What is the relationship between economics and investing? You might think a strong economy would lead to a sharp rise in share prices and vice versa. You might also believe a sound knowledge of economics and the constant monitoring of economic news are prerequisites for investment success. In fact, the relationship is complex and ignoring mainstream economists and the financial media might just be the best option for investors.
Mrs Thatcher, the UK’s most influential post-war prime minister, was wary of economists, once joking that she would like to abolish the government’s economic service. She had good cause to be sceptical. In 1981, 364 of the country’s leading economists wrote a letter to The Times saying the government’s economic policies would end in disaster. The economy began to recover almost as soon as the letter was published.
However, Mrs Thatcher did have one favourite economic advisor, Sir Alan Walters. Maybe she liked Walters because he was only too well aware of the limitations of the ‘dismal science’. He once told an acquaintance of mine, for example, that “economists know nothing about investing”, adding that “if I tell you to invest in something, do the exact opposite and you will almost certainly make a lot of money”.
Sadly, few other economists share Walter’s humility. They will solemnly forecast that the Portuguese economy will grow by 2.034% in 2021 while inflation will average 0.34% over the next five years, when in truth they have as much knowledge about what will happen tomorrow as the rest of us, i.e. none.
Certainly, few predicted the global financial crisis and I don’t remember many saying that the London stock market would soar if the UK voted for Brexit. You might as well ask a witchdoctor to chuck some chicken bones on the floor to find out what will happen to the economy next year.
Economists are also fond of changing the goal posts. When I was a boy, the focus was on the trade balance. Ten years later, when I was an economics student, the money supply was deemed to be the key piece of data with news broadcasts leading on the latest growth of a measure of the money supply called M3. Now nobody seems to care a jot about either indicator.
Little wonder then that professional investors tend to ignore what they call “noise”, or the constant stream of economic data and opinion that gushes from the media. Certainly, if you took notice of the slick-haired business broadcasters who announce in urgent tones that an economy is in “freefall” or “rocketing” ahead, based on a minor change in a quarterly figure that will almost certainly be revised, your investment losses would be vast.
So, what do professional investors look for? The best search for companies that will perform well year in, year out almost irrespective of the state of the economy. That could be because the businesses have a fantastic management team, supply products or services that enjoy steady demand, and work in areas where it is difficult for competitors to emerge. When they find those companies, the best investment managers stay invested for the long term.
For example, Warren Buffett, arguably the world’s most successful investor, looks for companies that are surrounded by “economic moats”. These allow a company to maintain an edge over its competitors in order to protect its long-term profits and market share.
Moats exist for a number of reasons. Take GlaxoSmithKline. The UK pharmaceutical company’s “patent-protected drugs carry strong pricing power, which enables the firm to generate returns on invested capital in excess of its cost of capital,” according to investment website Morningstar. Furthermore, “the patents give the company time to develop the next generation of drugs before generic competition arises”, adds Morningstar.
Even if you find a company with an economic moat, the stock price is key to deciding whether you want to invest or not. There is no point in buying even the best company in the world if its share price is overvalued. There are many factors that influence the price of shares and the outlook for the economy is certainly one of them. But it is far from decisive.
Bargain basement UK
Take the UK. Its economic prospects seem grim. Many pundits have argued Brexit will prove an economic catastrophe in the long term. Yet share prices have surged since that Brexit vote. That largely reflects the fall in the value of the pound. A large proportion of profits for FTSE 100 companies is made in dollars, so, if sterling weakens, the dollar revenues of these companies once converted back into sterling are worth more, boosting overall profits, the key driver of a share price.
Yet, despite the rise in share prices since June 2016, UK companies remain undervalued compared to other global markets. That means you may be able to pick up UK companies with deep moats at reasonable prices. Alternatively, invest in a fund that focuses on UK businesses that can maintain their competitive advantage over the long term.
Moreover, some excellent economists such as Tim Congdon, Liam Halligan and Pippa Malmgren believe the UK economy will do just fine after Brexit. If they are right and the majority of economists are wrong, just like back in 1981 and many times since, your investment could fare even better.
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Anthony Beachey is a former BBC World Service journalist now working on a freelance basis in Portugal, where he specialises in economics and finance. [email protected]