Graham or Growth? Part 2 - Future States

May 2018
James Anderson
JOINT MANAGER, SCOTTISH MORTGAGE INVESTMENT TRUST

When we first attempted to explore and explain our enthusiasm for Growth Investing 15 years ago it was natural to try to learn from our predecessors. The problem was that there was very little literature to guide us. The only text in the canon of investment that espoused Growth Investing was Phillip Fisher’s ‘Common Stocks and Uncommon Profits’. It dates from 1958. What follows is James’s musings after he reread Ben Graham’s value bible, ‘The Intelligent Investor’.

Future States

We can only posit the nature of possible future returns if we develop some perspectives about the underlying nature of the global economy. This is very far away from predicting GDP or interest rates in the next year. What it seems to require from us is contemplating the conceivable directions and levels of change that may take place over the coming 10 to 20 years.

All too often the oscillations between growth and value, between extreme growth and GARP (Growth at a Reasonable Price) are seen as independent financial variables disconnected from the evolution of the underlying economy. In the long term, outcomes are generally guided by the battles and interaction between systemic change versus comparative stability and then merely reflected in their market versions of Growth versus Value. In conditions of relative but progressive calm then Berkshire Hathaway reigns supreme, in repeating but not transforming cycles then the philosophy of “vicissitudes” and “ups and downs” of Graham are formidable weapons. But if change is wrenching and dramatic then the equation is likely to be very different. It becomes evident that as Schumpeter proclaimed “Surely, nothing can be more plain or even more trite common sense than the proposition that innovation is at the centre of practically all the phenomena, difficulties and problems of economic life in capitalist society”.

So beneath the periodic financial crises that have marked the last decades, what we have been living through seems to have been rapid structural change in the Information Technology driven areas but deep stability in most sectors reinforced by globalisation. Hence the arguments between those like Robert Gordon who see innovation as exhausted and the optimists of Silicon Valley.

Our own contention would be that the likelihood is that we are now entering a period where transformations will be much more dramatic – and much more demanding for incumbents. What has assailed newspapers and retailers of DVDs may well spread far more dramatically – 2018 provided meaningful clues. So for instance even investment banks are now willing to acknowledge that investors are questioning the terminal value of oil companies as the fossil fuel era wanes. We’re likely to be moving into an age where mean reversion is much less significant than mass creative destruction. The post World War Two model is likely to seem quaint by 2030. Or once again much as Schumpeter put it decades ago:

"This civilisation is rapidly passing away, however. Let us rejoice or else lament the fact as much as everyone of us likes; but do not let us shut our eyes to it."

A World Utterly Transformed?

But what if the world coming into view is so profoundly different from our prior existence that we simply can’t contemplate or analyse it in any meaningful sense? It’s possible that the transition that we are facing is just as wrenching and disorienting as the emergence of the industrial revolution appeared to agricultural labourers. It’s not just that the rules of the games will be unknown but that the nature of the economy and corporate life will be mysterious. Against such a potential background of existential uncertainty it’s surely wrong to have confidence in any patterns of past behaviour persisting as iron laws of returns. Predicting is intrinsically dangerous, especially if it’s in the form of believing that it can be measured in terms of historic volatility. All we can do is explore the possibilities. Keeping an open but prepared mind seems to be the best policy. Another compatible methodology is to adopt the Taleb philosophy of putting our portfolios at risk of beneficial Black Swans without pretending that they are other than unlikely and unpredictable.

We should disassociate such musings from the mantras of finance. This world of deep uncertainty and tectonic shifts is radically opposed to what after 50 years of failure is still presented as ‘Modern Portfolio Theory’. Perturbingly this with its broader partner of equilibrium-based economics, still holds general academic and professional sway. Amongst our academic partnerships we’ve had a focus  on the importance of history at the broadest possible level in terms of time frame, global reach and its meshing with economics at those scales. We’ve talked about the work of Ian Morris in the past in this context. We’ve also cited Carlotta Perez of Sussex University and her brilliant Technological Revolutions and Financial Capital. We therefore started to work with Sussex University on the possible transformations of the future. This led to the somewhat complex chart below, but to the much simpler conclusion that we might indeed need to prepare our minds for a New World or even a New Golden Age.

Professor Perez herself is less convinced of the likelihood of this transformation than her colleagues. She thinks we need a financial bubble in order to create the pre-conditions – and that we don’t get beneficial bubbles just because we require them. Finance is too risk averse for that. Alternatively or additionally we need major government action to make the necessary changes. It’s quite possible that this is happening in China under an autocratic regime. Given the dominant narrative of first neoliberalism and then populism it does appear unlikely that the government action that Professor Perez focuses on as an essential ingredient in building a Golden Age stands any chance of occurring. But it may already be driving the seeds of transformation. The Californian enthusiasm for electric vehicles (EV’s) may be cultural but it is also the direct output of legislative pressure and incentives decades before Tesla. In Europe the spate of national and urban plans to ban internal combustion engines in the aftermath of the diesel fiasco seems poised to twist the future. Trump, Brexit and the AFD in Germany excite headlines far more but the rising popularity of green policies and programmes may become more significant. This might even affect American national politics.

The Impact In Stock Returns

If economic and social change set the bounds of stock market possibilities we all know that they are insufficient to drive great stock performance over the long term. Revenues and returns require persistent competitive strengths and cultural evolution. The examination and identification of competitive moats has been central to the splendour of Buffett and Munger. But just as the neoclassical equilibrium-based version of macroeconomics (and its financial cousins of the calm world of measurable risk within a smooth bell curve) appears distant from reality so too does the established microeconomic legacy seem unable to explain corporate success and failure today. In particular the central idea of declining returns to scale seems lacking in explanatory power. The importance of assets and hence Tobin’s Q appears undermined with many physical assets worthless and with dominant companies which have few assets themselves.

But Graham’s model has found new support from an unanticipated direction. One of the most stimulating books of recent years is Geoffrey West’s Scale: the universal laws of life and death in cities and companies. Professor West, though once President of the Santa Fe Institute himself, takes the view that beneath deep complexity there are not just patterns but laws that control the destiny of companies. West sets himself a series of demanding challenges. This is not least true of his putative project assessing companies: “Could there possibly be a quantitative, predictive science of companies...how they grow, mature and eventually die”.

Certainly companies occur and vary in size according to a power law as do cities. Yet cities get stronger and more resilient the more they grow, demonstrating an increasing return to scale. But there’s no historic evidence that this is so in the corporate world: companies have done about as well as organisms and much less well than cities as they grow “many of their key metrics scale sublinearly like organisms rather than superlinearly like cities...their sublinear scaling therefore suggests that companies also eventually stop growing and ultimately die”. This is surely the territory of Graham’s “vicissitudes”. All large, mature companies revert to market growth as West concludes.

Yet this compelling general picture across times and societies is challenged by the examples we cited earlier. Plainly there have been companies that have scaled superlinearly in recent decades: is this a temporary chance that is noise in the data or something more serious? The answer to this probably carries the future prospects of Growth and Value investing in its wake.

Our answer would be that there’s reason not to exclude the probability of further superlinear scaling in coming decades with the associated extreme performance implications. As to why, we’d turn to a long-time colleague of Geoffrey West. At about the same time that Microsoft’s business model first appeared, Brian Arthur started writing about the changing nature of returns. This was not coincidental as Microsoft was one of his key examples.

Increase Returns to Scale

Brian Arthur’s theory – or rather early explanation of emerging economic reality – provides a convincing rationale for why the era of Value ended. If there are increasing returns to scale (and indeed self-reinforcing increases in revenues to scale) then surely it’s rational for firms displaying such characteristics to have the opportunity to be persistently attractive investments. Or in contrast to Geoffrey West’s models to be able to display superlinear characteristics. One might even want to suggest that such firms are in important ways more like cities as they are the centres of ecosystems and their advantages stem from this more than traditional competitive moats. It would be naive to expect otherwise. After all the noted economist John Hicks prophesied back in 1939 that any notion of increasing returns would lead to “the wreckage of the greater part of economic theory” so surely it can wreck the best laid plans of stock market participants. As Brian Arthur himself puts it the world is divided:

“So we can usefully think of two economic regimes or worlds: a bulk-production world yielding products that essentially are congealed resources with a little knowledge and operating according to Marshall’s principles of diminishing returns, and a knowledge-based part of the economy yielding products that essentially are congealed knowledge with a little resources and operating under increasing returns”. Brian Arthur

It would be strange indeed for these two systems to produce similar stock market outcomes. Plainly we consider it likely – as far more importantly does Brian Arthur judging by both his recent writings and our enjoyable conversations with him – that the increasing returns system is growing in relative power. Whilst the stock market has intuited much of this it seems questionable to us as to whether practitioner adjustment is nearly complete.

Brian Arthur

The views expressed in this article are those of the author. Its express purpose is to highlight areas of intellectual thought and debate which inform the investment philosophy that underpins Scottish Mortgage, in the hope that they may be of wider interest. The author(s) therefore make(s) no suggestion that this article constitutes independent investment research and it is not subject to the protections afforded to such.

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