Building long-term wealth in a low-growth world
The secret to building long-term wealth is simple – earn consistent, attractive returns on capital, and then allow them to compound and accumulate over the long-term, preferably decades.
Here, we look at the three components of what we refer to as ‘capital accumulation in a capitalist society’ – building wealth, in other words. We also discuss the importance of the investment style in determining the likely cumulative rate of return an investor will achieve over the next decade.
ACCUMULATING WEALTH IN A CAPITALIST SOCIETY
Simplistically, a capitalist society is one in which there are both workers and investors. Investors provide capital to businesses (to purchase plant and equipment, for example) and businesses pay workers to create the goods and services demanded by households.
Capital accumulation, or the process of investing capital with the objective of growing the initial investment over time, is a key element of a capitalist society. Those with access to capital and the skill, ability and willingness to invest that capital have the potential to earn attractive rates of return over time. If those returns are re-invested, they can enjoy exponential growth in capital over the long-term.
Growth in corporate profits positively contributes to equity investors’ returns, because profit growth results in growing income streams and intrinsic values through time.
However, corporate profit growth over time is predicated on an economy that also continues to expand over time. When the economy ceases to grow over an extended period, the rate of compounding stock market returns will be significantly diminished overall.
During this slowdown, average businesses are more likely to suffer disproportionally, from the combination of poor economic conditions and loss of market share, compared to “better”, higher quality businesses. Index-based stock market investors could still enjoy some potential compounding returns from reinvesting income (dividends), however they are unlikely to receive the returns they achieved historically.
To enjoy the full benefits of compounding returns, it becomes increasingly important to identify companies with the ability to grow profits when economic conditions are difficult, and growth is stagnant. The challenge is that these companies are difficult to find and require significant skill to identify consistently. Qualitative analysis comes into its own when screening for quality investments – offering far greater insights than short-term financial heuristics, such as price to earnings (P/E) or price to book (P/B) ratios.
THE RICH GET RICHER: INCOME INEQUALITY IS GROWING
Most of us are workers, in that we rely primarily on income from personal exertion, and do not have major equity ownerships in businesses and/or other investments from which we can accumulate wealth. The investors have a massive competitive advantage in term of their access to capital and ownership of capital.
The reality is that people who do not have much capital to start with need to:
- Achieve higher rates of return;
- Save and invest more from their personal exertion income; and/or
- Invest over a longer period, in order match the ending capital of others who had more capital to begin with.
Common sense tells us that the more capital an investor starts with, the greater the dollar amount returned, and the more capital that investor has to reinvest.
This means that over time the wealthy get wealthier at an exponential rate. Those who start out with more capital are at a distinct advantage, and this is one of the reasons for the concentration of capital among the wealthy because income is derived from capital as well as personal exertion. It is also the key reason for increasing income inequality in most countries. As chart one shows, wealth inequality is on the rise in a number of countries and remains high in others.
An added problem is that the income and capital differential tend to expand over long time horizons as the extra income creates more capital, which in turn generates more income.
Chart 1: Wealth inequality is either very high or rising in most countries
Source: World Inequality Lab, World Inequality Report, 2018
SUPER OFFERS SOME RESPITE FROM RISING INEQUALITY
Compulsory superannuation in Australia mandates that employees save and invest a proportion of their income over their working life. The rationale is that on retirement, workers will enjoy savings that have had the opportunity to benefit from the impact of long-term compounding returns.
Our compulsory superannuation system has been partly responsible for Australians being ranked the world’s wealthiest people, according to the Credit Suisse 2018 Global Wealth Report. It has also acted to reduce wealth inequality in Australia, by forcing most Australians to save part of their salary during their working lives.
START SAVING AND INVESTING EARLY
Without the benefit of a large starting capital base, we all need to start saving early in our working lives to enjoy the benefits of compounding returns. Savings can be regulated, as in the compulsory super system.
However, where a country’s economic conditions are such that most people cannot accumulate capital due to factors beyond their control, such as insufficient employment opportunities, inadequate wage levels, high healthcare and education costs or highly restrictive credit conditions, the divide between the wealthy and the rest of society will continue to grow. The wealthy will continue to enjoy the advantage of compounding returns from a large capital base.
Ultimately, time is compounding returns’ greatest ally. The longer the period over which capital is invested, the larger the impact of compounding returns on wealth. Starting to save and invest early in life allows time for returns to compound, resulting in larger amounts of capital later in life, when individuals might like to retire.
In order to achieve the maximum benefit from compounding, an investor should:
- Invest in a portfolio of companies with superior economics and long-term structural growth - companies that are not reliant on the expansion of the overall economy to grow their profits;
- Take a long-term view and be patient, acting like a business owner rather than a share trader;
- Reinvest into their portfolio as much of the income and sale proceeds as possible; and
- Maximise the amount of capital invested over time.
This approach focuses on finding a small number of stocks with healthy returns that can compound multiple times over a long period of time.
EARNINGS GROWTH IS LINKED TO GDP GROWTH - WHICH IS DECLINING
Chart two reveals that the broad-based equity indices show earnings growth as strongly linked to nominal GDP growth, which is true not just in the US but in Australia too.
For listed businesses that make up the key stock market indices, effective earnings-per-share (EPS) and dividend-per-share (DPS) growth over time is usually below both the rate of nominal GDP growth and the rate of corporate profit growth, primarily due to dilution from increases in the number of shares on issue. In the US, dilution in EPS has been reduced because of the large number of share buy backs that have occurred in that market.
The rate of GDP growth in the US has been declining over the past 50 years. The multiple tailwinds the US economy enjoyed for most of the 20th century, including high levels of innovation, cheap and abundant energy, a young population, increased financial gearing, and a robust and growing middle class have now given way to mounting structural headwinds that are forcing the sustainable rate of GDP growth lower.
Chart 2: Corporate profits, GDP, EPS and CPI – U.S.
Source: Federal Reserve Bank of St Louis; UBS; Hyperion
Many of the businesses which supply the economy goods and services are constrained by the overall growth of the economy.
ECONOMIC GROWTH IS DEPENDENT ON CONSUMER DEMAND
In most developed economies, the rate of overall economic growth is largely driven by the consumer sector because, generally speaking, the higher the rate of economic growth, the higher the rate of growth in sales, and therefore profits for the businesses in that economy.
The corporate profit share of the economy can vary over time. In recent decades, the corporate profit share has been increasing and wages share declining in key economies, including the US. This is shown in charts three and four below.
Chart 3: US corporate profits after tax as a % of GDP
Source: Federal Reserve Bank of St Louis; Hyperion
Chart 4: US Wage income as a % of GDP
Source: Federal Reserve Bank of St Louis; Hyperion
The reality is that the increase in corporate profit has been achieved at the expense of wages growth. Profit growth has supported returns on capital invested in businesses but has also contributed to the hollowing out of the middle class and increasing income and wealth inequality. Chart two shows that corporate profit growth has outperformed GDP growth since 1961; this has occurred not only in the US, but also in Australia.
History show us that there are natural limits to how far profits can expand as a percentage of GDP without causing social unrest. We therefore believe it is unlikely that corporate profits will continue to expand as a percentage of GDP over the long term. We think corporate profits are likely to remain range bound, relative to the overall economy, and the rate of growth in the U.S. and global economies is likely to continue to experience structural declines over the next decade.
In a capitalist society, the keys to wealth generation are saving capital to invest, investing for the long term, and identifying high quality businesses that are well-positioned to grow sustainably over the long term. When these simple rules are followed – investors do benefit from compounding returns over time.
The low-growth and disrupted world we now live in means investors need to focus on quality more than ever and allocate capital wisely including making careful, prudent stock selection.
Mark Arnold is chief investment officer of Hyperion Asset Management and Jason Orthman is his deputy.
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