“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.
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.