Making money made simple
There is a simple secret to building long-term wealth – earn consistent, attractive returns on capital, re-invest these returns and allow them to compound and accumulate over the long term, preferably decades. The challenge is that this seemingly simple course of action lies in the investor’s ability to earn consistent, attractive returns. Which, if you are thinking about equities, means choosing businesses which produce attractive returns over time.
The increased challenges for investors in low-growth world
In times of economic growth, all businesses benefit to some extent. However, when the economy ceases to grow consistently each year, the rate of compounding stock market returns is significantly diminished. During a slowdown, which we would argue is happening now, average businesses are more likely to suffer disproportionally – not only because economic conditions are more challenging generally, but because ‘better’, higher-quality businesses will take more and more of their market share.
Passive investment strategies are also likely to be adversely affected. Index-based stock market investors could still enjoy some potential compounding returns from reinvesting income (dividends); however, they are unlikely to receive the returns they achieved historically.
To enjoy the full benefits of compounding returns, when economic conditions are difficult and growth is stagnant, it becomes increasingly important to identify companies with the ability to grow profits when economic conditions are difficult and to grow them consistently.
Of course, this is what all investors would like to be able to do, but the challenge is that these companies are difficult to find and require significant skill to identify consistently. A research-based, robust investment process which incorporates qualitative as well as quantitative analysis is paramount – particularly because qualitative research offers far greater insights than short-term financial heuristics, such as price to earnings (P/E) or price to book (P/B) ratios.
Time is compounding returns’ greatest ally
The longer the investment period, and the higher the proportion of returns reinvested, the greater the impact of compounding returns. This is why it is important to start saving and investing as early as possible.
In addition, in order to achieve the maximum benefit from compounding, an investor should:
- Invest in a portfolio of companies with superior economics and long-term structural growth – companies that are not reliant on the expansion of the overall economy to grow their profits
- Reinvest into their portfolio as much of the income and sale proceeds as possible
- Maximise the amount of capital invested over time
Earnings growth is linked to GDP growth – which is declining
Figures 3 and 4 below reveal that the broad-based equity indices show earnings growth as strongly linked to nominal GDP growth. For listed businesses that make up the key stock market indices, effective earnings-per-share (EPS) and dividend-per-share (DPS) growth over time is usually below both the rate of nominal GDP growth and the rate of corporate profit growth, primarily due to dilution from increases in the number of shares on issue.
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 20thcentury, 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 3: Corporate profits, GDP, EPS and CPI – U.S.
Figure 4: Corporate profits, GDP, EPS and CPI – Australia
Economic growth depends on consumer demand
In most developed economies, the rate of overall economic growth is largely driven by the consumer sector, because the higher the rate of economic growth, the higher the rate of growth in sales, and therefore profits for the businesses in that economy.
In recent decades, the corporate profit share has been increasing and wages share declining in key economies including the U.S. This is shown in Figures 5 and 6 below. Unfortunately, the increase in corporate profit has been achieved at the expense of wages growth. 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.
History show us that there are natural limits to how far profits can expand as a percentage of GDP without causing social unrest. We therefore 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 as modern businesses with strong value propositions and innovative cultures take market share from 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 5: U.S. corporate profits after tax as a % of GDP
Figure 6: U.S. wage income as a % of GDP
For example, certain low-growth businesses, such as banking as well as capital-intensive, low-growth industrial companies, and structurally challenged sectors, like the resource sector are likely to under-perform going forward. In contrast, we believe some technology and healthcare businesses which have a strong structural growth outlook will outperform.
Looking forward we expect low long-term earnings-per-share growth from major stock market indices. Structural headwinds such as ageing populations, high debt levels, growing income and wealth inequalities and the hollowing out of the middle class will all negatively impact the ability of certain businesses to perform. And there are other factors at play as well – increasing technology-based disruption which will negatively impact human capital markets and traditional industries and increasing natural resource constraints, including climate change, will restrict economic growth levels and consequently long-term share market returns.
This article was co-written by Mark Arnold and Jason Orthman, Chief and Deputy Chief Investment Officers at high-conviction equities manager, Hyperion Asset Management.
This article was originally published on Livewire.