In their simplest form, investment markets provide a forum for capital seekers and givers to exchange monies today for the hope or promise of the later return of initial capital plus financial compensation for both risk and the time value of money. Asset prices, therefore, are ultimately a reflection of future cash flows. When those cash flows do not manifest themselves as hoped — or conversely, exceed expectations — the discounting mechanism of capital markets adjusts prices accordingly. Which begs the question, what drives cash flows?
In short, we believe there are four material factors: units, price, margin and earnings. How many units will the company sell over the next three to five years? At what price? What will the margin structure look like at maturity? Finally, what will earnings or free cash flow be and how much of that is already reflected by market pricing?
Over the long-term, we think fundamentals drive cash flows and cash flows drive asset prices. Day to day, however, the market’s short-term orientation and overreliance on information that may prove to be less than-material can lead to market long-term inefficiencies. For example, when legislative action will occur or how investors may interpret any such action is hard to predict. This makes successfully forecasting short-term market moves daunting at best, yet market strategists will undoubtedly try do-so in abundance over the next few weeks.
Coming out of the 2008 crisis, companies drove net margins higher due to falling input costs as capital became cheaper and labor was being shed. Yet three to four years into the business cycle the global economy was still dealing with the aftershocks of the financial crisis and revenue growth failed to materialize for many. While margins were unusually high, unit growth and pricing power remained modest. Many companies resorted to using their balance sheets to sustain free cash flow growth levels, and the credit markets were willing financers thanks in no small measure to unorthodox central bank policies like quantitative easing.
As the cycle matured, bond issuance and leverage ratios rose, covenants became less restrictive, collateral requirements fell and the overall quality of the corporate bond market deteriorated. Whether credit concerns manifest themselves in 2019 or much later, leverage is our most fundamental concern because, in our view, highly leveraged companies have less control over their own destinies. Without above-average unit sales growth or pricing power, margins and earnings will ultimately fall as input costs rise, as companies face higher interest rates when rolling over maturing low coupon debt.
Under more challenging market conditions, companies that have become less competitive in a digital economy will no longer benefit from leniency on the part of credit rating agencies. And these companies’ likely hunger for credit could come at a time when the bond market is experiencing indigestion. Funding rates, for some, may become operationally prohibitive, and many could become stressed. Under that scenario, asset selection will be critical, as differentiating between those companies with sustainable margins and those without will have a greater impact on portfolio returns than it has in recent years.
Longer term, most of the market gurus indicate 10-year capital market expectations are for materially lower returns compared with what investors have experienced for the prior 10 years. Our forecast in general is we believe markets will decelerate from the above-average returns experienced the last three decades.
Now that we have elaborated a bit on our greatest concern, let us conclude with this; we learned a thing or two in our college statistics class. Among them, that in the statistics game one must incorporate the law of large numbers (defined below), sample sets that span greater time and provide more input, tend to digress back to the mean. Given that the markets have averaged an outsized annual return over the past 3 decades when compared to the – over 100 year – historical return of 6.4%, the markets will digress back to the mean. We could have said all that in one paragraph but because we are conversationalist creatures, we decided to explain the reason why markets will digress to the mean, rather than just stating ‘what has happened for 100 years is likely to happen for the next 100 years’ especially when it comes to human nature and emotions. Times change, the world changes, but human nature has remained the same for thousands of years and the markets are driven by human nature. There may always be the next reason why, but the bottom line is, it happens because we are all human.
In probability theory, the law of large numbers (LLN) is a theorem that describes the result of performing the same experiment a large number of times. According to the law, the average of the results obtained from a large number of trials should be close to the expected value, and will tend to become closer as more trials are performed.
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