“Life’s tragedy is that we get old too soon and wise too late.” – Benjamin Franklin.
‘That men do not learn very much from the lessons of history is the most important of all the lessons that history has to teach’ — Aldous Huxley
Read the previous week’s Investment matters about the budget analysis.
Finding wisdom from history
What are the two quotes about? The first is so true and deeply sad that it is almost a tautology, and the second is so grounded that it can be helpful!
Probably the best part of my market role is the almost limitless opportunity to read and listen to various writers and thinkers in microeconomics, history, philosophy, and political economy.
As a fan of a good quote (who isn’t), I can be as guilty of selective use of quotes as the next person. But now and then, a quote provides a unique combination.
- reminding the reader of an essential idea
- being cogent enough to suggest an organising principle
- suggestive of an authenticity that makes you reassess current conditions.
That combination can be instrumental in running an equity portfolio. This week, I was prompted by a presentation by the economist Russel Napier, ‘Twenty-One Lessons from Financial History for the Way We Live Now’. Napier is the Keeper of Edinburgh’s Library of Mistakes and a renowned global markets analyst.
Napier opened his presentation by referencing a recent article by Angus Deaton, to which I will return. Among his lessons, he reminded the audience, is that markets get very excited about future demand and are often surprised by future supply.
“Supply rises from the dirt, and demand shines in the stars.”
Extrapolating future demand, always shining like a star, can prove illusory. But unexpected increases in future supply, which is much less spectacular, can prove disastrous to business owners and entire industries. The lesson is that you need to worry deeply about the supply risks in your portfolio. This is especially true.
Napier suggested that human nature explains why markets get so excited about demand and spend so little time on it. Like much extrapolation, future demand forecasting needs less research, not more, and involves more sentiment and less fact. As Mark Twain quipped about extrapolation: “Such Wholesale Returns of Conjecture Out of Such a Trifling Investment of Fact.”
At this point in the market cycle, the latest escapade into future demand extrapolation involves artificial intelligence (AI) and data centres. Companies with existing exposure to these trends are bid up, with little attention to how likely it is for many other companies to enter the space easily in the future. Markets are currently faced with a limited supply of investable opportunities despite the huge future supply of such companies, a recipe for disaster, with history providing countless examples.
In a similar vein to the discussion at last year’s Annual CIO Client Dinners’ presentation that focussed on the emergence of weight loss drugs such as Ozempic and the new technology ChatGPT, we are more interested in the impact on existing business models of supply shocks than necessarily finding the shooting star company that benefits from demand.
Tracking supply is tricky, especially in highly competitive industries such as fashion/clothing, fast food, and household services. The next big thing is just around the corner, and on that corner is usually someone willing to fund the idea of destroying existing players.
Forecasting future supply
Future supply is much easier to forecast in cooperative monopolies, duopolies, or oligopolies. Clients may notice that their portfolio (and the Australian economy) are replete with these names across retailing, banking, and insurance. Concentrated industries need to coordinate future supply well.
When ownership concentration is low, predicting future supply may require counting the future mines, factories, or planned stores. You face higher risks in these circumstances, and failing to do the work can be expensive.
We have shortcuts or rules of thumb that we can consider for other industries with a mixed amount of competition. These factors are often related to government and include.
- Barriers to entry – what type exist and how impactful are they?
- Brand value and pricing power – in otherwise competitive industries where new players can rapidly enter, driving down prices, one of the offsetting features some businesses have relates to brand power. When companies can create brand power in commodity markets, this can be a powerful inhibitor of future supply. Examples include breakfast cereals, power tools, and clothing brands.
- Regulatory hurdles or costs of regulation.
Great examples of otherwise competitive industries with considerable barriers to entry include shopping centres in Australia, blood product companies, pathology centres and quarries or cement works. Most manufacturing businesses in Australia benefit from planning, environmental and public support issues that limit the supply of future competition.
We look to accentuate the holdings of companies that benefit from these constraints in our portfolios. Higher local barriers to entry in businesses that operate globally have an additional value consideration that we believe is important. When international firms face barriers to entry but a strong desire for geographical expansion, they are even more likely to acquire existing players, increasing the likelihood of takeovers.
Let’s look at the top eight positions in clients’ Australian equities sub-portfolios and consider issues impacting supply instead of demand.
| Top Eight Exposures | Where supply impacts returns |
| Macquarie Group | Australian-headquartered, we consider it the world’s premier investment bank. Thanks to superior risk management and capital allocation skills, Macquarie has delivered an enviable track record of growth and profitability while building an enviable reputation as a specialist manager of infrastructure assets. |
| Sandfire Metals | Underinvestment in new mines, especially high-grade opportunities, is limiting the global supply of copper. While supply is unlikely to be constrained forever, the outlook is constrained in the medium term. |
| Woolworths | The control of the supply of new supermarkets by the supermarket duopoly and ALDI, combined with abysmal economic prospects for standalone competitors, reduces the risks of supply shocks. |
| National Australia Bank | Big Four Banks have proven that the scale of investment required to replicate their distribution and meet regulatory and compliance costs is material. The privileged position of their regulatory capital regime also provides them with a return advantage. |
| QBE Insurance | Supply in insurance is a little more nuanced than a regular industry insofar as it primarily relates to the supply of cheap capital to underwrite insurance providers. After the decade of US quantitative easing and new zero interest rates, future supply shocks in insurance appear less likely. |
| Seven Group | Access to longer-term growth themes in infrastructure and mining investment, privileged assets within Boral, and astute capital allocation. Supply constraints in quarries and Caterpillar parts are almost bulletproof, and the network advantages created by Coates are substantial. |
| Reliance Worldwide | Benefiting from the concentration of channels to market in the US and Australia, Reliance is growing in scale through acquisitions and has developed brand value in products that have successfully turned commodity-type goods into higher-margin products that are hard to compete with for new entrants. |
| Newmont Mining | It owns the best gold mines in the world and has the longest mine lives. This portfolio effect makes it exceptionally difficult for a new entrant to replicate such a portfolio. |
In the remainder of our top 25 positions, we can also see our dedication to assessing future supply conditions in our investments in Cleanaway, Nufarm (seeds business), Steadfast, Johns Lyng Group, and the recent addition of BlueScope Steel.
When oversights become permanent features of our economies
One of the fascinating elements of the market’s ongoing myopia regarding supply and overhyping of demand is the degree to which it has been maintained over time. Hence, it is included in Napier’s list of “lessons.”
This reminded me of the power of a recent article that I urge many to read. The wisdom of age pervades in an article published by the IMF titled “Rethinking My Economics: Questioning one’s views as circumstances evolve can be a good thing”
The author, Angus Deaton is the Dwight D Eisenhower Professor of Economics and International Affairs, Emeritus at the Princeton School of Public and International Affairs at Princeton University. He is the 2015 recipient of the Nobel Memorial Prize in Economic Sciences.
His critique of his profession is compelling and potentially prescient as we move towards an era of more government intervention, rethinking accepted mores of politics, and reorganising global politics.
The five failings he identifies are especially relevant to equity portfolios as governments and policymakers begin to address the shortcomings. The shortcoming are detailed below:
- Power – ‘Without an analysis of power, it is hard to understand inequality or much else in modern capitalism.’
- Philosophy and ethics – ‘We often equate well-being with money or consumption, missing much of what matters to people.’
- Efficiency – ‘when efficiency comes with upward redistribution—frequently though not inevitably—our (economists) recommendations become little more than a licence for plunder.’
- Empirical methods – “…..currently approved methods, …., focus attention on local effects, and away from potentially important but slow-acting mechanisms that operate with long and variable lags. Historians, who understand about contingency and multiple and multidirectional causality, often do a better job than economists of identifying important mechanisms that are plausible, interesting, and worth thinking about….”
- Humility – “recognize that there are almost always competing accounts and learn how to choose between them”
We suspect that after almost 50 years of focus on efficiency, false humility, and a post-covid generation of younger people who refuse to equate well-being with consumption, the economic models under which we evaluate long-term investment decisions also need modification.
Those who adapt quickly are likely to benefit considerably.
The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.