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Active Versus Passive Without A Peace Dividend

FYI | Mar 09 2023

The world is changing yet again and three fund managers built a case around active investing as the logical strategy for investment outperformance.

-Three global investment managers presented the argument for active stock picking and the ability to outperform passive index investing over the long term
-Heightened challenges from climate change, decarbonisation and rising geo-political tensions support a more fragile environment for investors, and potentially lower than historical returns going forward
-Professor Bessembinder says empirical data analysis supports both active and passive investing, but all depends on you personally or your fund manager

Joint hosts Orbis, MFS and Baillie Gifford recently organised the Active Advantage 2023 conference in Sydney during which each presented on the long-term value of an active approach for investment portfolios.

Professor Hank Bessembinder from Arizona State University featured as Special Guest.

FNArena attended through author (and soon AusbizTV anchor) Danielle Ecuyer.

By Danielle Ecuyer

A World Without A Peace Dividend

The day’s first presentation by Simon Gresham from MFS zoomed in on three major secular themes – productivity, money growth and valuation.

Productivity has been declining since 2010 when China, the beneficiary of globalisation and free trade agreements, started raising wages.

Forget friend shoring and onshoring post pandemic, the elephant in the room is decarbonisation of global economies.

To reach net zero emissions by 2050, the International Energy Agency forecasts 1% of gross GDP, annually, will need to be spent on just replacing existing carbon emitting energy generation.

As Gresham explained, this in effect translates into a 1% tax on economies to achieve the same output of production, referred to as “Long Wave Productivity – De-carbonisation”.

Invoking Simply Red in the 1980’s “Money’s Too Tight (Too Mention)”, the argument then shifted to the Regan/Thatcher years, when meaningful deregulation of the banks was enacted.

The resulting impact, according to Gresham, is a substantial increase in global debt levels and with this debt comes consumer price inflation and/or asset price inflation.

Some 95% of today’s volume of money is coming from commercial, not central banks.

Gresham argues valuations have yet to revert to the long-term average. They currently sit around the average over the last 20 years. From a corporate earnings perspective, margins remain at elevated levels.

His conclusion: investors need to build resilience in a fragile world, think climate change and rising geo-political tensions.

The concept of a “peace dividend” referring to the benign state of global politics since 1989 was framed as a tailwind for markets over the following 30-year period.

Looking ahead, Gresham points to more a fragile environment including “lower productivity growth, higher leverage and high profit margins”.

It is MFS’s view that investment return expectations need to be moderated from 10% p.a. (historical average for US equities) to 4%-5% per annum, with inflation events and recessions both more likely in terms of amplitude and frequency.

These challenges are equally seen as opportunities for resilience in portfolios and for active fund managers who have shown the ability to deliver above 10% returns over a 10-year period.

Gresham advocates investors should “seek outperformance over the cycle”.

An Everything Bubble?

Gresham’s opener was followed up by Bermuda based Orbis portfolio manager, Alec Cutler.

Starting with a few quotes from Jack Bogle, whom Cutler could describe as Uncle Jack because he was, in fact, his biological uncle, Cutler predicts the next bubble to burst will be “passive investing”.

The presentation unpacked the reasons why investing in both cheap stocks and good companies work, as well as investing in companies that are both.

In both instances “cheap” and “good” companies have offered above average long-term gains since the mid-1950s and mid-1960’s.

Both factors have also experienced periods of underperformance, compared to other styles such as growth and momentum.

Cutler suggested patience through the cycles is a must, as well as a good marketing team to support skittish investors and stop funds outflows.

Orbis currently assesses value as cheap and even more attractive than the “extreme” 2000 valuations prior to the dotcom bust and is questioning whether we are in the everything bubble?

The Mighty Few

The final presenter on the day, Baillie Gifford’s Dr Eve Hepburn explained how academics helped provide a basis for longer term strategic thinking and the targeting of secular trends, such as Sustainability, Food and Energy, as well as Digitalisation and the growth in AI.

One of the highlights of the conference was Professor Henrik (Hank) Bessembinder whose original study of 26,000 US stocks from 1926 to 2016, backed up by a global study of 64,000 stocks from 43 countries, 1990 to 2020, showed “very few firms have very large compound returns”.

In his first study, the top 90 firms or 1/3 of 1% created half of all shareholder wealth (relative to U.S. Treasury Bills) or in layman’s terms 4 out of 7 stocks underperformed Treasury bills.

The conclusion was replicated across the world where 57.7% of all stocks led to wealth destruction with the top 1529 stocks or 2.39% of the total 63,785 firms accounting for 100% of the US$75.7 trillion in (net) shareholder wealth created.

Just in case anyone wants to see which companies made the list, the professor kindly dished up the winners in the chart below. Tim Cook is one mighty CEO!

The Professor has been looking for leading indicative factors of future performance and, although there is no one absolute predicator, his data analytics threw up that the CEO matters, the top performers had experienced large drawdowns, growth in earnings matters, organic growth is better over acquired growth, while research and development also rated.

In conclusion, Bessembinder’s research found support for both “low-cost and broadly diversified portfolios for most investors” as well as “hold select (narrower) portfolios for some investors.”

Simply stated, some investors have a comparative advantage when it comes to picking outlying winners and not everyone can claim that title. Munger and Buffett’s record at Berkshire Hathaway would suggest they fit the bill.

Summing up, keeping an eye on the world’s shifting dynamics and being open to the concept not all corporate successes and share price gains last forever, plus acknowledging our own limitations and strengths as investors should help buffer us against the winds of change.

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