For mature economies two per cent is the new four per cent

6 June 2016

Passive strategies will not help in finding relative value and emerging markets are not going to save the market this time, Damien McIntyre writes.

With diminished prospects for economic growth, the theme for every economy in the world, many investors are re-evaluating their investment return expectations.

It is true that developed economies are on the whole experiencing an economic recovery, but it is an anaemic one.

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Government debt has risen substantially since the financial crisis and is acting as a drag on economies. Ultimately, growth in real gross domestic product (GDP) depends on growth in the workforce and growth in productivity, and neither appears promising.

What's more, emerging markets are not going to save us this time, as many had hoped. A marked slowdown in China is acting as a counterweight to recoveries in the developed world.

There is much debate about the causes and cures regarding this economic malaise. Some characterise it as secular stagnation, a term coined during the Great Depression to reflect low growth, low interest rates and low inflation stemming from a chronic lack of demand.

The recommended prescription is fiscal stimulus directed at areas in need of investment, such as infrastructure. But that seems unlikely to occur in either the politically gridlocked US or austerity-minded Europe.

Debt shift

Others believe it is due to global imbalances that were the true root cause of the Global Financial Crisis. The belief is that we can return to previous levels of growth after a period of deleveraging.

But while we have witnessed substantial debt reduction among consumers and financial companies, the face is that the debt has merely shifted to the government sector.

In this environment, the reality is that two per cent is the new four per cent for mature economies' GDP, and equity market investors need to revise their expectations in line with this.

Lower GDP levels in mature economies will naturally have a flow-on effect to global equity market returns. This makes determining the correct investment strategy all the more important.

The future is uncertain, and in uncertain times it is important to return to principles.

And the first principle is there are only three determinants of returns for equities: earnings, dividends, and price-to-earnings (PE) multiples.

A changing landscape

Over time, the relative importance of these three determinants has changed dramatically in response to changes in the economic landscape.

In the 1980s and 1990s, for example, rising PE ratios were the principal drivers of equity returns, leading to the popularity of valuation methodologies that reflected price-to-book value and price-to-earnings metrics. Underlying this 20-year PE expansion was a collapse in interest rates.

It is likely that we have now entered a period in which PE ratios are more likely to contract than expand as interest rates begin to rise rather than fall from recent historic lows.

Given the inverse relationship of PE ratios to interest rates, the expansion of PE multiples will no longer be the primary explanatory variable of equity returns.

This leaves earnings growth and dividends, the two variables that have been the dominant sources of equity returns over the past 80 years. These two variables are derived from a single source: cashflow.

Free cashflow, and how it is allocated, is ultimately the source of earnings and dividends.

The key to producing superior risk-adjusted equity returns is the identification of companies with a consistent ability to both generate free cashflow and to properly allocate it among internal reinvestment opportunities, acquisitions, dividends, share repurchases, and debt repayments.

The determination of how to deploy free cashflow should be guided by the company's cost of capital. Acquisitions and reinvestments should only be undertaken when the return on capital is greater than the firm's average cost of capital.

Otherwise, free cashflow should be returned to shareholders via the other three uses: dividends, share buybacks, and debt repayments — in other words, as shareholder yield.

Good companies are those that create free cash. Great companies are run by people who know how to allocate that excess cash to create value.

Build something and buy something. And if you can't do that, you need to return the money to the owners of the business. Because that's what businesses are for: to generate capital for their owners.

The focus needs to be on companies that return six per cent on a regular basis, while still investing enough to grow at three per cent or more a year. Invest in these companies and you'll find good returns.

Epoch chart

Lower peaks for longer

With our economic and business cycles expected to have lower peaks for a long period of time, any recovery will take place in the context of a slow-growth world.

Consequently, equities are not likely to benefit from expanding price earnings multiples as they did in the 1980s and 1990s.

However, the evidence demonstrates that long-term equity returns are driven by growth in earnings and dividends, with the vagaries of PE multiple expansion and contraction washing out over time.

Nevertheless, as we look at companies across markets, the economic reality is having an influence on their capital allocation decisions.

In a low growth environment, there are fewer opportunities to reinvest that will meet required return thresholds, even with the generally low cost of capital.

Merger and acquisition activity will likely increase, but companies with established businesses that generate free cash and have a disciplined capital allocation process will also be giving more back to shareholders.

Globally, the economic outlook notwithstanding, the expectation is that buybacks and dividend payouts will continue at a high level.

If investors collect these free cashflow payments up front, with the intention of making them compose the bulk of the investment return, it will provide a measure of reliability and reduced volatility within an equity allocation.

Finding relative value is never easy in times like the present, but it will be visible in those companies generating free cashflow and possessing managements that have a history of wise capital allocation.

Value will not be found in passive strategies where large proportions of the names have no earnings and no earnings before interest, tax depreciation and amortisation (EBITDA). Indeed, mispricing opportunities arise in volatile markets and those investors with longer holding periods will benefit.

Note: Grant Samuel Funds Management has funds managed by Triple3, Tribeca, Epoch, and Payden and Rygel.

Damien McIntyre is the director and head of distribution at Grant Samuel Funds Management.

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