The Restless Investor, Trust and the Global Cycle

On face value, Woodside Petroleum and Macquarie Bank have little in common.  One is an oil and gas company, the other an investment bank.  For a long time, investors have considered both to be growth stocks; their revenue growth is projected to exceed growth in the broader economy.  Woodside is exposed to strongly growing demand for liquefied natural gas (LNG) from Asia while Macquarie has transformed itself into a global asset manager, exposed to the growing demand for private pensions among ageing developed country populations.

Both companies raised their dividend payout ratios in 2013 and announced they would maintain a higher than normal payout ratio going forward.  Investors normally interpret higher dividends from growth stocks as a signal of lower future growth prospects and mark them down accordingly.  But these announcements were favourably received by the market and each stock delivered higher returns than the ASX200 over the course of 2013.

In recent years, companies globally have deferred or abandoned growth options and increasingly returned cash or capital to shareholders via higher dividend payments and stock repurchases.  Skeptikoi believes this phenomenon stems largely from the financial crisis and the rise of the restless investor, with an assist from the disappointingly slow global recovery which has dulled investors’ appetite for risk.

The defining feature of the restless investor is a loss of trust arising from the financial trauma of 2008.  Research studies have shown that low levels of trust discourage stock market participation.  Trust might have an important bearing on the finding that macroeconomic experiences can have life-long effects on attitudes towards risk; investors who experience low market-wide returns in their formative years tend have more conservative financial portfolios through their lifetimes, reflected in smaller stock allocations.

The restless investor has lost trust in the ability of companies to undertake value accretive acquisitions or large capital expenditures that have distant payoffs.  Against the backdrop of still weak revenue growth, higher discount rates and shorter expected payback periods, companies have eschewed grandiose growth options and turned to a new cost discipline to boost profitability.  While a subdued nominal GDP growth environment has undermined the ability for companies to achieve meaningful top line growth, they are aggressively attacking their operating expenses and deferring capital expenditures where feasible to boost margins and free cash flow.  And strong free cash flow helps to support a sustainable lift in payout ratios.

Is there a risk that the restless investor’s loss of trust and preference for capital now over future capital growth could undermine the ability for firms to deliver sustainably strong growth in earnings per share?  Skeptikoi doesn’t think so.  The new cost discipline is a welcome development following decades where CEOs remained focused on growing revenues – at times, at the expense of profitability and shareholder value.  The renewed cost discipline will continue to focus the minds of CEOs on what they can control rather than chasing the pipedream of double digit revenue growth and market share gains that destroy shareholder wealth.

Stocks with sustainably high payout ratios will under-perform when the supply of income from the corporate sector eventually outstrips demand.  At that point, expect companies to re-engage their growth options more aggressively, which will put a smile back on the faces of the shrinking army of downtrodden investment bankers.

But if market gyrations are any guide, the journey to equilibrium is rarely seamless or linear.  Do not discount the role that the disappointing global cycle in recent years has played in fostering the rise of the restless investor.  The IMF and other forecasters have consistently downgraded world growth prospects since 2010.  The IMF’s preliminary estimate shows that world nominal GDP expanded by around 6.5% in 2013, down from 9% in 2011 and the lowest annual growth in over a decade excluding 2009.

Skeptikoi is wary that material upgrades to world growth prospects would raise the appetite for risk and be associated with under-performance of stocks offering strong and sustainable yield.  But the signposts suggest that we are not at one of those junctures just yet.  The IMF is projecting global nominal GDP growth to pick up over the next two years to around 7.5%, still weak by historical standards.  And the IMF has a long history of producing excessively optimistic world growth forecasts.  The persistence of large output gaps in many developed economies remains a headwind and should keep central bank policy rates close to zero for at least another year.  Moreover, any snap-back in risk appetite typically occurs when stock markets are very cheap, which isn’t the case at present.

Looking through the vicissitudes of the global economic cycle, the restless investor’s loss of trust will continue to constrain the parameters of corporate financial policies for some time yet.  Skeptikoi believes that the process of healing from the financial crisis is far from over; we have only just passed the fifth anniversary of the collapse of US investment bank Lehman Brothers.  In the wake of the financial trauma of 2008, the corporate sector is learning an expensive lesson about the asymmetric nature of trust; it can be lost very quickly, but takes a very long time to re-establish.

The Conglomerate's Fall From Grace: Two Tales of Diversification

By the time he had stepped down from the roles of Chairman and CEO of one of America's largest and oldest industrial companies in 2001, Jack Welch was arguably one of the country's most successful business men, a CEO superstar.  During the two decades he ran General Electric (GE), the stock rose 4000%.  Following his retirement from GE, Mr Welch was in hot demand on the public speaking circuit; many were prepared to pay handsome sums to get insights on how he had successfully managed a global, sprawling conglomerate.

GE represents an anomaly to text book theory and the trend in recent decades towards corporate focus. Long gone are the days where it was common practice for firms to undertake mergers and acquisitions in unrelated industries to boost flagging growth prospects. 

The development of Modern Portfolio Theory (MPT) through the 1950s and 1960s espoused the benefits of financial diversification; the value of corporate diversification is limited to the extent that investors can achieve diversification for themselves.  But at the time, the reality of high transaction costs was far different from the assumptions underpinning MPT; it was expensive for investors for investors to achieve home made or DIY diversification.  Corporates were all too willing through the 1960s and 1970s to help investors diversify by buying up target assets in unrelated industries.

By the 1980s, two developments had changed the conventional wisdom towards corporate diversification.  It had become apparent to investors that the conglomeration of corporate America has failed dismally.  Growth prospects for many diversified enterprises had not met expectations.  The failure stemmed from a lack of focus and the inability of internal capital markets to allocate resources efficiently across often disparate and unrelated divisions.

Second, the growing institutionalisation of the stock market had made it easier and cheaper for investors to achieve financial diversification themselves.  In particular, the launch of the world's first index funds in the 1970s by Wells Fargo and Vanguard was a game changer not only for the asset management industry but also for corporate diversification.  The ability to access low cost funds that tracked the S&P500 index meant that investors no longer had to rely on companies to undertake diversification themselves.

By the early 1990s, corporate America had undone most of the legacy of the conglomeration experiment.  Many diversified firms restructured voluntarily, selling off underperforming assets that were not central to their key competitive advantage.  And where management refused to see the writing on the wall, capital markets obliged, in the form of highly geared and aggressive private equity firms.  Some of these firms would spectacularly fail burdened by excessive levels of debt.  But investors had already delivered their verdict; corporate focus had won over corporate diversification.

The Schumpeter column in the Economist magazine suggested recently that the conglomerate might be staging a return ('From Dodo To Phoenix').  After all, the prospect of still subdued growth in nominal GDP around the world continues to undermine the corporate sector's ability to achieve meaningful revenue expansion.  Corporate diversification could help to boost flagging growth prospects and larger firms might be able to offer higher salaries than their focussed counterparts thus attracting and retaining the best minds the labour market has to offer.  The internal capital markets of conglomerates can also reduce reliance on at times fickle capital markets.

But Skeptikoi believes that a sequel to the first conglomerate wave is unlikely for three key reasons.  The costs of financial diversification have continued to decline sharply.  The advent of exchange traded funds (ETF) has revolutionised the asset management industry by increasing liquidity and transparency, as well as further reducing the costs of tracking a wider range of country and sector indices.  An S&P500 ETF typically attracts a management expense ratio of less than 10 basis points and can be traded on the market just as easily as a stock can. 

Second, a loss of investor trust since the financial crisis has meant that shareholders have little faith in CEOs to undertake value accretive acquisitions, particularly in industries unrelated to their core focus.  They are increasingly rewarding companies for returning cash or capital back to them in the form of share repurchases and higher dividend payments.  To this end, Skeptikoi expects the trend towards corporate focus to become even more entrenched; more companies are likely to break-up and sell off underperforming and unrelated assets to boost free cash flow and cater to investors' insatiable appetite for income.

Third, the financial crisis has failed to revive the fortunes of conglomerates.  If there was ever a time for conglomerates and their internal capital markets to shine, it was in the wake of the financial crisis, where external sources of funding either became prohibitively expensive or even dried up completely for smaller firms.  But if anything, their prospects have continued to deteriorate.  Emerging markets - where conglomerates are more common - have underperformed significantly in recent years.  And the great aura surrounding GE is no longer.  From the lofty heights of the credit boom where the stock typically traded at a 20% book premium to the broader market, it now trades closer to a 20% discount.  It remains to be seen what judgement history will deliver on the legacy of GE's superstar CEO.