Hamish McRae: Change of corporate cultures should prove a welcome tonic for risk-averse investors

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The Independent Online

The US is starting to stir itself and reform its model of capitalism. Accounting practice, the organisation of the financial services industry, and now the legal penalties for misbehaviour will all be tightened. But perhaps more important than any of this, the market itself will impose new disciplines on the way companies are managed.

The US is starting to stir itself and reform its model of capitalism. Accounting practice, the organisation of the financial services industry, and now the legal penalties for misbehaviour will all be tightened. But perhaps more important than any of this, the market itself will impose new disciplines on the way companies are managed.

Everyone is – quite understandably – focussing on the legal and regulatory changes; much less attention is being paid to the change in market discipline. Companies will behave differently because that is what the market will demand of them. What forms might this change of behaviour take?

This is all very new but you can already catch the change of mood. For example, chief executive offices are no longer prized for the risk-taking or their aggressiveness. It is no longer fashionable for CEOs to push "stretch targets" on their workforces – targets that will be beyond their reasonable expectations of what might be met. If you do that, you encourage risk-takers who may manage to meet the targets in the short-term but at the cost, at best, of damaging the long-term results and at worst of massaging the figures.

Mergers and acquisitions will be regarded as much more suspect. Here, the relegation of the merged AOL/TimeWarner businesses to the 90 per cent club – companies whose shares have fallen by 90 per cent – has been enormously significant. The arguments made for the merger has been shown to be rubbish; the people who made those arguments have been shown to be fools.

The change in mood is, of course, not just evident in the US. Here in Britain and in France corporate leaders who piled up debts have been ousted, and by all accounts the same occurrence is about to take place at Deutsche Telekom.

So we can see the change of mood in general terms. Arrogance is out; humility is in. Debt is out; cash is in. Risk is out; caution is in. Investors will require that companies be built for comfort – their comfort – not for speed.

But how should one translate this change of mood into a useful investment strategy? I have been intrigued by a new paper from ABN Amro, which looks at cyclical strategy – how should investors move their portfolios about to take advantage of the business cycle? It is a rather technical study (whenever I see the words "sector rotation" my eyes glaze over) but it helpfully sheds some light on some longer-term structural trends. Some of these are illustrated in the graphs.

For example, take the flight to quality that has taken place in bond investment. One way of measuring investors' willingness to take on risk is to look at the spread in the yield between government bonds and company bonds of the same maturity.

On the top graph you can see how this gap rose dramatically through the 1990s. In the early 1990s the gap was typically less than 1 percentage point between 10-year US Treasury securities and 10-year top-quality company bonds. Note that these were triple-A company bonds, the very highest quality variety, not the rubbish. A few months ago this gap had widened to 2.5 percentage points – even top-quality companies had to pay an extra 2.5 per cent on top of the rate at which the government could borrow.

And perhaps most interesting of all, the gap had started to widen in 1999, well ahead of the market falls that started the following spring. It looks as though the bond market caught its bout of jitters long before the equity market. Maybe bond investors are wiser creatures than the share-tippers.

Since then the spread has narrowed a bit but it is still wide: people are still frightened. The interesting investment question is whether, as company managements become more risk-averse, the spread will narrow further. My own instinct, for what it is worth, is that over the next five years it will go back to the 0.7-1 percentage point region of the early 1990s. If that right, it is an important opportunity in what are likely to be tough times.

The second graph shows another phenomenon: the way in which the return from companies in "safe" industries contrasts with those in volatile ones. The comparison here goes back further, to the early 1970s. The ABN Amro team has plotted the total return, relative to its trend, on an investment in two rather different industries, using the FTSE classifications. One is food and drink retailing, the other telecommunications services.

As you can see returns from food and drink are very stable. The line wiggles up and down a bit but generally stays within a plus or minus 10 per cent band on either side of the long-term trend. By contrast the telecom line is all over the place. In a good year you did wonderfully, and in a bad year it was awful. The 1973/4 period – the last time prior to 2000/1 when UK shares ended down two years on the trot – was particularly awful.

If investors are going to continue to be risk-averse for the next two, three or whatever years, then expect them to want to have inherently non-volatile stocks. We will still go on buying food and drink, and enjoying ourselves in cafés, whatever happens to the economy. We may not want to upgrade our computers or buy new mobile phones. However as we become less risk-averse, as eventually we will, then expect us to plunge back into the hi-tech arena.

We will go on buying food and drink and evidently 20 per cent of us will go on smoking. As the share price of telecommunication companies have plunged, the shares of tobacco companies have soared. The bottom graph shows what wonderful investments European tobacco companies have been over the past 30 years, far better than investment in the market as a whole. Smoking may be risky, but investing in tobacco certainly hasn't.

I suppose the message here is that if you can identify products and services for which there is a really reliable demand then you will prosper. Of course tobacco may not be quite as good an investment in the future as it has in the past and we cannot easily invest in the burgeoning cannabis empires that our government has just encouraged. But I do suspect that in investment terms "sin" will remain "in". As a matter if fact, a "sin portfolio" with heavy weighting in armaments, tobacco and alcohol, would have done very well through these tough times.

Above all, investors have to prepare for a slower-growth world. That will not necessarily be a slow-growth world and certainly not a no-growth world, despite what has happened in Japan. But slower growth will mean lower returns than we have been used to. Just as companies found themselves pushed by the market to puff up their profits every quarter, now they are being pushed into ultra-cautious accounting practices. Right down the line the message is "be honest, be cautious" instead of those silly exhortations to "push out the envelope" or "feel the burn".

It is the little things that mark the transformation. Just as dressing down became first a symbol of energy, enthusiasm and youth, and then a symbol of sloppiness, now companies are getting their staff back into suits and ties.

Rule of thumb one: never buy shares in companies whose CEO appears in public without a tie. Rule of thumb two: buy shares in companies that announce they have dropped "dress down Friday".

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