Buy Australian

Investors are spoiled for choice. Every cycle there is a new investment theme, product or structure which is going to be the golden opportunity. A generation ago it was TMT. Then BRICS, structured products, disruption, smart beta, private assets. Artificial intelligence is just on the horizon, ready to be the thematic investment strategy that works for sure this time.

Forget all that. We think one of the single best opportunities for long term wealth compounding sits right under our noses. Easily accessed and low cost but overlooked due to familiarity.

We are talking of course about Australia and Australian Equities.

Now we are all for diversification but let’s not lose sight of the fact that over an investment generation (from 1990 to 2023) Australian equities (S&P / ASX All Ordinaries) have delivered total returns of 9.9% per annum, handily out pacing global equities (MSCI World Index) at 8.6% p.a, and emerging markets (MSCI Emerging Market Index) at 8.3% p.a.

And within Australian equities you can do even better. Over the same time, while the median large cap manager just kept sight of the index (9.8% p.a net of fees per Morningstar), the median small cap manager delivered 12.6% p.a net of fees over the same period. That return difference compounds over 33 years to more than double the wealth for the small cap fund investor relative to large caps.

There are many factors that enable and support long term economic growth. Three high on the list are 1) demographics, 2) natural resources and 3) capital. In 2023 Australia remains developed-world-leading in all three.

Our demographics are the envy of all other developed markets. We have a faster growing and younger population – expected to continue for at least the next 25 years. Australia is endowed with natural resources beyond mining. We grow enough food to feed 70m people. We have large critical transition mineral deposits (rare earths, lithium) and huge potential for solar power generation.

It is easy to get anchored to our past as a small country (population wise). Sure, a lot of Australia is desert, but we have arable, coastal land larger in size than all of Japan, housing less than a quarter their population.

Source: WorldData.info. Population growth from 2013 to 2022 and 2022 – 2050.

Source 1. Austrade & World Bank, Global photovoltaic power potential by country.  2. ABS & Longwave.  3. Geoscience Australia & Longwave.

Some emerging markets (EM) have great demographics or abundant natural resources (and sometimes both in the same country), but there are many investment risks that come with them (sound government, rule of law, protection of property rights, weak corporate profitability and governance), which reflects in the long term returns of EM being lower than DM over three decades. We should be thankful in Australia that a few free tickets to a fancy waiting room are enough to mobilise the electorate against government corruption. We are still a long way from emerging market levels of grift. Active EM investors may be able to sufficiently reduce the portfolio drag from EM risks to extract higher than index returns, but with a recent downward trend in active EM alpha as these markets become more efficient, the future net of fee benefit for investors may be similar to the index.

Source: eVestment, Frontier, before fees

Economic growth is not the same as equity market returns (China is exhibit A for this). As we have seen, equity index returns are also not the same as the net of fee returns captured by investors in active funds.

Source: Dimson, Elroy, Marsh, Paul, Staunton, Mike, 2002. Triumph of the Optimists: 101 Years of Global Investment Returns. Princeton University Press, Princeton. Dimson, Elroy, Marsh, Paul, Staunton, Mike, 2003. Global Investment Returns Yearbook 2003.ABN Amro, Amsterdam.

Australian active small cap investors are wise to the long-term value added by active funds relative to the benchmark. This is a market that pays to be active.

We will almost certainly have a recession at some point in the future. Lots of other bad things will also happen. Knowing what may happen and investing based upon an opinion of precisely when it will happen are two different things. It is no co-incidence there are no economists with worthwhile investment track records. Their opinions should be considered media content not investment advice.

There are always reasons to sell. There will always be pundits worried about the imminent collapse of something (the economy, markets, family values, their sports team, twitter). We know we have this bias ourselves – humans are hardwired to survive threats so we pay a lot of attention to them. We easily forget the journey over the past 33 years was filled with just as many fears as today, and active small cap funds delivered 12.6% per annum anyway.

Australia will more than likely remain a wonderful place to live, grow a business and invest. Active small caps – despite the last couple of difficult years – are likely to return to being one of the best options for compounding wealth available to investors. And today they remain ‘on sale’.

Source: Bloomberg, Longwave Capital Partners. 31 August 2023. Starting point was the highest relative small cap index performance prior to drawdown.