulation in a capitalist society. Our second paper (part two) discusses the importance of investment style in determining the likely cumulative rate of return an investor is likely to achieve over the next decade. Part three focuses on traditional value investing and provides an explanation as to why it is unlikely to produce strong compound returns going forward. Paper four discusses the importance of good management in achieving attractive cumulative returns on capital over time. Finally, part five investigates the natural resource constraints to exponential economic growth and capital accumulation in the future.

Capital Accumulation
In a capitalist society there are two broad groups of people – workers and capitalists (investors). Capitalists fund the employment of labour (workers) and provide capital (such as plant and equipment) through businesses in order to create goods and services demanded by households. The workers earn income from businesses for primarily selling their time. The capitalists (investors) invest their money (capital) in:

  1. ownership of businesses (equity)
  2. loans to others including businesses (debt); or
  3. other assets, including land and commodities

Capitalist-based societies encourage the accumulation of capital by individuals and other legal entities through investment and its subsequent legal protection of ownership (property rights). Capital accumulation is a key characteristic of capitalism. Accumulation of capital is the process of investing capital with the objective of growing that initial investment over time through the production of profits. Those members of society who have access to capital and have the ability, skill and willingness to invest that capital, have the potential to earn attractive rates of return over time. If those returns are reinvested, they can enjoy exponential growth in capital over the long term.

Hyperion invests capital on behalf of its clients, taking the perspective of a business owner. We invest our clients’ capital in high quality, structural growth businesses using our proprietary investment process in such a way as to protect and grow that capital. Hyperion’s portfolios have benefited from cumulative returns above their benchmarks over long time periods. Most of our FUM is the result of the capital Hyperion has generated from cumulative returns rather than from contributions from clients. Two key aspects of Hyperion’s ongoing success, in reaping the rewards of compounding returns, are:

  1. identifying quality businesses that can generate sustainable attractive returns (even in the presence of ongoing economic headwinds); and
  2. our long-term approach to investing.

“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.”

– Albert Einstein

Capital and compounding returns
The three factors that influence capital accumulation are:

  1. the amount of capital invested;
  2. the period the capital is invested; and
  3. the cumulative rate of return on that capital

A compound return is the cumulative rate of return earned over multiple periods where the income, gains and losses on a capital investment are reinvested over the life of the investment. Compound returns are measured by comparing the final value of an investment with its original investment value, normally expressed in average per annum (p.a.) terms as a compound annual growth rate (CAGR).

The Hyperion Broad-cap Composite is an example of the long-term benefits of compounding returns (refer Figure 1). It has produced a CAGR of approximately 13.1% p.a. (before fees) and approximately 12.1% p.a. (after assumed fees) since October 1996.[2] This means that if you had invested $A100 in this composite in October 1996 and had reinvested all the cumulative income and gains (after fees) over the 22 years from your investment, it would be worth more than $A1,256.[3] If you had invested in the S&P/ASX 300 Accumulation Index over the same 22 year period, your CAGR would have been approximately 8.7% p.a. and $A100 would be now worth approximately $A639.

Figure 1: Hyperion Broad-cap Composite vs S&P/ASX 300 Accumulation Index since 1996

The Hyperion Broad-cap Composite did not produce a 12% p.a. (after fees) return every year. In fact, its returns varied meaningfully from year to year, but if the investment was left to compound over time it would be worth approximately 12.6 times the original investment, versus around 6.4 times if you had invested in the index.

Historically, growth in corporate profits has been beneficial for equity investors because this growth has resulted in growing income streams and intrinsic values through time. However, this aggregate corporate profit growth is predicated on an economy that continues to expand at an exponential rate over time. When we reach a point where the economy ceases to grow over an extended period, then the rate of compounding stock market returns will be significantly diminished overall. Average businesses are likely to suffer significant declines in value from the combination of poor economic conditions and loss of market-share to a smaller number of elite businesses. Index-based stock market investors could still enjoy some potential compounding returns from reinvesting income (dividends) they receive. However, they are unlikely to receive the returns they achieved historically, in a lower growth, more competitive world. To enjoy the full benefits of compounding returns it will be necessary to identify those companies with the ability to grow profits in more stagnant and difficult economic conditions. These companies will be hard to find and require significant skill to identify consistently. Qualitative analysis will become much more important than short-term financial heuristics, such as price to earnings (P/E) or price to book (P/B) ratios.

i) The amount of capital invested
As mentioned previously, a capitalist society can be divided broadly into workers and capitalists (investors). Workers tend to have to rely primarily on their income from personal exertion and have limited equity ownership in businesses and other investments. Access to capital and ownership of capital are massive competitive advantages for the wealthy and a substantial impediment for the poor in accumulating material wealth. People who don’t have much capital to start with need to:

  1. achieve higher rates of return;
  2. save more and invest more from their personal exertion income; and/or
  3. invest over a longer period to match the ending capital of others who start with more capital.

Obviously, the more capital an investor starts with, the greater the dollar amount returned and the more capital that investor has to reinvest. Consequently, over time the wealthy get wealthier at an exponential rate. This increasing concentration of capital with the wealthy in society is a key reason for increasing income inequality in most countries, because income is derived both from personal exertion and capital. Since the wealthiest hold the most capital, they earn more income. This income and capital differential tends to expand over long time horizons as the extra income can create more capital, which in turn generates more income.[4] Hence, the generation of a compounding capital base. Figure 2 illustrates the trend towards increasing wealth inequality that has occurred in the U.S. since the mid-1970s. The wealthiest 0.1% of the U.S. population has approximately the same wealth as the bottom 90% of the population. The last time this occurred was in the 1920s and 1930s. Figure 3 shows that wealth inequality is on the rise in a number of countries and remains high in others.

Compulsory superannuation in Australia mandates employees to save and invest a portion of their income over their working life – the underlying concept being that, on retirement, workers will enjoy savings that have had the opportunity to benefit from the impact of long-term compounding returns. This compulsory superannuation system has partly contributed to Australians being ranked the world’s wealthiest people according to the Credit Suisse 2018 Global Wealth Report.5 The system has also acted to reduce wealth inequality in Australia by forcing most Australians to save part of their salary during their working lives.

The key takeaway is that without the benefit of a large starting capital base, workers need to start saving early in their working lives in order to enjoy the benefits of compounding returns. Savings can be regulated, as in the Australian system, forcing everyone to participate in compulsory superannuation. However, where conditions are such that the general populace is unable to accumulate capital as a result of economic circumstances such as insufficient employment opportunities, inadequate wage levels, high healthcare and education costs or highly restrictive credit conditions, we will continue to see a growing divide between the wealthy and the rest of society. The wealthy will continue to enjoy the advantage of compounding returns from a large capital base.

Figure 2: Wealth inequality is high in the U.S.

Figure 3: Wealth inequality is either very high or rising in most countries

ii) Time is the friend of compounding returns
The longer the period that capital is invested, the larger the impact of compounding returns on wealth. Starting to save and invest early in life allows time for returns to compound, resulting in larger amounts of capital later in life when individuals reach an age where they might like to retire.

The compounding effect can be illustrated by looking at Hyperion’s FUM. Total FUM currently stands at approximately $A5.8 billion, of this amount, only $A1.3 billion or 22 percent is from net client contributions of capital over the past 22 years. [6] The rest of Hyperion’s FUM is from cumulative returns on capital. That return on capital over the past couple of decades has created $A4.5 billion in FUM or 78 percent of the total. The alpha (after fees) component of Hyperion’s FUM is approximately $A1.3 billion or approximately 22% of the total.

We believe, that in order to achieve the maximum benefit from compounding, an investor should:

  1. invest in a portfolio of companies with superior economics and long-term structural growth i.e. companies that are not reliant on expansion of the overall economy for their profit growth;
  2. take a long-term view and be patient, acting like a business owner rather than a share trader;
  3. reinvest as much of the income and sale proceeds as they can afford, back into the portfolio continually over time; and
  4. maximise the amount of capital that is invested over time.

This approach focuses on finding a small number of stocks with healthy returns that can compound multiple times over a long period of time.

iii) The cumulative rate of return
Capital investment can be broadly categorised as either equity ownership of businesses or debt related investments. Hyperion invests only on the equity side (although we also do hold short-term cash equivalents). The long-term rates of return from owning equity capital in businesses tend to be higher, on average, compared with returns available on interest bearing investments over similar periods. This is primarily because there is increased uncertainty associated with owning equity in a business compared with a debt investment. The risks associated with equity ownership relates to multiple factors including:

  1. timing and quantum of future underlying cash flows is uncertain;
  2. market value at the time of disposal is uncertain; and
  3. the future sale date is uncertain (i.e. there is no fixed maturity date).

The long-term exponential growth from equities is generally higher than debt related investments because of the higher return on capital that is normally associated with business ownership and the ability for some businesses to expand their invested capital at attractive rates of return. The returns from debt related investments tend to be lower but more certain in terms of the income likely to be received, the duration of the investment and its terminal value. Thus, because of these lower rates of return on capital, debt related investments generally do not compound at the same rate as equity related investments.

For the broad-based indices, earnings growth is heavily linked to nominal GDP growth (refer to Figures 4 and 5). For those listed businesses that comprise the key stock market indices, the effective EPS (and DPS growth) over time will normally be below both the rate of nominal GDP growth (the green line in Figures 4 and 5) and the rate of corporate profit growth (the two orange lines in Figures 4 and 5) primarily due to dilution from increases in the number of shares on issue. The blue line in Figure 5 represents the effective EPS of these businesses. In the U.S., dilution in EPS has been reduced because of the large number of share buy backs that have occurred in that market.

The rate of GDP growth in the U.S. has been declining over the past 50 years. The multiple tailwinds the U.S. economy enjoyed for most of the 20th century including high levels of innovation, cheap and abundant energy, a young population, increased financial gearing, and a robust and growing middle class have now given way to mounting structural headwinds that are forcing the sustainable rate of GDP growth lower.

Figure 4: Corporate profits, GDP, EPS and CPI – U.S.

Figure 5: Corporate profits, GDP, EPS and CPI – Australia

The businesses that supply the economy with many of the goods and services are in aggregate constrained by the overall growth of the economy. In most developed economies, this rate of overall economic growth is largely driven by the consumer sector. Generally, the higher the rate of economic growth, the higher the rate of growth in sales and profits for the businesses in that economy. The corporate profit share of the economy can vary over time. In recent decades, the corporate profit share has been increasing and the wages share declining in key economies including the U.S. (Refer Figures 6 and 7). The increase in corporate profit has been achieved at the expense of wages growth. This profit growth has supported returns on capital invested in businesses but has also contributed to the hollowing out of the middle class and increasing income and wealth inequality. The expansion of corporate profits can also be seen in Figures 4 and 5 with corporate profit growth outperforming GDP growth since 1961 both in the U.S. and Australia. There are natural limits to how far profits can expand as a percentage of GDP without causing increasing social unrest. Thus, we believe it is unlikely that corporate profits will continue to expand as a percentage of GDP over the long-term. We think corporate profits are likely to remain range bound relative to the overall economy and the rate of growth in the U.S. and global economies is likely to continue to experience structural declines over the next decade. However, it should be noted that the mix of profits across the business sector is likely to change over time with modern businesses with strong value propositions and innovative cultures taking market share from the traditional, structurally challenged businesses. The profit shift to modern business models will result in a “hollowing out” of average and traditional business models over the next decade.

Figure 6: U.S. corporate profits after tax as a % of GDP

Figure 7: U.S. wage income as a % of GDP

Growth in the EPS and DPS of Hyperion’s portfolios is a function of the stocks held in the portfolios and the weights those stocks are held at through time. Hyperion’s Broad-cap composite has produced an EPS CAGR of approximately 9.3% p.a. over the past 22 years, compared with the benchmark that has produced EPS CAGR of approximately 4.1% p.a. The differential explains most of the alpha (pre-fees) of 4.4% p.a. since 1996.

Table 1 illustrates the long-term benefit of holding a portfolio of stocks that produce superior and sustained EPS growth.

Table 1: The current value of a $A100 invested in the Hyperion Broad-cap Composite in 1996

Figures 8 and 9 below illustrate the long-term relationship between EPS and the market value of the shares. Both charts show that the Hyperion portfolios have produced superior EPS growth over long time periods compared with the relevant benchmark.

Figure 8: Hyperion Broad-cap Composite (ex-dividends), S&P/ASX300 Index and EPS

We believe the EPS CAGR for the Australian Broad-cap composite should be higher over the next 5 to 10 years (compared with the last 22 years) because the current portfolio has a higher exposure to structural growth businesses. The portfolio also has a lower than historical exposure to the low-growth banking sector and other capital-intensive, low-growth industrial companies and zero exposure to the structurally challenged, low-quality resource sector. In contrast, the index has a very large exposure to all these sectors and a small exposure to structural growth businesses such as technology and healthcare. Consequently, we expect our Australian portfolios to produce stronger EPS growth over the next 5 to 10 years, whereas it is likely the index will produce weaker EPS growth than it has achieved historically.

Figure 9: Hyperion Global Growth Composite (ex-dividends), MSCI World Index and EPS

The Hyperion Global Growth fund is expected to achieve higher EPS growth relative to our Australian Broad-cap composite over the next 5 years with a higher level of confidence. The average quality of businesses in the Hyperion Global Growth fund is superior to the Australian portfolios because there is a larger number of high-quality companies listed outside Australia than there is in Australia.

We expect low long-term EPS growth from major stock market indices because of the structural headwinds of ageing populations, high debt levels, growing income and wealth inequalities (hollowing out of the middle class), increasing technology-based disruption (negatively impacting human capital markets and traditional industries) and increasing natural resource constraints (including climate change related impacts). These factors will restrict economic growth levels and consequently long-term share market returns.

Conclusion
In a capitalist society, the keys to wealth generation are saving capital to invest, investing for the long-term and identifying high quality businesses that are well-positioned to grow sustainably over the long term. Hyperion’s portfolios have benefited from the application of the key concepts underlying compounding returns.

The global economy faces numerous structural headwinds. Average businesses are heavily reliant on a strong economy in order to be able to grow their profits. A lower growth world will make it more difficult for these traditional businesses to grow profitably. In addition, the world is becoming more competitive and technology-based disruption continues to increase. These factors are likely to continue to place downward pressure on index-based equity market returns over the next decade.

In a low growth and disrupted world, capital allocation becomes much more important and thus investors need to be very selective regarding stock selection. At Hyperion, we are extremely discerning and only invest in the highest quality businesses within the relevant universe.


Mark Arnold (Chief Investment Officer) and Jason Orthman (Deputy Chief Investment Officer)




[1] As at 31 January 2019
[2] As at 31 January 2019. Returns are before taxation related expenses
[3] Assuming management fees of 95 bps
[4] Capital in the Twenty-First Century, Thomas Piketty
[5] Median wealth per Adult of $US191,453
[6] As at 31 January 2019

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