Fund managers often lose the performance contest over erroneous, non-factual beliefs, writes CHARLIE FELL
CHARLES ELLIS, a revered pension fund consultant, penned an article more than three decades ago that likened active investment management to a loser's game. His controversial thoughts were published by the Financial Analysts Journalin the autumn of 1975, where he defined a loser's game as one in which the outcome is determined by the actions of the loser and not by the performance of the winner.
Ellis referred to the work of the eminent scientist, Dr Simon Ramo, to elucidate his argument. Ramo identified the critical difference between amateur and professional tennis in the book, Extraordinary Tennis for the Ordinary Tennis Player. He observed over several years of study that professionals win points, while amateurs lose points. Thus, the key to success in a loser's game is to make fewer unforced errors than an opponent.
Investment managers often lose the performance game as a result of erroneous beliefs or unforced errors that are not supported by historical fact. One of the more notable examples is the appealing but misguided logic that spectacular economic growth rates equate to high long-term returns. There is an observable relationship between the two variables, but unfortunately for the growth bulls, it is the wrong sign. Academics have compiled a substantial body of evidence that reveals a negative correlation between long-run economic growth and stock market returns. This surprising result can be explained by a number of factors.
The first unforced error that investors commit is their attachment to the idea that per-share market earnings track economic growth in the long run. US data reveals that the growth rate of corporate profits is virtually identical to GDP growth over the past half-century; both have increased at a real rate of roughly 3 per cent per annum since the second quarter of 1960. However, current investors do not have a claim on economy-wide corporate profits, which includes all US businesses; they only have a claim on the per-share earnings of publicly quoted companies.
Aggregate SP 500 earnings have tended to grow in tandem with the economy over long periods, albeit at a slightly lower rate, as America’s largest businesses have captured a progressively smaller share of total profits. More importantly, per-share earnings have increased in real terms by less than 2 per cent per annum over the past half-century. The verdict of history reveals that the SP 500’s per-share earnings growth has proceeded at a rate over the past 50 years that is 40 per cent below the rate of economic growth over the same period.
This observation can be explained by new business start-ups, which account for more than half of US economic growth, and the subsequent capitalisation of the successful ventures with equity. Current investors do not have a claim on the profits of these new businesses unless they dilute their existing holdings to buy shares in these enterprises. Consequently, earnings to which investors have a claim increase at a substantially lower rate than the growth in aggregate profits.
The dilution effect can be material and particularly so for emerging markets. Academic research reveals that new equity issuance has subtracted as much as 30 percentage points from earnings growth rates in some Asian markets. Think about it – a 30 per cent increase in aggregate profits is required just to stand still.
The second mistake that investors make is their failure to recognise that stock prices lead analyst estimates of long-term growth and not the other way around. This phenomenon was more than apparent during the heady days of the late-1990s. Analysts are always an optimistic bunch, but they excelled themselves during the technology bubble, as their expectations of long-term earnings growth soared by almost eight percentage points to a mind-boggling 18 per cent. Of course, the high share prices and low cost of equity capital, in tandem with high return expectations, meant lofty earnings estimates would never be realised, as new enterprises came to the market like bees to honey. The subsequent debacle revealed the truism “price is what you pay, and value is what you get”.
Investment managers’ relative performance game is a losing proposition from the outset, but combined with unforced errors, the result can be deadly. Managers routinely espouse the idea that high growth leads to high returns, and promote the exciting themes under the auspices of diversification. The evidence does not support their theses. Mark Twain describes it best when he wrote, “Let us be thankful for the fools. But for them the rest of us could not succeed.”
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