WITH ECONOMICS IN DISARRAY, YOU CAN DO IT BETTER YOURSELF.
Whilst economists are understandably loathe to admit it, their social science is in chaos.
All the old verities have gone up in smoke. Keynesians are at a loss to explain why brisk growth has not been restored despite the injection of truly staggering amounts of stimulus.
Liberal economists, meanwhile, are keeping their heads well below the parapet, since their ideology of minimal (for which often read “negligent”) regulation must carry a huge share of the blame for the biggest boom-bust in economic history.
Perhaps worst of all, those economists who claim to be most committed to the capitalist system often show a woeful ignorance of what capitalism actually is.
There can never have been a better time, then, for investors (in particular) to ask themselves this question – do I need economists, or can I do a better job of this myself?
The reality, you see, is that you really can do a far better job of the economy than economists can.
Official forecasting underlines this point. In round terms, the real (inflation-adjusted) output of the British economy is going to be roughly the same this year as it was in 2008. Had the forecasts of the independent Office for Budget Responsibility (OBR) been right, however, it would have been more than 7% larger. This is a huge difference.
The key point, though, is not just that even the best economists’ get their growth forecasts woefully wrong, but that they concentrate almost entirely on growth, to which they then append some supposedly growth-linked numbers such as unemployment.
Where investors do better
This almost exclusive concentration on growth is analogous to an investor who looks only at reported profits. Such an investor would not get very far, because his approach would be hopelessly narrow and naïve.
Rather, the astute investor is likely to look at equity investments very differently.
First, he looks behind the earnings statement to see if the reported number has been distorted by “extraordinary”, “special” or “non-recurring” items.
Second, he looks at cash flow as a better guide to performance than earnings, recognising that it’s cash, not earnings, which pays dividends, funds expansion and indicates whether performance is improving or weakening.
Third, he excludes movements in working capital (cash and equivalents, debtors and creditors) from his definition of cash from operations, which is not to say that he ignores these movements.
Fourth, he looks at the balance sheet, noting how cash flow, expenditures, debt and cash interact. Growth in earnings (or, for that matter, in cash flow) is all very well, but not if it is being “bought” using disproportionately large amounts of debt.
Fifth, he looks at industry prospects in the sector (or sectors) in which the company is involved. If the business is a conglomerate, of course, he balances his view of each of the activities in which the company is involved.
Next, he assesses both management quality and governance, since the quality of the hand on the tiller and the navigator on the bridge will do a lot to determine the course that is followed, and how competently the corporate ship weathers unexpected storms.
Lastly (for now, anyway) he looks at the creation of value for shareholders, since the bottom line has to be the return on investment earned for the owners of the business. Of course, the wise investor realises that companies also serve a broader constituency which includes stakeholders such as customers, employees, suppliers, the environment and the broader community, and recognises that a corporation which exploits or disregards any of these interest groups may be courting trouble.
The economy – the investor perspective
Getting away from the obsession with the simple “growth” metric, and adapting investor methods to the economy, can produce a much more nuanced and broader assessment of the economy.
Taking Britain as an example, what conclusions might “the investor-economist” arrive at?
Well, he would certainly look behind seemingly satisfactory growth figures to discern that, on an “underlying cash flow” basis, the picture is far from rosy. He would note that growth is being bought very expensively, in that additions to debt have long exceeded (and continue to exceed) increments to GDP.
He would further note that cash flow (and GDP) are being flattered by unsustainable movements in working capital, specifically a very severe current account deficit (which shows that 5.5% of GDP is being funded by the forbearance of overseas trading partners).
He would then notice that asset sales and borrowing are being used to bridge this gap, and would wonder quite how long this can go on, given that UK plc is very heavily indebted, and has already sold a big chunk of its industrial asset base.
Indeed, debts of almost 500% of GDP, plus “off balance sheet” contingent liabilities (including public sector pension commitments) would give our “investor-economist” very considerable food for thought.
Industry prospects, too, would worry him, since about 70% of the British “economic conglomerate” is invested in “ex-growth” sectors dependent either on private borrowing or on debt-funded public spending.
I’m not going to comment here on UK plc’s “management quality” but, where “governance” is concerned, I have no hesitation in observing that a more genuinely democratic system might be better than the over-centralised, under-responsive “Westminster model” where shareholder value is concerned.
Lastly, shareholder (and stakeholder) value looks less than robust, since income growth has now lagged living costs for an uncomfortably long time (anywhere from seven to twelve years, depending on how you measure it).
Do It Yourself
In this discussion, I argue that the ordinary person, using sound investment principles, can do a better job of the economy than economists can.
There can be no better way to conclude than by asking you to try this for yourself – and share your conclusions here!