The inside workings of an investing rulebook
Simon Steele – educated, articulate, British – has little hesitation when asked what the key to investing is.
“Find and understand a company that can genuinely and persistently compound its wealth, almost regardless of the environment. That will give you higher returns and a defensive quality.”
Fair enough. Sounds reasonably straight forward.
It isn’t.
Steele is the head of global equities for AMP Capital and has one of the trickier jobs at the investment manager – screening hundreds of stocks across geographies and industries, trying to find companies that will outperform in the long-term, while avoiding those that underperform.
His starting point is simple.
“My fundamental belief, and there’s plenty of empirical evidence of this, is that markets are inefficient over the longer term, but not necessarily over the shorter term. Long term markets are inefficient – always have been and remain so.”
“It means that investors with a genuine long-term mindset have an exploitable edge. If you can assess value over a time frame that is longer than the average holding period, you have an advantage.”
“The empirical evidence behind this is that over the long term, returns are principally driven by the change in value markers, which are earnings, dividend or cash flows. Over a 10-year period, anything between 85 per cent and 110 per cent of total returns are explained by the increase and receipt of these cash flows,” Steele says.
“In the short term, that relationship is completely reversed. Over a six-month period, the majority of total shareholder return is explained by changes in valuation.”
His logic is hard to fault. In the very short term, earnings and dividends haven’t had a chance to compound, so there’s no reason why they should they explain a significant portion of one, two or three month returns. But in those time periods, as seen recently, equity markets can easily move 10, 12 or 15 per cent.
In other words, short-term volatility is explained by changes to earnings multiples subscribed to stocks.
With such a starting point, it’s not surprising that at the core of Steele and his team’s philosophy is investing for the long-term. He is surprised that stock analysts don’t think in longer time frames.
“Look at the availability of analysts’ estimates for the S&P500. We have lots of 2020 estimates available, and 2021 estimates. But we have nothing for five years. It’s just not in people’s mindsets.”
This, in part, causes investors to hold stocks for too short a period of time, he says.
Investors with a genuine long-term mindset have an exploitable edge. If you can assess value over a time frame that is longer than the average holding period, you have an advantage.”
The ‘long-term’ is a very fluid notion. Is it five, 10 or 20 years?
“Our time horizon with data has been five years or more, because no-one wants to wait more than five years,” Steele says. “But equally you shouldn’t be investing in equities unless you’ve got that time horizon because you are just going to take on more risk than the fundamentals can deliver. The shorter your time frame, the more speculative it is.”
“We hope there are companies that we will stay with way longer than five years.”
An argument against such a pick-and-stick philosophy is that companies eventually revert to the mean?
“If markets were efficient, a company shouldn’t be able to earn more than the cost of equity in the long term,” Steele concedes. “But some companies can do it. Amazon has been doing it for decades. Adobe has been doing it for two decades.”
“There’s a fundamental economic belief that high returns fade down over time, and low returns move up. And that is statistically true on average. But there are businesses out there that haven’t faded down after 20 years. And there are bottom companies that haven’t gone up."
“Persistent high returns is a real economic fact. Our philosophy is about beating the fade. Can we find persistent, high economic rents for the long term?”
Steele regularly uses economic terms to talk about investing. One of his favourite phrases is economic rent. The term’s precise meaning depends on the philosophy of economics being discussed, but broadly it refers to what a provider of a good or service receives in excess of what he or she should receive in a perfectly competitive market. Steele and his team are constantly seeking high economic rents.
Critical to any company’s success is cash flow, Steele says, and it’s central to investment decisions.
“When a company lets you down, it’s because cash flow is disappointing,” he explains. “And when you get a company that goes to near zero, it is almost certainly because cash flows weren’t there or weren’t sustainable for one reason or another.”
“We are looking for compounding cash flows. Given that the long-term performance is driven by fundamentals, not valuations, what we need to do is find superior compounding of cash flows with as little risk as possible,” he says.
Steele characterises his search for superior compounding cash flows in a company as a stool with a comfortable cushion on top. The three legs of the stool are the pillars of the framework that enable compounding of cash flows at a superior rate.
“The first leg is competitive advantage. Easy to say but not easy to deliver. We think of competitive advantage as the driving license. It enables a company to print higher economic rent year in, year out. It’s rare and it’s sacrosanct.”
“The second leg is capital allocation. It’s the responsibility of management and a nod to governance. Management has the licence and is the driver of the machine. How are you going to drive with that licence? You have stewardship of this economic surplus you have created.”
Management, Steele says, is part of this second leg, but is an intangible. He wants management to make decisions based on long-term outcomes. “We want companies that are genuinely thinking about the future, so they are aligned with our view of shareholder value.”
The first two legs, combined, are a value-creating machine.
“But the machine needs fuel and that’s the third leg. We call it runway for growth, and it is the positive structural shifts in the economy. It’s the new economy that provides the tailwind to allow the compounding machine to spin.”
“The benefits of the runway for growth is that it enables re-investment and compounding to come through, and it also gives some cyclical protection. While we can’t take cyclicality off the table completely, we can provide some cyclical immunity by trying to find pockets of growth that are structural.”
Our time horizon with data has been five years or more because no-one wants to wait more than five years. But equally you shouldn’t be investing in equities unless you’ve got that time horizon because you are just going to take more risk than the fundamentals can deliver.”
Steele uses the example of robotic surgical procedures. Will the number of procedures fall if economies went into recession? Not for long, because embedded into the healthcare economy are structural reasons for those procedures to increase.
“The reasons are around productivity, and reducing costs and better patient outcomes. A growing cohort of surgeons are now trained in robotic surgery… and will use robotics surgery as a default, as opposed to laparoscopic surgery.”
Atop the three legs is what Steele calls a comfortable cushion, which is a way of describing his preference for stability over lumpiness.
“There are a lot of companies out there that can create an enormous amount of wealth over a five-year period or more, but have a lot of volatility along the way. We will dismiss companies if they’re too lumpy and the ride isn’t stable enough for us,” Steele says.
“This predictability speaks to the relationship between the provider of a product or service and their customers. Is it a highly-valued ongoing relationship or is it lumpy?”
The three-legged stool with a comfy cushion is the rulebook and he and his team relentlessly apply it. It doesn’t augur well for some more traditional sectors, where economic rents are contracting.
“I think about areas of the economy, like financials and energy, where it’s really difficult to invest because there is a structural headwind in the make-up of economic rents,” he says. “We are attracted to structural trends… and find the old legacy areas unattractive.”
Steele is unapologetic, pointing out that throughout history, technology has been at the heart of disruption.
“It’s technology that has enabled economic growth, that has enabled productivity. The industrial age was a massive transformation based on technology. It’s no different today, though I acknowledge the shift is faster than it was.”
The rulebook doesn’t pay deference to many of the traditional categorisations of investing.
“We are completely benchmark agnostic,” he says. “Diversification for us means extracting economic rents from different customers, different business models and different end markets. We think of geography not in terms of where they are domiciled, but in terms of where they get economic rents from.”
“It has nothing to do with how much we have in resources versus technology. That’s not what diversification means to us.”
“The language of a good company is consistent across industries, across geographies. There really is no difference. People ask whether the translation from a UK to global mandate is difficult. It’s not. It is more like being in a bigger sweet shop.”
Disciplined investing needs a team all following, and importantly, believing in the same philosophy. How do you find those individuals?
“The first thing you have to do is be incredibly selective about the person you employ. I want seasoned, experienced investors that are genuinely philosophically aligned but bring cognitive diversity. You’ve got to be someone who is prepared to accept respectful challenge and thrive on it.”
The two most dangerous ingredients in my industry, which I’ve seen, are complacency and arrogance. The two together are just lethal, incredibly toxic."
The long-term rulebook allows investors like Steele and his team to look past volatility of recent months.
“The questions for us is through an economic lens: is there anything we need to think about the quality, trajectory, or the stability and durability of our economic rents, given the environment?”
“Some of what we are seeing now is dislocation from fundamentals, but some of it is an absolute expression of the fundamentals. I have no doubt in my mind that there will be a significant earnings contraction in 2020.”
Steele has been in financial markets for more than 25 years. His career hasn’t always been prosperous. When he was working as a small caps fund manager in mid-2001, his firm closed.
“I was in a bit of a predicament. I had no job. A baby had just arrived. We had a big mortgage and it was weeks before 9/11. I look back on that and think being humbled wasn’t a bad thing.”
“The two most dangerous ingredients in my industry, which I’ve seen, are complacency and arrogance. The two together are just lethal, incredibly toxic. Being humbled helps me keep balanced. I look over my shoulder every now and then to make sure those characteristics haven’t crept in.”
So why does he keep doing what he does? “We are empowered and entrusted to manage someone else’s capital and the most important decision we make is to invest their money for the long term. We could be holding on to it for 10 years or more. It’s an honour and privilege to be able to do that.”
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Important Notes
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While every care has been taken in the preparation of these articles, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in them including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. Performance goals are merely goals. There is no guarantee that the strategy will achieve that level of performance. The information in this document contains statements that are the author’s beliefs and/or opinions. Any beliefs and/or opinions shared are as at the date shown and are subject to change without notice. These articles have been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. They should not be construed as investment advice or investment recommendations. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.