Evolution is revolution
As a new year begins, there is the temptation to think this brings in new market dynamics and a new set of opportunities and risks to deal with. These are usually wrapped up together in an outlook for the year ahead.
Of course, markets pay little attention to calendar years, and what we face on 31 December is the same on 1 January. More instructive perhaps is to think of the gradual evolution of markets over longer time frames as a way of picking up on investment trends. To do this it is worth spending some time on evolution as a topic.
The theory of evolution began with Charles Darwin, who published ‘On the Origin of Species’ in 1859. Within this, the most famous idea was that the struggle for existence would allow only those with favourable traits to survive. The idea that an individual’s traits could be inherited by its progeny was also worthy of mention, and we think both these ideas have investment relevance.
Generally, we struggle to observe evolution in the biological sense as it happens over millions, if not billions, of years. For example, it is believed that dinosaurs became extinct around 65 million years ago, and that the first humans appeared in Africa two million years ago. Given the average global life expectancy from birth is 72 years (75 for women and 70 for men) you can see the problem, or more to the point we cannot see biological evolution. This of course does not mean it isn’t happening, and over the long-term evolution is revolution – there is no difference.
In the corporate and investment world evolution, and therefore revolution, happens much more quickly and is accelerating. In 2020, the average lifespan of a company in the S&P 500, the US stock market index, was 21 years. This compares to 32 years in 1965. What can Darwin teach us about this? If we use the two key points noted above and paraphrase them into investment speak, only those companies with favourable characteristics will survive an increasingly competitive world, and those characteristics can be passed down through the different generations of existence of a business. Our role therefore needs to be to understand ‘the struggle’ and how those who are succeeding today can succeed in the future.
The struggle today for corporates is to make themselves relevant in an increasingly digital, low carbon world, where the role of a business is to serve a wide range of stakeholders, from the environment, communities, and employees, not just shareholders who provide the capital to create and grow businesses. The challenge is also to be able to do this over the long term by innovating and creating a business culture that allows positive evolution. This is a set of challenges that an increasingly small number of companies can meet, hence the decline in the lifespan of corporates. On the positive side, those who can succeed will see rewards far greater than those in the past.
Our point here is to say that over the last decade evolution has led to a revolution in investing. The type of company strategically and culturally that can win in this struggle for existence has changed significantly and investor mindsets and stock selection processes need to evolve with this. This is something we spend a lot of time thinking about as sustainable investors. What are the favourable traits a company needs to survive? And how can these be passed down through different generations of management? As we move into 2022 this is something we will sharpen our thinking on as we too evolve as investors. For those interested in learning more about evolution, ‘The Blind Watchmaker’ by Richard Dawkins is an excellent introduction.
Nothing surprising about surprises
One thing for sure about 2022, it will contain surprises. Every year comes with events that have not been forecast. What does this tell us about investing? Daniel Kahneman, of ‘Thinking fast and slow’ fame, said this of surprises:
“Whenever we are surprised by something, even if we admit we made a mistake, we say “Oh, I’ll never make that mistake again.” But in fact, what you should learn when you make a mistake because you did not anticipate something is that the world is difficult to anticipate. That’s the correct lesson the learn from surprises: that the world is surprising.”
Another way of putting this is that what’s non-apparent is much vaster than what’s apparent. We all only know and understand a tiny fragment of what is going on in the world around us, so for each of us there will be many surprises. Put in an investment context, and using a sailing analogy, we must build a boat (portfolio) not knowing the seas (market) we are going to sail on. Although this may sound like an impossible task, it is liberating as an investment idea as it takes away the focus from the world of forecasting and what we cannot control, and back into something we can and do understand, business analysis.
Continuing with the sailing analogy, we will we face some storms of a magnitude we have never seen before (a financial crisis and a pandemic being the two storms of the last 12 years, climate change perhaps the next big one?) but also tailwinds that can drive us forward faster and safer than we ever thought possible (technology and innovation being the strongest tailwinds of all). For safety we need to avoid leverage and illiquidity, so when the unexpected happens we can survive; yet we also want to be investing in some of the most innovative areas of the economy, so we can pick up those tailwinds. Getting the balance of these two things right is the essence of being respectful of what isn’t apparent to us (and accepting we will be surprised) but at the same time accessing the huge opportunities for progress that are available in today’s markets.
Lessons from 2021
In some respects, 2021 was as much more about what you didn’t do with respect to your portfolio than what you did. A portfolio that performed well last year was one that didn’t respond to the rotation into value, nor one that invested in the ‘Covid recovery’ trade. Both ideas had their moments, but largely fizzled out. Equally a portfolio of good quality companies at reasonable, but not cheap, valuations performed well and likely much better than wider markets. When we look at our own funds, and as a general observation, the lower the valuation the weaker the share price performance last year. Price is what you pay, value is what you get. And the best value has been at the higher price points again in 2021.
Another lesson is that how markets respond to macro events is becoming increasingly difficult to foresee. In a year when inflation rose to 6.8% in the United States, the yield on the 10-year treasury remained largely unchanged at around 1.5%. In 2020, the near complete shutdown of the global economy was, in the end, bullish for equities. We suspect the macro event this year is the removal of stimulus from the economy by central banks and governments. The last two years have seen the most stimulative monetary and fiscal policy ever, and it is appropriate that it is now decreased. Knowing this will happen does not give certainty as to how financial markets will respond.
Whatever happens in 2022, rest assured that the investment process that sits behind the RLAM sustainable funds has been tested across many economic and market cycles. So long as we continue to evolve what we do in a thoughtful way, there is every chance we can successfully navigate through whatever the months and years ahead bring. Happy New Year!
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.