Sunday, September 05, 2010

Revitalising the cult of Equity

The value of experience in any industry is to identify when something apparently new turns out to be an idea that has been rejected by a previous generation- often for a reason that is fundamental and fundamentally obvious, but which is discounted by a current generation of managers. For some reason, probably because the turnover of staff is so rapid, the City of London seems particularly adept at forgetting some hard learned lessons from the past. Experience in the City takes second fiddle to innovation.

Innovation in finance is part of the fundamental warp and weft of the whole business. It is through innovation that different firms seek to gain a competitive advantage and thus the young whizz-kid, who in most other industries would still be climbing the corporate ladder, in finance commands the highest rewards- including extremely high salaries. Yet, as we have seen from the recent financial crisis, there is a risk in preferring innovation over experience: there are few who dare to challenge the oracle when large profits are at stake.

Yet there is also a cyclicality in the way ideas are revived. Sometimes the phrase "nothing new under the sun" seems specifically devised to cover the way that financial innovation seems to proceed. After all there are actually a fairly limited number of variables to consider: time, price, whether a yield or a capital cost, risk appetite, perceived risk covers most variables. In fact, much of the innovation is designed to cover a different variable: Tax. Many- if not most- of the financial innovations of the past decades have been tax related.

In that sense one could argue that governments are the primary drivers of much that takes place in the financial markets: they regulate and control directly or indirectly, but they also change the instruments in the financial markets according to the capricious whim of their exchequers. Now, of course, many governments are shareholders of the banks that they once sought to control only through regulation. Some politicians- usually those with little or no understanding of the financial markets- have suggested that the lending policies of these now state-owned banks should be adjusted to promote what the politicians proclaim to be the "general well-being of the economy". New or discounted lending to the corporate sector is suggested as being one way out of the economic malaise that the crash has delivered us into.

Yet the fact is that the corporate sector remains deeply unfashionable: in the UK the number of recent graduates entering industrial jobs is dwarfed by the huge numbers who seek to become accountants. Recent investment trends have been far more towards the financial instruments such as bonds- ideally government bonds- that have least to do with exposure to corporate risk. Equity returns have plummeted. Even the most fundamental conventional wisdom: that equities will, over the long term, always outperform debt is now being challenged. Equities are in the doldrums.

To a certain extent, one could explain the out performance of the bond market simply in terms of fear: the risk appetite for equities is low, and investors have been seeking the safe haven of secure bonds- even with a yield that is now in historic terms extremely low. Yet there is one thing that corporates might do to boost their lagging performance, which they have not done. Equities have been priced off the value and stability of their estimated future earnings, and this is mostly given to shareholders in the form of the capital appreciation of their shares. Yet there is an alternative form of compensation, which is of course the annual dividend that shares pay out. The dividend is analogous to the bond coupon, and some investors indeed price their shares based upon a dividend yield. In the difficult economic conditions that we have faced, there is, paradoxically, nervousness about companies that pay out high dividends: since they are perceived to be making themselves vulnerable to market weakness or to takeover, if they do not preserve their capital. However in my view, the mature Western markets -though not emerging markets- should be expecting a much higher dividend yield than they have been getting. The fact is that investors have not been receiving enough cash for their investment in equities.

Now, I suspect, we are coming to yet another inflection point in the market. It is clear that the historically low bond yields will not continue indefinitely. At some point in the relatively near future, the opinions of investors will change: the benign environment of the bond market will become extremely volatile. At that point I think a low leverage corporate with a stable dividend will look dramatically more attractive. A spike in bond yields could cause a dramatic sell-off, and at that point, the prospects of the equity market, once the short-run turmoil is over, will be dramatically improved.

So, if I can just find a financial instrument that will flip me from one asset class to the other at just the right time... yes, you guessed it, financial innovation will continue unabated, and that really is experience talking.

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