I was recently asked when the best time to start a new fund might have been. Not that most fund managers really have control over this, however, if I could go back in time, around 1988 would be a good place to start.
Immediately you might think my answer has something to do with the stock market crash of October, 1987; but it does not. It has everything to do with the tailwind that increasing corporate profit margins and falling interest rates had on equity markets over the subsequent period.
As illustrated by the chart below, corporate profit margins have been on an upward trend for the last 25 years. Typically corporate profit margins have mean-reverted – thanks to competition and the laws of industry supply and demand; so the last 25 years has certainly represented an unusually good run.
Furthermore, over the same period, interest rates have been falling. As illustrated by the chart below, the discount rate applied to future dividends – defined as the sum of the risk-free rate and equity-risk-premium – has either been declining or moving sideways. This has provided a boost to price-to-earnings multiples on equities (which can be roughly viewed as the reciprocal of the discount rate).
So with margin expansion driving earnings growth; and with falling interest rates driving price-to-earnings multiple expansion, we can start to see why equities delivered stellar returns over this period.
Today is a very different starting point: corporate profit margins are at record highs; and interest rates cannot move any lower. It would seem sensible to conclude, therefore, that equity returns over the coming decades may be materially lower than they have been in recent decades.
Such conditions only strengthen the value proposition of Montaka – for two reasons:
- Montaka, with its dual long and short portfolios, significantly increases the scope for us, as the Investment Manager, to add value through superior stock selection. In finance speak, we are saying that, in a lower equity-returning environment, every 100 basis points of “alpha” is a higher share of the total return and, therefore, relatively more valuable; and
- Montaka’s dramatically reduced net market exposure (resulting from the short portfolio offsetting the long portfolio) enhances the downside protection of client capital.
We think the space of increased alpha generation and downside protection is a good place to be in the current market environment.