Tuesday, September 30, 2008

The fallacy of modern management

When I first began investing on the stock exchange, things were relatively simple. Select a small but balanced portfolio and then hold it for the long term.

So long as your firms were reasonably well managed, then you knew that continuing business improvement and reinvestment would lead to increased profits over time. In turn, this would translate to increased dividends, higher share prices, plus reasonably regular issues of bonus shares. Further, when your firms wanted new capital, you could either buy new shares or, alternatively, sell the rights for cash.

No more I fear. The failure rate among modern corporations is now so high that the only way to capture the compounding effect in a reasonably low risk fashion is by investing so as to follow the index.

Our current problems lie in a fundamental conflict between management styles and the underlying financial maths.

To illustrate, assume that the real economy is growing by 3 per cent per annum. In simple terms, this provides the growth umbrella across the economy as a whole. Now assume that firms as a whole set annual growth targets of 15-20 per cent.

Quite clearly, they cannot all achieve this. The more individual firms get to 15-20 per cent, the more other firms will have have to fall below 3 per cent to accommodate the faster growing firms.

It has always been the case that some firms are more succesful than others. That, after all, is the market. However, when all firms strive for very high growth targets the risk of failure inevitably increases.

Our problem today is that there is very little scope for conservative, rational management in a world dominated by high growth targets on one side, quarterly reporting requirements and the desire for quick profits on the other.

Assume, for the moment, that a firm thinks that 6 per cent real growth is a reasonable target. This is twice projected economic growth, but still within conservative bounds.

Over a ten year period, annual profits will grow from $100 to approximately $180 or by around 80 per cent. If dividends are set at 50 per cent of profits, then the dividend stream will increase from $50 to $90. On a constant PE ratio, share prices will also increase by 80 per cent. So over a ten year period you will get an 80 per cent increase in dividends plus 80 per cent capital appreciation. Plus, of course, the compound return on reinvested dividends. Not bad really.

The problem with modern management approaches is that it turns investment into a gamble on management's ability to achieve ambitious growth targets. The higher the aggregate growth targets, the greater the gamble because of the increase in the number of firms that must fail just on plain maths to deliver.

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