There are many types and styles of active equity & long term investing. But each has a distinct strategy built upon a fundamental and strategic perspective, either explicitly or implicitly. What is a fundamental strategic focus investing, and why is it crucial for long term equity investing and its destiny? It has a vital significance even for an exclusively stock-picking oriented strategy. Why?
Simply put, you have to go to the right field to increase yields during harvesting. A pro as human has a limit in scaling out the reach of investment research.
You might think that the right screening tool does it, but it is capable f handling non-contextual and short-mid term analysis. You cannot expect it can generate ideas that cannot be learned from the dataset. Its vital importance is intact when a stock selection is the primary value-added process for the portfolio.
If you looked back upon the history of the equity market since the 80s, you would immediately find that every decade has its critical sector, regions, or stories.
For instance, the 80s was the decade of Japanese equity. The 90s was information technology. Emerging markets and energy/commodities dominated the 00s until the financial crisis. They worked in each period as a dominant and central axis of corporate activities. If you were to go against the direction of the axis intentionally or unintentionally, you would put yourself in a low-yielding field.
What I am referring to as a fundamental strategic focus investing not only helps improve investment efficiency as a business but also organize ideas in the big picture. Without it, it would be less secure for a manager to understand the right context of investment risk and put it with the portfolio in the long term.
How then should we look at the current decade emerged out from the financial crisis? We also know that it has been born out of the financial crisis triggered by the golden age of engineered financial products. Back then, no one knew precisely the actual size and nature of credit risk exposure of engineered credit derivative products, as they multiplied exposures through the “X in X” structure.
However, people felt fine as long as they received statements with a positive NAV figure without knowing the basis of the valuation of elements constituting NAV. Those days are almost behind us (well that said there are still many structure notes, products and FoF sold to clients as they are so profitable for financial service providers – with many tricks and who knows what and how they verify NAV, etc.)
I have been firmly believing that, in the investment world, this decade should be called the decade of lightweight, stably recurring, and agile business, which sits on the opposite end of the highly regulated financial sector.
What does this mean? Let’s see what happened from its origin, the financial regulation with an objective not to repeat the crisis.
- SEC and FSA’s objectives: a robust financial system that withstands a potentially sizable economic downturn.
- Central banks’ efforts: provide liquidity to help the damaged credit creation mechanism and help the private sector self-heal the wounds.
- Financial leverage: Deleveraging through lighter fixed cost structure and high revenue growth enough to have a prospect of FCF generating ROI
First, as inflation is a product of economic growth, low economic growth is accompanied by low inflation. Central banks supplied lots of liquidity to the markets, wishing that it will lower marginal cost of capital for the companies to invest more, or it can make it easier for banks to provide funds to the businesses that need capital to grow their business. Low growth and low inflation are very consistent.
Why low growth? The regulators are obsessed with the idea of “no systematic meltdown again.” It forced financial service companies to trim risky and edgy lending or capital injection to the businesses with low credit.
That looks reasonable, but it shifted the dynamics of the credit cycle that we have experienced from the past. The world economy has been prospered, through both growth and recession. As we have such a shift periodically, the train of the economy moves forward fast. In other words, the growth with the managed zero recession probability is destined to stay lower than the one without it. And then using aggressive liquidity as a monetary policy tool is just like to clean up the consequences that were self-induced intentionally.
I still remember a social history professor told me in his small lecture that the young and growing countries have more dynamic violence.
He continued that as they mature, they see a more peaceful, “calm and gentle” society and low growth under the regulation to bring down violence. His point was that the instability of society is accompanied by growth, and the controlled and gentle environment has never had high growth in history. He also added this applies to the age of demographics from young (developing) generation to (developed) adult and matured elderly.
We sacrificed opportunity and active “animal spirit” and obtained a kind of downward protection from the sharp financial meltdown.
Stay calm, and be safe. Move and dodge when needed, and you will be fine.
Some might argue that the financial leverage, measured by the total amount of debt, has increased that is not consistent with these views. However, if you look at not only the entire amount of debt but also the free cash flow and equity, in relative terms to these, the total debt level is not as high as in the period of pre-financial crisis.
Lastly, that means we live in the least probability for the economy in history to face a systematic financial meltdown event in an exceptionally shallow and sustainably-low growth world. That is why we need sources of growth and value it brings and will bring is entirely different from the perspective of fundamental strategic focus investing.
Yes, still, some noises occasionally shake it, but it is not as vast and uncertain as the amount of synthetic credit in the complete black boxes we had before.