Mark LaMonica is the head of individual research at Morningstar Australia
I recently went on leave and read two books exploring financial meltdowns that have me thinking about capital cycles and the impact they have on us as investors. I write on both those books in Greed, Overconfidence and Capital Cycles.
The overarching lessons for investors.
Growth alone doesn’t make a good investment.
Many investors focus on the business cycle. And this makes sense. When we buy a share we take an ownership stake in a company. Some companies are cyclical and their prospects will vary based on how the economy is doing. Some companies are non-cyclical and the economy will have little impact on their prospects. Where we are in the business cycle will impact how the overall market does and how sectors and individual companies perform.
Economic growth is important as is the growth in certain sectors in the economy. But growth is not the only thing that matters. As investors we need to be mindful that growth alone does not a good investment make.
Capitalism is designed to foster competition.
That competition becomes more intense as the level of growth increases. And competition is not something we relish as investors. We want to own companies that can fend off competitors and keep more of the spoils for shareholders. That is why we look for companies with a sustainable competitive advantage or moat. Too often we lose sight of that investment principal in our pavlovian response to growth.
Capital always chases growth.
A company in a high growth sector will be able to borrow with abandon. Venture capitalists, private equity and public market investors will battle to throw increasingly large piles of money at new and existing companies in a high growth sector. This infusion of capital creates more competition and often leads to poor outcomes for investors.
At first everyone is happy as revenue growth is off the charts. Companies expand to meet untapped demand. Faster revenue growth leads to even more capital. Companies soak up capital like a sponge and they will do anything to keep growing faster. They will lower prices, increase marketing and hire more people to further the production of goods and services.
It isn’t long until we read about the amazing employee perks in these high growth industries. Meals, facilities and offsites grow increasingly more lavish. The costs don’t matter because there is always more money available to fund anything and everything. Profitability doesn’t matter because that is tomorrow’s problem. The name of the game is revenue growth.
It is inevitable that challenges will arise. Running a business is hard in any environment. Running a business in an environment with increasing competition with unlimited resources is even harder. At some point it is inevitable that supply will outstrip demand.
In a rational environment supply would be lowered. But the pressure to keep the party going is intense. Some companies will do dumb shortsighted things that hurt them over the long-term. Some will commit fraud. Whatever it takes. There are just too many cheerleaders between employees, investors and the media that don’t want the party to end.
Eventually things fall apart. Valuations collapse as investors finally catch on that the limitless future hawked by ‘visionaries’ might not be realistic. Some companies will fail. Some will be sold at fire sale prices in a desperate bid at consolidation. Eventually a more rational competitive environment develops but only after investors have lost lots of money.
Smart investors understand that the seeds of growth may be demand based but eventually they sprout into an abundance of supply.
Competition always has winners and losers.
I’m a fan of history. Anyone who studies history must be careful when reading secondary sources. They are written after the fact by authors who have the benefit of hindsight. They are a commentary on historical events.
Those events can take on a sense of inevitability as the author crafts a narrative with the knowledge of how things ended up. Yet the participants who shaped and witnessed that history didn’t know how things would end. As Warren Buffett famously said, the rearview mirror is always clearer than the windshield.
The question for us as investors is how can discern these situations prior to their inevitable end. One way is to be a student of history. As unique as we perceive the present there is very little that is new. Studying history increases the chances that we will recognise patters.
Be mindful of runaway growth.
Be alarmed when the foundation of that growth is a simple and widely recognised truth which gets combined with a unifying vision that the growth contributes positively to society.
Growth will always be characterised as an appropriate reaction to demand. Capital will chase those prospects for growth. Valuations will rise. Supply will surge beyond demand. Poor business practices and fraud will follow when insiders understand the imbalance and are desperate to keep the party going.
We have passed through a period of low interest rates and plentiful capital. There is little doubt we will uncover similar stories as the world adjusts to the new normal. Where are the issues and what are the foundational truths and unifying visions that are justifying an unrealistic view of the future? I’m not 100% sure.
It could be in private assets which apparently offer higher returns and less volatility than the same assets trading publicly. These assets still haven’t been marked to market despite the fastest increase in interest rates in history and teetering public markets.
It could be in zombie companies operating in industries with supposed exponential growth that is always just around the corner. They took a page from Milken’s junk bond approach and just kept rolling over their debt in a low interest rate and permissive environment.
It could be in the opaque world of private credit where underwriting standards are apparently superior without the bothersome meddling of regulators. Perhaps it is commercial real estate, Chinese residential real estate or heavily indebted consumers and governments. It could be crypto or NFTs which are already teetering as fraud gets uncovered.
A good place for drawing up your own list is to pick a thematic ETF that has been issued in the last few years. AI? Decarbonisation? A good story may not mean a good investment opportunity. Are all of them overhyped narratives waiting to collapse? Of course not. But some undoubtably are.
These stories will seem obvious in retrospect but they will all follow patterns we’ve seen time and time again. I for one am happy to stay ensconced in the world of profitable and boring companies who regularly go through the monotonous activity of paying dividends. these are the companies that will benefit from new breakthroughs without the ruinous competition.
