#28. Be your own “investor-economist”



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!

10 thoughts on “#28. Be your own “investor-economist”

  1. Thanks Dr Morgan for another thought provoking piece.
    Do you have any thoughts on the sort of personal equity plans as sold by the big banks – how professionally are these managed ?.
    The value of these investments seem to have gone up lately with the rising stock market but i wonder if the market is overvalued (distorted with QE funny money) and that a crash is around the corner ?.
    I have though about cashing in my PEP but what would I do with the money – gold was once a save haven but that seems to be overvalued.

    • Kenneth

      Thanks. In replying, I must point out that I don’t make investment recommendations, but I can discuss general principles.

      The big problem nowadays is income – we have an income-starved economy with inflated asset values. Governments, and economies more generally, are horrendously indebted. Neither can afford to pay much in the way of interest. Of necessity, interest rates have been set at near zero, and QE has been used to drive up bond markets (high capital value = low yield = climate of lonw interest rates). Equity markets have followed suit.

      So price-to-income ratios in capital markets are very high. Meanwhile, property markets are high, so the price to income ratio is very stretched. The same effect has hit other investment instruments such as annuities – so pensioners are in the same boat as savers – whilst wages have continued to deteriorate vs. inflation, yet another instance of income starvation.

      With equities, best value is likely to be in companies which: have decent dividends; have good cash flow/dividend coverage; and are in essential industries, i.e. they sell what people need rather than what people simply want,.

  2. Tim,

    I’m kind of just jumping into the comments of this article to ask a general question, as opposed to one pertaining to the article.

    I’m conversant with issues of EROEI, have read the oil drum back to front, am profoundly irritating friends and family with talk of impending doom and basically think that the UK is probably one of the worst places to be in the coming years. I’m also 30, have no savings and no skills that are likely to be valuable in a post crash world, unless physicists are somehow better qualified to work on farms.

    What the hell does one do? Staying in the UK seems like suicide, but leaving seems to offer little hope either. The only option seems to be to prop up a deckchair and enjoy the band as the boat goes down. Why are you staying? Do you still have any hope? It’s all rather dour.

    • Maybe you should consider a move to Sark, the smallest of the inhabited Channel Isles. It is self-governing, not in the EU, just one bureaucrat, no income tax, no VAT, no cars and no welfare state. A self-managing population of 600. Does this provide a hint of things to come for the rest of us?

    • Mum and Dad went there on holiday aeons ago and loved it. But I’d prefer somewhere a little bigger and a little warmer…..

      Whether Sark provides a future model I don’t know – but it’s an interesting thought…………….

  3. Thanks Dr Morgan I can see the logic of investing in essential industries – when the next financial shock comes I can forsee luxury type business suffering badly,
    We do seem to live in strange times – orthodox views no longer seem to provide the correct answers. So many commentators seem to believe that value and wealth can be created out of nothing – your analogy with the ponzi scheme strikes a chord.

    • Thanks. So much “accepted” economics is unravelling. Also, one of the “black holes” in economic theory is becoming far more important. It’s called general factor productivity (GFP).

      Once upon a time, economists thought increased labour accounted for growth. Then they found that labour increases actually explained only 20% of growth. Then they thought capital might account for the rest of it – wrong again, capital can only account for another 20% of growth.

      So this left 60% of growth unaccounted for – “oh well, let’s give it a fancy name, even if we can’t analyse or measure it”……..General Factor Productivity!

      PS Perhaps the sequel to “Life After Growth” should be “Life After Economics”!

  4. “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.”

    Umm, I will take issue with that.

    Minimal regulation will be effective if the government doesn’t step in to support companies that fail as a result of the regulatory regieme, as a result we have seen numerous financial companies behave recklessly and frequently illegally but get supported by their national governments when they should have failed. What has been completely overlooked in the last thirty years is the role of so called constructive destruction in the capitalist economic model*.

    We have the worst of both worlds, minimal regulation coupled with politically motivated intervention to support the companies that behaved recklessly and should have gone bankrupt.

    Now we have artifically low interest rates to ‘stimulate’ the economy, but in fact destroying capital formation, which will postpone any recovery, all because we have a enormous debt overhang that should it be allowed to collapse, would destroy several significant economies.

    In the end it’s all down to government intervention for short term political advantage.

    *The result being, we don’t live under a capitalist economic model, rather a facist economic model.

  5. Can I make a suggestion? It’s rather late in the piece, but I only just found your blog.
    I want to recommend Modern Monetary Theory. I really believe all discourse related to macroeconomics should now be done with MMT in mind. It snuffs out the shibboleths supporting political economic discourse so beloved of todays bunch of incompetent politicians – a world wide epidemic – and shows exactly how this field should be discussed.
    /MISCELLANEOUS/MONEY:DEBT/13-06.pdf [not sure this will open] It’s a pdf article by Bill Mitchell [bilbo.economicoutlook.net]. Also Warren Moseley; “The seven deadly innocent Frauds of Economic Policy” W. Randall Wray, Stephanie Kelton and others.

    BTW, I am v impressed by your Report “perfect storm”

    • Hi John

      Thanks – I will chase up these sources, and MMT is something that I’m interested in. Glad you like Perfect Storm – my book (“Life After Growth”) is along the same lines.

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