Creative destruction – does it risk capital misallocation?
Remember Blockbuster Video? Back in the 1990s and early noughties, the movie rental business was a big success, having become people’s go-to stop for a cosy night in. But the company died a death in 2010, after the rise in streaming services helped consign it to history. In retrospect, it seems a certainty that the idea of physically renting and returning videos would fall by the wayside in the internet age. That’s not the whole story, however. Blockbuster had the chance to evolve – back in 2000, Netflix’s founder proposed that his company would run Blockbuster’s online businesses, while Blockbuster would promote some Netflix services in their stores. Having been turned down flat, Netflix went on to become the behemoth it is today – a dominant player with a market cap of $125 billion.
While Netflix’s success is very much a 21st century phenomenon, the economics underpinning it go back much further. Back in the 1940s, an economist named Joseph Schumpeter coined the term “creative destruction” – the idea that innovation creates new businesses and industries, while making others obsolete. Back then, Schumpeter was struck by the demise of traditional industry in the face of technological advances. But his theory is just as valid today, especially in the technology sector, which is constantly evolving in the face of innovation.
The risk of capital misallocation
For stockpickers, the holy grail is to have the foresight to recognise which businesses are on the wane, and which are the economic generators of the future. But that’s easier said than done, especially in the wake of the unprecedented policy accommodation of recent years. An eye-watering $1.7 trillion in debt has created negative interest rates throughout the developed world, lowering borrowing costs and creating plentiful liquidity. This has prolonged the lifespan of numerous businesses which have been able to refinance at increasingly lower interest rates. Arguably, this muddies the waters, and interferes with the process of creative destruction. With that in mind, we believe the most effective way to remedy capital misallocation is to invest in businesses based on their ability to consistently increase their economic output and generate a return above their cost of capital. As active managers, we can also avoid allocating capital to businesses we believe to be in structural decline.
Of course, there’s another aspect of capital misallocation to consider. As we saw in the dot-com boom of the early 2000s, sentiment towards a particular stock or sector can become unjustifiably exuberant – a classic warning sign of an asset bubble. At such times, the fear of missing out takes over, with investors piling into a stock well after the optimal time to invest has passed. Again, active managers have an advantage: we can take stock, pull back, and reallocate capital when warning signs appear.
Stock picking in tumultuous times
The flip side of investor sentiment is fear – an emotion we’ve seen in abundance since the UK’s vote to leave the European Union in 2016. Since the referendum, amid the uncertainty surrounding the terms of the UK’s departure, UK equities have been markedly out of favour relative to global peers. Diminished investor appetite has led to equity withdrawals, resulting in a dramatic derating of the asset class. Within global equity funds, UK equity allocations are now materially below historic levels, which reflects withdrawals of over $30 billion from the asset class over the past three years. Meanwhile, the MSCI UK Index is now around 30% cheaper than the MSCI global, according to various metrics including price-to-earnings ratio, price-to-book value and dividend yield.
Although the valuations of UK stocks look compelling, we need to be mindful of macroeconomic and geopolitical factors. This includes US President Donald Trump’s consistently unpredictable stance towards his trade policies with other countries, particularly China. The pace of growth in the Eurozone continues to slow, while there are concerns that Germany is on the brink of a recession.
Avoiding the misallocation trap
For the moment, although anxiety is widespread, global liquidity is abundant, inflation is subdued and, over the past year, global equity markets have risen. Against this backdrop, we focus on UK and internationally-exposed businesses, where the fundamental drivers of profit are entrenched, and equity holders benefit from the capital allocated and risks taken by management. We continue to believe that a rewarding strategy is to actively invest in UK-listed companies that are compounding their earnings and dividends and where corporate governance is world-leading. Balance-sheet strength and the quality – and accessibility – of company management teams are also crucial indicators. Instead of second-guessing the outcome of macro events, such as the trade war and Brexit, we see far more value in focusing on a company’s fundamentals. To us, that’s the most effective way to avoid the trap of capital misallocation – and to generate long-term returns for our clients.
 Netflix CEO Reed Hastings says subscriber numbers aren’t the right metric to track competition, CNBC, 6 November 2019
 EPFR Global Data; Investors pull billions from UK on prospect of no-deal Brexit, The Irish Times, 2 September 2019
 Morgan Stanley as at 31 March 2019
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