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.