Predicting The Future

"There are several key reasons for this," explains Criticos. "Prolonged periods of low inflation have made it impossible for many companies to raise their prices, so profits growth has all but halted for many. This has naturally impacted on their share prices. "Meanwhile, technology may have helped improve productivity but it has also helped to reduce inflationary pressures as has the rise of the independent central bank."

These clear trends have helped to all but erase the impact of geographical boundaries. As Criticos explains, "Companies have had to struggle to achieve the economies of scale needed to become truly global providers. Now that so many have succeeded," he says, "international borders are becoming less and less relevant."

"Similarly as economic cycles are now reducing in terms of their intensity [see Table 1 below] it's now stock specific risks that are the greatest determinant of future growth [see Table 2 below]. In other words," he says, "gone are the days when companies of a similar type reacted in the same way to economic conditions. That effectively means that taking the traditional method of generating performance primarily from allocating assets to different investments sectors and regions is now a thing of the past."

This is perhaps best illustrated by example.

Let's take two well-known companies in the same sector - in this case, consumer non-durables. We'll call them 'X' and 'Y' for now.

Company 'X' has a sales split in 1999 of 46% in Europe, 22% in North America, 11% in Latin America, 16% in Asia, and 6% in the rest of the world. Company 'Y' looks very similar - it's equivalent sales split is 45%, 24%, 11%, 16% and 4% respectively. But here's the difference. If you invested in company X, you'd have lost 29.6% and 6.5% over 1 and 3 years respectively. If you invested in company Y, however, you'd have gained 26.2% and 83.6%.* And the two companies? Unilever and Nestle.

It's the same story in sectors like banking. Over the last 12 months there's only a 40% correlation co-efficient between HSBC and Lloyds TSB. Barclays and Royal Bank of Scotland are similar while there's just a 20% correlation co-efficient between HSBC and Halifax.

As Nick Criticos comments, "This makes it very difficult to decide what being 'overweight in banks' actually means these days. Are we talking about mortgage banks, banks with international operations or banks with more of a domestic focus. The fact is," he says, "they no longer have enough shared attributes to make them comparable."

The rise of the stock picker

"The only effective strategy for a fund manager in this sort of marketplace is to increasingly focus on the individual stock specifics," says Criticos, "that means backing individual stocks for their own merits rather than the fact that they previously conformed to some recognised pattern of behaviour.

"Of course, investing in a smaller portfolio which contains only the most productive stocks means taking on more risk. At the same time however, it avoids the issue of your returns being eroded by investing in larger funds which are compelled to hold poor performing stocks by virtue of their size in the index.

"Now that the retail investment market has attained a new level of sophistication," he says, "this is the perfect strategy for delivering higher returns. Investors with existing 'mainstream' equity funds now need to diversify not by geographical region but by risk. After all, where a company is based often has little or no bearing on how it performs. "Times are a changing." he says, "These days maintaining a low risk investment portfolio could be the most dangerous investment decision a private investor ever makes."

Table 1 : Ever Decreasing Circles

Source : DKBR

This table shows the downward trend in GDP volatility over successive decades. This illustrates the lessening impact of economic cycles over the period.

Table 2 : Investment Risk has become stock specific

Source : Goldman Sachs

This table shows the increasing proportion of stock specific contributions to equity prices i.e. almost 90% of the factors affecting share prices in the TMT sector were specific to individual companies involved.

For more information on RSA Investments' and our range of investment funds investors should contact their Independent Financial Adviser, call 0845 702 3746 or visit our website at www.rsainvestments.com.

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