Don’t trust your emotions. When you feel euphoric, you’re probably in for
a bruising. When you feel down, remember that it’s darkest just before dawn and take no action. Activity in investing is nearly always in surplus.
Charles D. Ellis – Winning the Loser’s Game
Looking forward to 2013
As 2012 draws to a close, it is good to reflect back on the year just past and to look forward with confidence to the year that lies ahead. That may not seem very easy in these austere times with the UK’s debt rising, weak economic growth and the Eurozone crisis that rumbles on and on. Yet it is a good opportunity to regain some perspective and to reaffirm our faith in the capitalist system’s ability to generate wealth over time.
Markets in perspective
The equity market is made up of all those who, quite rationally, are seeking the rewards of global capitalism (i.e. dividend payments and share price rises on the back of growing corporate earnings) from their ownership stakes in companies around the globe. Yet, the human mind’s predisposition to overweighting the significance of current events, and failing to place them in perspective, sometimes makes it hard to see the wood for the trees. It may even make some investors lose faith in the long-term ability of equities to grow wealth.
While we should not underestimate the scale of the challenges ahead, we need to keep them in perspective. To many it will feel that we are caught in a downward spiral of debt, weak leadership, stagnation and a sense that the future lies in the East not the West. Is this really the case? From an investor’s perspective, what does it all mean? Most likely, just more of the same; markets will go up and down, as they always have done, and they will capture the growth of the global economy, in the form of positive, after-inflation returns, as they must do, eventually.
Benjamin Graham, who was one of the founding fathers of modern investing, once stated that in the short term the market is a voting machine, but in the long term it is a weighing machine. The voting machine reflects the release of new information, such as forecasts for GDP, prospects for an industrial sector, or specific information relating to a company. In turn this affects investors’ day-to-day perceptions of the future outlook (i.e. earnings) for companies, which translates into the new price for their shares. Short-term market movements compound our sense of uncertainty and even anxiety.
The chart below shows both the voting and the weighing machine in action. The weighing machine reflects the rewards that come, over time, from the hard work, sound strategy, innovation and dynamism of companies operating in a capitalist society. On average, over the last 30 years, the UK equity market returned 7% a year above inflation. Over the very long term (since 1900) UK equities have delivered around 5% a year after inflation. During this 30 year period, returns have been volatile. That is the voting machine at work.
Figure 1: The voting machine vs. the weighing machine – UK equities (past 30 years)
Data source: FTSE All Share after inflation. Morningstar Encorr. All rights reserved.
The economy in perspective
Seeing the wood from the trees is important when it comes to the economy. Commentators get very excited over the fact that the economy has grown or shrunk (or the numbers revised) by 0.1 percent. But what is the margin of error on these numbers? Probably in the order of 0.5% at least! In a recent series by Stephanie Flanders of the BBC, the Governor of the Bank of England stated that they did not know how the economy really operates and that forecasting it was well-nigh impossible – perhaps a point worth noting.
Positive signs ignored by the press
While the mood may seem somewhat gloomy, there are a number of positive items that have received less attention from the press than perhaps they ought.
· Job creation by the private sector. At the start of October 2012 there were more people in work than at any time in the UK’s history. Even accounting for some jiggery-pokery on the numbers (some public education sectors were reclassified as private), the private sector has created over 850,000 jobs since the coalition government came to power, absorbing the job losses arising as austerity measures hit the public sector.
· Corporate cash hoarding. Non-financial companies in the UK are holding around £750 billion of cash on their balance sheets, which equates to 50% of the UK’s GDP. The same is true in the US and Europe. At the moment this cash hoarding is part of the problem, as business investment is falling. However, at some point, the emotional tide will turn and companies will have the confidence to begin investing this cash mountain in new plant, machinery and jobs.
· New car sales. For a nation suffering from austerity, recent data on new car sales tell a very surprising and contradictory story, particularly given the flexibility that consumers have in delaying new car purchases. New sales were up by over 5% for the year to November, while European car sales fell on average during the same period by almost 8% according to ACEA, the European Automobile Manufacturers’ Association.
· Check and balances. The justifiable indignation seen in the UK and elsewhere at reckless risk taking and immoral behaviour in parts of the financial sector, ‘fat cat’ salaries, and broad tax avoidance both at the individual and corporate levels has lead to a ground-swell of activism. Examples include executive pay that fails to reflect value to shareholders, which is being increasingly challenged in the ‘shareholder spring’, with three CEOs at Trinity Mirror, Aviva and AstraZeneca resigning as a result in 2012. Let’s not forget the indignation that the canny (but legal) tax accounting of the likes of Google, Starbucks and Amazon has created, summed up in the witty comparison by Andrew Street, the MD of JohnLewis Partnership, who referred to his firm as ‘never knowingly under-taxed’! Perhaps this will spur the Government into action with its global counterparties. These may be small steps but they are significant checks and balances to the capitalist system.
· The global economy. It is worth remembering that the global economy is growing at around 3% in 2012.
Taking the longer-term view
Over the longer-term developed market economies are expected to grow at a rate of around 2% to 3% after inflation (usually measured by real GDP). Whilst the UK’s economy has been struggling to deliver sustained growth and the next couple of years are expected to see growth at below this long-term trend, the economy will recover. The chart demonstrates that the UK has more than doubled its GDP since 1980, after taking account of inflation. This has not happened by chance but through the collective strength of the companies operating within our economy. We would be have been delighted with a similar level of GDP in 2005, but having inflated our national budget in subsequent years, and due to lower tax take today, we are now having to borrow to pay our bills. The dynamism that created this long-term growth still remains today.
Figure 2: Growth in context
Data source: International Monetary Fund.
Shale gas and a seismic shift in global energy production
The issue of shale gas and its extraction by a process known as ‘fracking’ has been pretty low on most people’s radar, until the recent announcement that it may resume in the UK. Some estimates suggest that the UK’s shale gas reserves are as large the gas reserves previously discovered in the North Sea. However, the most startling news is that the US has, in a very short space of time, become almost self-sufficient in gas, which has come about due to high energy prices and the capitalist system at work, seeking profit from extracting hydrocarbons using innovative techniques. The Economist described it is ‘as sudden and startling as a supertanker performing a handbrake turn’. In addition, the International Energy Agency (IEA) predicts that the US will also become the world’s largest oil producer by 2020, eclipsing Saudi Arabia, and should self-sufficient in energy by 2035. President Obama, using the IEA’s numbers in his state-of-the-union speech stated that shale gas reserves represent over 100 years of supply at current consumption rates.
The competitive advantage that the US should derive from cheap and home-produced energy could be immense, particularly in high energy use industries such as steel, aluminium, glass, petro-chemicals and plastics, where costs will become highly competitive relative to low-labour cost countries, such as China.
Portfolio structure and emotional fortitude will see you through
So what does all this have to do with your portfolio?
The investment industry has always been focused on the ‘next best thing’ which in is often the last best thing! Over the past five or so years, much has been made of the decline of the developed markets of the western world and the inexorable rise of the emerging economies, including China. The reality is that it is very hard to predict the future and we write off the well-educated, innovative, capitalist and very large developed economies at our peril. In addition, the anticipated higher returns from emerging markets come from their higher risks, which include weak rule of law, lack of property rights, corruption, the risk of social unrest, and potential nationalisation of companies. Exposure to the latter should be modest, yet material enough to add value to a portfolio.
The key is to capture the combined, capitalist-driven dynamism to be found around the world. Broad diversification remains a central tenet of sound investing and the only real protection that we have from the uncertainty of the future.
Succumbing to our emotions, at this time, and questioning the long-term ability of equity markets to deliver strong returns, or being shaken out of the markets due to short-term worries is most likely to be very costly. In the wise words of Jack Bogle, the grandfather of passive, low cost investing:
“Your success in investing will depend in part on your character and guts and in part on your ability to realise at the height of the ebullience and the depth of despair alike that this too shall pass”
We can all look back with pride on 2012 as being a wonderful year of sport and the reinvigoration of the UK as a can-do nation. We delivered a fantastic Olympic games to the World – safe, respected, exciting and on time (if over budget). We moved from being a nation of gallant losers to steely winners across many sports and disciplines, not least our cricketers in India. We are a tolerant, multi-cultural society with a deep history, but also a renewed sense of self-confidence. In that context, we must surely feel positive about the future.
Wishing you a prosperous and happy 2013.
Other notes and risk warnings
This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
Past performance is not indicative of future results and no representation is made that the stated results will be replicated.
Errors and omissions excepted.
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 That is not to imply that capitalism is either a fair or a perfect system, most would accept that it is not, but it has done a considerable service in improving the lives of those in many countries around the world, raising living standards and longevity across this and the last century.
 Barclays Equity Gilt Study 2012
 Earnst & Young ITEM Club 2012