Many experienced investors, especially those with a sound understanding of economics, have been perp...
Many experienced investors, especially those with a sound understanding of economics, have been perplexed by both actual and relative price trends in recent years.
Fortunately a number of popular misconceptions concerning macro and microeconomic behaviour are now being exposed. These can be summarised in the five following points which can be taken separately, although they are in many ways interrelated.
The first point concerns the marked difference in attitudes towards large companies versus smaller ones. Institutional investors have been convinced that large companies earn a high return on capital and grow while small companies are poorly managed and unable to compete in the new global market place. Thus small companies can be ignored provided 'we get the decisions right' on the large stocks. However, many smaller companies are well managed with strong market positioning in their own field and have clear growth prospects.
The second point is the growth versus cyclical debate which is similar to the big versus small argument. In reality, all companies have both growth and cyclical characteristics. Large companies have the greater capacity to 'smooth' reported performance but this should not confuse experienced investors.
Given the magnitude of valuation difference on the corporate size scale, there is a huge opportunity to select small so-called cyclical companies that might be regarded as growth stocks in the future.
Third, we look at the question of whether stronger growth means higher inflation. Most investors are now prepared to accept that the UK economy is growing again. However, many believe there is an inherent inflation threat. Longer periods in economic history show that high growth rates can be associated with low or even negative inflation. Investors ignoring so-called cyclicals in the belief that interest rates will rise sharply may be making a big mistake.
We come to the momentum versus value debate. New equity valuation techniques, which compare return on capital with cost of capital and project forward, can be dangerous. Economic value added analysis typically pays insufficient attention to change and competition.
Finally we turn to the concern over the return on capital invested compared to the cost of capital. Stock market performance over the past two decades has been strongly correlated with a widening gap between the return on and the cost of capital.
This is fully justified if sustainable. Economic theory and history would suggest the current gap is too wide. Value is not an optional extra when considering the merits of a particular investment opportunity, it is the key. Investors should not allow fashion and momentum to distract them from the economic facts of life.
Paul Harwood is a director at Mercury Asset Management.
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