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November 1, 2021 | A Step Ahead
Growth Is Not Enough

Olga Bitel, Partner

Global Equity Strategist

Hugo Scott-Gall, Partner

Portfolio Manager,
Co-Director of Research,
Global Equity Team

Have a question for Hugo and Olga to explore on a future walk?

Send us your suggestions at astepahead@williamblair.com
 
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Investability is the link between economic growth and corporate profits generation. How investors can access these profit streams completes the triage of relevant factors. Hugo and Olga explore rather interesting contradictions here and find the role of government to be rather more useful than mere sand in the wheels of the perpetual economic growth machine.

Hugo Scott-Gall: Last time, we had a very enjoyable and productive conversation about growth. Why and how does growth happen? I don’t want to sound like a James Bond movie title, but sometimes growth is not enough. Growth is a necessary but not sufficient condition for an attractive investment opportunity set. And how well we as investors can exploit an opportunity is of equal if not more importance. So, having discussed your growth framework on our last walk, I want to discuss your investability framework.

So tell me, what’s the difference between an opportunity set and your investability framework?

Olga Bitel: Sure. The link between an opportunity set and investability boils down to the exploitability of the opportunity. That’s a mouthful. Let me rephrase that. As investors, we need to assess a company’s ability to exploit economic growth to generate profits and our ability to access these profits and returns. We find three parameters relevant in this assessment: economic growth, corporate returns, and access to these profit streams.

Economic growth, corporate returns, and accessibility—access of investors to these returns—are the core tenets of our investability framework.

The link between growth and corporate profits is quite interesting. Companies cannot generate profits consistently and indefinitely without economic growth. It seems uncontroversial, but there is an inherent time-related tension here. A given company can maximize its profits in the near term by becoming a monopoly. As investors, we are drawn to the near-term abundance and visibility of profit streams, so we love monopolies. But monopolies actually undermine future growth, thereby limiting the time over which we can earn high returns. Our investability framework recognizes this tension explicitly. We can tease out which business models require or rely on monopoly as a source of competitive advantage versus those companies generating profits from innovation in a more competitive setting, thereby sustaining and advancing future growth.

Access to corporate profits is nontrivial. Can we, as private investors—foreign or domestic—invest in these companies? And crucially, can we repatriate the profit stream that we then derive from these investments? So the three considerations, economic growth, corporate returns, and accessibility—access of investors to these returns—are the core tenets of our investability framework.

Hugo: That’s a nice start. So we can apply this investability framework to geographic areas, including countries. Can we apply it as far down as the company level? Probably not.

Olga: I see what you are saying. You are quite right: we do not need an investability framework to compare two companies’ near-term earnings streams.

In a broader sense, however, what kind of grower a company is informs its business model and its source of competitive advantage. For example, if you are an innovator, you are only as good as your culture and specialty talent; for a marketplace business such as exchanges, network effects represent a key competitive advantage.

As a sort of arbiter, the role of government between near-term profit maximization and longer-term economic growth quickly rises to the surface. It is not a coincidence that the best companies in industrial machinery and high-end consumer durables are located along the Rhine, while the most aggressive gatherers of advertising dollars hail from the United States.

That balance between near-term profit maximization and longer-term economic growth is highly dynamic and constantly changing in real-time as per our perpetual growth machine. And we, as investors, have a unique vantage point as we continuously witness and assess these changes across hundreds of companies in virtually every part of the world.

There’s a healthy tension between the desire to create wealth, value, and a referee that does not allow excesses to build up.

Hugo: So, there’s a healthy tension between the desire to create wealth, value, and a referee that does not allow excesses to build up. The rule of law, the guarantee of property rights—but not rent-seeking—these protections are critical. In the majority of countries, there probably isn’t a billowing red flag that all your assets will be expropriated on a whim.

I suppose the more subtle point is what is the barometer of a healthy equilibrium for an economy. And that barometer must be a healthy reinvestment rate since a healthy reinvestment rate will happen when there is a forward expectation of the ability to generate wealth and then retain those generated earnings.

So there’s human capital, financial capital, et cetera, but there’s trust capital as well. And that trust capital is really quite correlated with a healthy reinvestment rate. And a healthy reinvestment rate is a very good clue for future growth, indicating a favorable regime for investors.

Does that all make sense?

Olga: I totally agree. I really like the idea of reinvestment rate as a KPI for the health of an economy and its future growth. That’s something we can monitor today to work out where returns are going to be tomorrow. But, here, too, there is a push and a pull component.

And for the better part of many decades now, we’ve been more preoccupied with the pull part. So if you guarantee my property rights, give me good access to capital, throw in favorable labor market policies, exchange rate, and regulatory support, my reinvestment rate will be high. And you could argue we’ve had all those things in the United States and more. And yet, the investment rates have been anything but high: in fact, they have been trending lower. So what’s interesting and what I think is missing from your balanced seesaw here is the push factor, the need, the founding principle of our perpetual growth machine.

Companies will reinvest in the face of slightly tougher regulation. Companies will reinvest to stay ahead of the competition. Companies will reinvest when the bar is gradually but constantly raised higher. You reinvest to stay afloat to protect your profit pool, to protect the integrity of your future business. When you are constantly cuddled, there is no reason to reinvest. Things are good now. And if something goes awry, you can always run to whatever your captive government agency is to complain, and they’ll do something to fix your short-term profit stream.

So, all I really want to emphasize is there’s a push and pull to the reinvestment and investment in general. And I think for the better part of the last four or five decades, we’ve concentrated unduly on the pull factors, all of which you just highlighted, and all of which are supremely important. You can’t have investment without property rights, stable currencies, and all the things we just talked about, human capital, etc. But you also can’t have a reinvestment rate without that need to keep one step ahead of the competition; going back to our perpetual motion machine and our growth framework, this need keeps the growth going, and complacency is really anathema to this process.

You know, it strikes me that this discussion on the tug of war we are having now can inform the current debate about the latest regulatory onslaught we are seeing in China. Are government actions really incentivizing and ensuring sustainability and reinvestment in future growth and future companies and future areas of endeavor? Or are they killing capitalism and the middle class? That’s the two camps, right?

I think having this barbell in our investability framework—necessary pull factors on the left, trust in societal institutions squarely in the middle, and push factors to incentivize and sustain-long term growth on the right—is a more useful, more comprehensive way to get at what’s happening.

Reinvestment rates should be used as a KPI for the health of an economy and its future growth.

Hugo: That’s a very interesting point. Are you suggesting the U.S. vs. China compare-and-contrast? At the risk of stating the obvious, I think that would be super interesting.

I suppose we talked conceptually about what the framework is. Hopefully, it will make sense to anyone reading that we have a perpetual growth machine, which gets us to why and how growth happens, how much growth will happen, and then the investability framework we use to assess whether a country or region is investable.

Are there any situations where this wouldn’t hold? For example, is our combined growth/investability framework better at discussing the extremes rather than most countries in the middle?

Olga: I’m keen to test it out broadly: Germany, Italy, India, Brazil. But we can start with the U.S. vs. China first, as you suggest. Time to hang up our coats for now?

Olga Bitel, Partner

Global Equity Strategist

Hugo Scott-Gall, Partner

Portfolio Manager,
Co-Director of Research,
Global Equity Team

Have a question for Hugo and Olga to explore on a future walk?

Send us your suggestions at astepahead@williamblair.com

SUBSCRIBE TO A STEP AHEAD

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