Slavish adherence to being ‘data driven’ should not be an excuse for avoiding thinking and intuition. The past decade has been vastly more abnormal than normal in the wider lens of history. Using this decade as the basis for future investment settings looks unwise to us.
When Maverick clutches the dog tags and whispers the words “Talk to me Goose” in the original ‘Top Gun’, he’s attempting to block out the noise. Clear thought and intuitive action. He re-engages in the dog fight and good things happen. As the 2022 sequel passes $1bn at the box office, it would appear the intuition of Tom Cruise continues to serve him well. Investing, like many other pursuits, has seen intuition give way to a slavish adherence to ‘the data’. Investors, like economists, desperate to be perceived as ‘scientists’ rigorously testing against a hypothesis (rather than as participants in exceedingly complex systems influenced by incentives and behaviours) wear ‘data driven’ as a badge of honour. The cloud, artificial intelligence, loyalty programs, social media; collecting more data is seen as the path to more knowledge. While in no way dismissing the importance of basing decisions on sound data and research, we feel the balance of importance between data collection and interpretation has perhaps been lost. A wise colleague puts it this way; “We are often faced with decisions which depend on a range of connected elements and data sources. The path from A to B, then B to C and C to D, all seem like perfectly rational connections. However, when one stands back and looks at the path from A to D, the conclusions are less obvious and sometimes crazy. What is rational to one person could appear mindless stupidity to another.”
I will use a little creative license to illustrate. The RBA has an extensive chart pack and an army of economists which help inform its decisions on interest rates. The charts below offer some data which could be interpreted in various ways. The past decade has been among the strongest in terms of growing household wealth. It has seen similar strength in the savings ratio. One could rationally conclude, as major banks and the RBA have, that households are in an extremely strong position and have significant buffers. One could also conclude, in observing the data, that a pandemic significantly accelerates growth in wealth and savings in the economy, making them thoroughly desirable.
The data in the bottom charts offers similar scope for differing interpretation. Over the same period in which household wealth has been growing strongly, business investment has been falling consistently. As has been the case in the past year, GDP growth is increasingly propelled by consumption and the government. The RBA has hundreds more charts which will offer support, both to those believing ever lower interest rates have provided useful and necessary support to the economy, and to those believing we have hollowed out and turned the economy into a housing and consumption Ponzi scheme that’s more akin to Bitcoin at US$60,000. The point? In complex systems, there is no obvious connection between the volume of data collected and the quality of decision making. Trying to define economies and investment markets as though they are finite, closed systems, akin to computer chess, makes no sense. Judgement, experience and intuition matter.
Choose your history wisely
Data interpretation is particularly relevant at present when it comes to equity markets. The same decade which saw the rapid wealth acceleration and declining business investment discussed above provides the data of greatest influence to investor behaviour. For many, it is their only decade of experience. The data on which investors rely in being ‘data driven’ emanates largely from financial statements and historic share prices. Correlations, earnings revisions and earnings growth rates are important to investors because analysis of past share price moves suggest they matter. If these observations on what’s worked (copying the behaviour of others (NB: this is not normally how it’s phrased on the investment philosophy page of investor websites!) are core to your investment approach, you need to decide which period of history to choose. Much of the love affair with (perceived) high growth, technology, and disruptive businesses reflects recent stock price performance. Cyclical businesses are low quality. Tech and high-quality structural growth are where it’s at. Constant reinforcement of these perceptions and ongoing justification that it was OK to pay ever higher prices for these characteristics resulted in the valuation gaps shown in the chart below. Using longer periods of history (choose any, just make sure they’re significantly longer), creates a different picture. Paying multiples this high has been a bad idea, regardless of the bond yield. Our intuition, and our aversion to exceedingly high multiples, lies in an admission that the future is uncertain and lower multiples offer greater margin for error. Real life says earnings growth isn’t always associated with ‘growing’ industries and ‘pricing power’ and ‘quality’ sometimes disappear or pass to new sectors. Perceptions of MYOB used to be similar to those of Xero today, Netflix used to leave other streaming services for dead, and buy now pay later and infant formula looked a little more exciting a couple of years ago than they do now. Extreme confidence in the distant future becomes more unsettling when one honestly examines errors over far shorter timeframes.
Source: Schroders Investment Australia Limited
Sustainability and the energy decade
Vaclav Smil doesn’t tend towards the airy fairy. His most recent book, ‘How The World Really Works: A Scientist’s Guide to Our Past, Present and Future,’ should be compulsory reading for those interested in understanding decarbonisation challenges. Cutting energy use is both tough and economically damaging. It is vastly more important to our wellbeing and lifestyle than technology. As Smil highlights, the world existed perfectly comfortably prior to the advent of technology companies that dominate investors’ attention today. Apps, online gaming, social media and the cloud are not essential services and the world managed comfortably without them. There is no possibility these companies could exist without energy. As the chart below highlights, the pandemic period was the first time the trajectory of coal usage approximated that necessary to reach 2040 targets. The global economy was decimated in the process and usage has reversed with re-opening. Intuition tells us the path to net zero will not be driven by further data collection, the number and complexity of emission measures and the length of sustainability reports. Capital should be supporting more engineers, fixed asset investment and technology (we’re not talking apps, slides, cloud and the metaverse here). Measuring portfolio emissions, targeting ever more investment into intangibles/companies not requiring capital and holding more investor sustainability meetings is missing the point. It should not be surprising that technology areas which have seen vast over-investment in recent years have incinerated investor cash and are struggling to transition towards profitable business models. Nor should it surprise that essential sectors which myopic emission focused investors have shunned are suffering from under-investment and skyrocketing prices. The job of investors should be to direct capital to where it is needed and most productive.
Source: Elements (Visual Capitalist)
Reactions are instructive. Skyrocketing prices are a vital signal in inducing supply to be expanded and demand to be quelled. Among recent political actions in the face of rising prices, a few come to mind. Rather than accept the demand impact of high fuel prices, governments around the world (including Australia) have leapt to fuel excise relief to artificially reduce prices. President Biden authorised the largest ever Strategic Petroleum Reserve release of 180m barrels (from the existing 580m barrel reserve) over the next six months rather than incentivising any additional production, and Queensland coal taxes (while admittedly fairly well designed), will strike further caution into capital which must support traditional energy sources until decarbonised substitutes are available. The next decade or two in energy will be some of the most crucial in history. They will require cool heads and rational conclusions from both investors and policymakers. Vaclav Smil will probably make you skeptical of the ability to transition in anything like the time frames which commitments currently envisage, however, he will also make you appreciate the importance of considered rather than emotional reactions to the challenges. We continue to believe investors should be looking for ways to invest in and support energy, materials, and infrastructure through this period, not run away from them.
The inflation puzzle
The ‘pricing power’, which investors so dearly love, also has another name: inflation. The reason sectors such as healthcare continue to grow and squeeze others is the continued exercising of it. While not claiming any great insight into the durability of higher levels of inflation, history does have some interesting lessons. Arthur Burns, the Federal Reserve Chair from 1970-78 during a period of rampant inflation, reflected on some of the mistakes made during the period which offer interesting parallels today. The overarching problem he identified was the public expectation that government will ensure prosperity and growth, alongside a willingness to levy taxes which fell well short of the propensity to spend. Sound familiar? The pandemic and a rotten period for natural disasters on the east coast has led to government handouts to support ongoing consumption and reconstruction. An almost non-existent manufacturing sector, and the aforementioned chart on business investment, suggest no such associated investment in supporting supply addition. Stimulating demand while not stimulating supply provides the impetus for inflation. Crushing demand is unpleasant and unpopular, however without significant supply addition, it is the only way to address rising prices. As Arthur Burns put it: “My conclusion that it is illusory to expect central banks to put an end to the inflation that now afflicts the industrial democracies does not mean that central banks are incapable of stabilising actions; it simply means that their practical capacity for curbing an inflation that is continually driven by political forces is very limited.” Investors extrapolating a future in which companies exercise ‘pricing power’ whilst expecting a level of interest rate and wage growth (which suggest there isn’t any) might want to read a little more history.
When the going gets tough, most will want cuts
Moving the interest rate dial on over-geared and thus hypersensitive economies is proving unsurprisingly challenging. Accustomed to the rising asset prices, apparent ‘wealth’ and buoyant consumption which interest rate declines have facilitated, the reverse was always going to be less appealing. Those without much of an eye for sustainability will quickly be calling for reinstatement of the policies of the past decade. Perhaps the ‘growing wealth’, consumption and diving business investment of the past decade can be resurrected just a little longer?
The shrinking labour pool of young workers relative to a growing pool of ageing asset owners creates obvious tension when the wellbeing of the former is consistently sacrificed to support the asset values and lifestyle demands of the latter, and the profit margins of corporates preferring to avoid the hard work of improving efficiency and ceaselessly campaigning for higher immigration as a supposed antidote to problems. We struggle to comprehend how anyone believes it is reasonable for the lowest paid workers not to receive wage increases (which compensate for inflation which has already occurred) using the argument that the economy will be better off if they tighten their belts a little more to avoid instigating a wage price spiral. Intuition tells us that might be a slightly misguided and short-term interpretation of a deeper problem. We’d interpret falling house and asset prices together with rising wages as part of a necessary and logical correction on the path to a more sustainable economy. Imbalances built over many years cannot clear in a few months.
Choose a wider lens
We are observing the same company financial history, share price and economic data as other investors. We are choosing a wider lens in interpreting the data. The reversion of the past year or so has come as a shock to investors focused heavily on the period of history since the last financial crisis. Longer observations of history suggest this period might be the abnormal one, with extrapolations of near zero interest rates, abundant consumption and government spending, limited business investment and no inflation a touch unwise. The future is uncertain. This is exactly why we prefer to buy businesses pursuing sustainable strategies at reasonable multiples. Investors should not be afraid of cyclical earnings, investing in staff and hard assets. This is how energy will be decarbonised and Australia’s extremely attractive position in the energy transition maximised. Growing productive capacity is a far superior way to suppress inflation than crushing demand, and a better way of creating wealth than inducing another pandemic or mispricing bonds through central bank intervention. It all depends on how your intuition tells you to read the data. “Talk to me Goose”.
Originally published by Martin Conlon, Head of Australian Equities, Schroders