The death of equity growth

Future returns on investments in shares will come less from growth in the underlying businesses and more from income. This means that ratings should be lower, and, in particular, we should expect higher yields.

In the long run, the growth that matters is economic growth. Without economic growth organic growth would be a zero-sum game, and negligible at the market level. There would be winners and losers, but the gains would be entirely offset by the losses, so the average investor would gain nothing from this growth.

The question is what drives economic growth? In the long term economic growth comes from improvements in technology. The economy cannot grow past the productive capacity of the economy, and technology enables this. This has not always been what we regard as high technology: the inventionĀ  of the horse collar had a tremendous impact on economic growth.

One thing investors forget is that technology often has an impact well beyond the the industry it occurs in. The agricultural revolution made available the pool of labour that enabled in the industrial revolution (not that it would have looked like a good thing to those in the pool!). Computers have allowed the automation of banking (manual processing of cheques is a lot of work) and made logistics more efficient (for example, fewer empty lorries because computers can match loads to journeys better than is practical manually).

I have been arguing for sometime that the last few decades have seen little new invention. I have recently noticed that the message seems to be getting through to the mainstream media (a recent article in The Economist, for example).

We have had economic growth driven by incremental improvements to existing technology. Computers may have ultimately similar designs to those available in 1970, and made using similar processes, but they would not have had the same economic impact if they were still the same size and cost!

The problem with this is that there are limits to incremental improvements. Once we reach the limits of, for example, reducing the size of integrated circuits (that the limits exist is a matter of the laws of physics), advances in computers and electronics will no longer be rapid.

There are also diminishing returns to incremental improvements. It is fairly clear that most of the productivity gains enabled by the automation of clerical work and financial transactions have already occurred, and the impact on productivity of making computers still smaller and cheaper will not be as big.

In the past by the time the impact of the big breakthroughs of one period were running down, the next lot of big breakthroughs were beginning to have an impact. With no big breakthroughs in the last 40 years, once the incremental improvements run out, growth is done.

Of course there are many exceptions to this. The largest lies in emerging markets where existing technology is not anything like fully utilised. The problem is that this is not a replacement growth driver, it is just one driver that is not disappearing with the slowdown in innovation.

Population growth may also help boost demand, at least in some countries, but it will also put pressure on limited resources, particular food and natural resources: slowing technology means that our ability to make more from the same inputs will not grow at the same pace as in the past.

There will also be some growth industries: I am not arguing that all advance will stop, just that it will be a lot slower. There will also be opportunities to consolidate and create economies of scale, and these may be easier to exploit when a lack of disruptive technology makes things more predictable.

None of this is enough to change things very much. Growth in one business will matched by a corresponding decline in another, as low economic growth means aggregate demand will grow slowly. If growth is lower, then returns need to be more immediate. The market as a whole should return far more in the short term: dividend yields need to be much higher than has been typical in the past. IN practice we also need to take into account other ways of returning profits to shareholders such as buybacks.

Although this may seem to be a triumph for value investing, I am not sure this is entirely true. Even growth that comes from wining a zero-sum game is growth nonetheless, and growth stock picking will continue: perhaps with gradual shifts in emphasis.

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