Investing for long term wealth creation - part 1

Long-term fundamental investing is more connected with the real world than the world on our screens. It is focused on aligning with the longer-term trend rather than speculating on the fluctuations around it. In this first instalment of a three-part series, we take a big-picture look at investing for long-term wealth creation. 

The ability to create a healthy and sustainable economic profit over and above all costs, including the cost of capital, and to continually reinvest and grow those economic profits over time is what truly unlocks the potential for enduring wealth creation. It is when those characteristics are present and married to a longer-term time horizon that the magic of compounding occurs.

AMP Capital’s Global Equities team time horizon is genuinely long term, in line with our 5-year expected holding period (hopefully much longer for many of our companies). This is counter to the short termism trend in markets, where holding periods are now measured in days or weeks, and the dramatic rise in quantitative and factor-based investing has merely served to reinforce this myopic focus.

We know that the drivers of short-term and long-term investment returns are quite different. Over the long run, fundamentals explain the majority of returns. As indicated in the chart below, typically over 80% of total returns over 10 year periods are due to the compounding of cashflows, and less than 20% due to multiple changes, whereas over 1-year periods it is almost completely the reverse . This makes complete sense, as the fundamental markers may not have had chance to move over such a short period, but stock prices are volatile in response to the ebbs and flows of news, flows, and sentiment.

We do not claim to have a particular skill or edge in understanding the short-term drivers of prices, but we do have a wealth of experience in understanding the long term drivers of fundamentals in companies; many of which are intangible and require a considerable amount of judgment and foresight, such as innovation, R&D, brand, culture, and talent.

The wealth creation framework we employ helps us to filter out the short-term noise and keeps us focused on the primary objective of allocating capital to a carefully selected cohort of exceptional companies that can sustain cash flow compounding over the long run and throughout the economic cycle. There are three key pillars to this framework - attributes we look for as we assess whether a company is a good fit with our strategy.

1. Competitive advantage: the ability for a company to generate persistent, protected and superior cash flows over and above the cost of capital, both in good times and in bad, and over a long period of time. 
2. Runways for growth: the support of enduring and non-cyclical growth tailwinds, which increase the rate at which excess returns can be reinvested and accelerate the process of compounding. Examples of long-term structural shifts include the transition from open heart surgery to robotic assisted surgery, the movement from on-premise computing to cloud computing, and the increasing share of retail expenditure that is done online rather than in a physical store.
3. Capital allocation: the ability and propensity to reinvest cash flows wisely; either to reinforce the economic moat, increase growth, or return to shareholders. The most important thing that a CEO has at their disposal is a cheque book and a pen, what it buys or builds can either set the company up for success for a decade or more or when done badly can destroy a lot of value and distract the organisation. So capital discipline and good governance is very important to wealth creation. 

Whilst the three pillars are our key criteria for defining exceptional companies, there are two additional important characteristics which determine whether we believe an exceptional company is an exceptional investment according to our mandate.

1. Valuation: As we have outlined, while the compounding of cashflows typically explains over 80% of long-term returns, pay too much for it and you’ll dilute the benefit. Valuation is a very important part of the equation, and as a matter of prudence we do not rely on multiple expansion in order to meet our required return. We want the fundamentals to do the heavy lifting. 
2. Predictability of cashflows: We need to know that the fundamentals we are seeking to extract are reliably sourced and can be easily identified, and the range of possible outcomes is within a reasonable standard of error. This is an important component of risk management; understanding how much of your cashflows are at risk, and the potential impact on performance should those more negative potential outcomes be realised.

In subsequent articles we will showcase the importance of bottom-up insights in long term wealth creation by profiling three different end markets.