News, Reflections and Ideas

Introduction

This is the beginning of a fortnightly feature of this website that is the companion to our latest book “The Experts and the Evidence: A Practical Guide to Stock Investing”. The purpose of this feature is to bring investment content to our community that is topical, makes you think about your approach to investment and offers fresh evidence on a whole range of ideas. Any thoughts on content and/or style will be warmly received – we are, after all, a learning community and the more we reflect and debate the better.

News - Big and Not So Grand.

There are lots of ways we could start this series of news items but given it is the first, we thought we would start with the big news of the day – the shifting shape of the global economy. In future issues we will focus on smaller items, such as the causes of the collapse in the Netflix share price, but given what we are witnessing at the global level and the impacts that will feed through to investments, it seems opportune to look at the big picture.

We are living through a radical shift in how the world operates. After 30 plus years of globalisation, we are retreating into more of a national focus. The pandemic highlighted the risks of long supply chains and the war in Ukraine has emphasised the costs of depending on despotic regimes.

We could spend many a page looking at how all of this might play out but for the moment we will touch on the immediate and then the medium-term consequences.

In terms of the immediate, consumers are facing a cost of living crisis and their spending is declining given their lack of confidence. Fears over inflation are real and when you have producer inflation of 20% and energy inflation of 30% plus, then the fears are well founded. These fears will feed into wage demands and the UK is in for a summer of discontent. While we do not have the same level of unionisation as the 1970s, the anger in the workforce is palpable and understandable.

Other immediate consequences are that a number of producers will struggle to pass on their input prices and some will go to the wall. Let us give you one simple example – pigs. At the moment pig prices are equal to their feed costs, and pig producers are making hefty losses given energy, staff and overhead costs.

So, from an investment perspective, you need to understand how exposed a company is to these short-term pressures of input prices and declining consumer confidence.

Looking at the medium term, there are pluses and minuses. The economy will adjust to the various pressures and gains will be made. As the security of supply becomes ever more important, thought will need to be given as to how this will play out across the various sectors. For example, Rolls Royce seems well placed to make the most of the need to return to nuclear and the stock market is slowly recognising this. On the minus front, some companies are heavily exposed to global supply chains and these will need to be shortened and reconfigured, and this will involve cost and some turmoil. It might be worth considering how far your investments are exposed to these risks. One simple example is microchips. A lot of the production of the very high value chips is concentrated in Taiwan and given the war in Ukraine, it might be worth reflecting on whether the geo-political risk has increased.

All in all, given the tumultuous changes to the world economy (and we will explore some of these in a lot more detail in future issues), it might be time to review your investments and strategies. We are not saying change for change's sake, as staying faithful to a strategy has lots of benefits (see the next section) but occasionally it is worth standing back and reviewing your approach, and this might just be the time to do it.

Reflections – The Power of Staying Put.

A lot of the reflections and ideas we will share with you in the coming months and years will argue for the power of compounding and staying in the game. A range of evidence shows that a lot of the truly stellar returns come from compounding gains and to achieve this you have to stay in the market, ride the storms and feel the warm glow of the bounce backs. Market timing is extremely difficult (we will discuss why in future features) and it is better to stay with your ‘bets’, insights, calculations, etc. if you can. This is not always easy because of the emotional costs of losses and these often occur by watching your portfolio too frequently and panicking when the volatility hits you in the gut.

However, staying put, being faithful, showing persistence etc. are often seen as hold hat and the modern world is about change, fresh pastures, excitement, micro careers, playing the market, etc. For some, such actions are unavoidable as companies change their structures, etc. And recently, we have witnessed the Great Resignations and Great Retirements that have followed the global pandemic. In the next couple of paragraphs, we will argue that there are great benefits to staying put – in investments, jobs and many other walks of life.

A lot of life is made easier if you are trusted and trust comes from people understanding that you will deliver on your word. We are writing this when the trust in our politicians, institutions, etc. are at an all-time low and this will increase the frictions (costs) of living life in the UK going forward.

Trust also has the benefit of allowing you to create networks, do your best work (by harnessing the value of others) and if you stay put these compound across time. Think about staying in the same area for any length of time and the costs of just living are eased considerably by knowing who to talk to, hire, where to go for the best service, etc. Effectively, the transaction costs of just living are reduced markedly by trust, the power of compounding networks and not having to search for answers in a new environment.

Effectively, staying put reduces transaction costs and frees the time you need to be creative and create value. This applies to investment as well as everyday life. Bear this in mind when you are considering a change for change's sake. We are reminded of a powerful insight from one of the best UK merchant bankers “I just wish my CEOs would learn to live with being bored – they create such havoc with their fancy ideas of change’.

Ideas – High profit margin as a protection of your investment for all weathers.

Given all of the above, the obvious question to answer is how to identify companies that hold up better in the different economic cycles and global destruction of value. The sources of outperformance are multiple factors such as the quality of the management team to create and maintain a resilient supply chain, the competitiveness of the offering (which will affect both sales and their bargaining power over price), and more. Instead of trying to understand the company through its fundamentals, an alternative and quantitative approach is to deduce all of these through an important output measure: profitability. It is important to a company’s valuation for obvious reasons. Furthermore, one key component of this profitability ratio is the profit margin (profit divided by total sales). This ratio measures a company’s ability to generate a return for each unit of sales.

The idea (hypothesis) here is that in a highly uncertain environment, companies that have historically higher profit margins will be able to adjust better either due to the quality of the management team or the nature of their product (being defensive or essential). In other words, if the above reasoning is correct, we can use the historical profit margin as a measure of the resilience of a company. Companies with a high-profit margin can deliver a lower volatility profit. If investors do not fully appreciate this fact in a timely fashion (known as underreaction in the asset pricing literature), we will see persistent outperformance of high-profit margin stocks over low-profit margin stocks.

We perform backtesting of this idea by selecting companies based on their relative level of profit margin in the FTSE 350 companies over the past 20 years. Since each industry has a different level of profit margin level (e.g., a supermarket has a much lower profit margin than an energy company), when comparing profit margins we need to take into consideration these industry differences. Therefore, we compare the industry adjusted profit margin (IAFM). The figure below shows the plots of five portfolios based on their relative ranking of IAFM. The portfolios are rebalanced every month. Overall, we have two conclusions:

· The cumulated return plot demonstrates a clear return pattern according to the strength of their historical profit margins.

· The statistics further confirm that the high IAFM portfolio offer not only a higher return but also lower volatility than the low IAFM portfolio.

Overall, the backtesting supports the idea that selecting companies with a high-profit margin relative to their industry peers would offer a more consistent and high return for your investment.