Fund managers are inundated with information every day. Their job is to pick and choose the information that assists them make investment decisions, while cancelling out the noise that so many of us use as the basis of our investment decisions. Much of the information is quantitative data. However, a new survey shows that the hunches and opinions of senior management – their ‘animal spirits’ – are as important for investors to understand today as it was when the term was first coined over 70 years ago.
‘ANIMAL SPIRITS’ – A CRUCIAL ECONOMIC LEVER
Most investors would feel that the information they consider while picking securities largely comes down to one type – quantitative. Price to book, revenue growth, trend lines, gross profit margin –terms that dominate the majority of investment research. The significant problem with this data is that by its very nature it is backward looking. The time that quantitative information can be calculated with certainty is also the time when the data is out of date.
However, companies are not run by robots. They are run by individuals with their own wants, needs and fears, and these motivations should also be taken into account when investing in listed securities. ‘Animal spirits’ are the emotive name John Maynard Keynes used in his 1936 publication, The General Theory of Employment, Interest and Money, to describe human emotion that motivates confidence and trust which are essential for economic prosperity. Keynes wrote in The General Theory: “…a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic…Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; though fears of loss may have a basis no more reasonable than hopes of profit had before.”
Showing that what’s old, but good, will be made new again, the ideas Keynes was espousing in 1936 have been resurrected under the term ‘behavioural finance’. A common finding of this area of study, which is in contrast with beliefs that all investors will act rationally and without bias, is that there is a psychological element to financial decision making. For example, at the individual security level, an investor may hold a losing stock too long or sell a winning stock too early to avoid the regret that comes from respectively crystallising a loss or losing the gains they already have. At the macro level, investment choices may be altered because of how an individual thinks about wealth – do I have enough? Do I need more? Am I comfortable with what I have? In other words, the greed versus fear trade-off.  Dictionary of Finance and Investment Terms (2006) p59
What we have all felt over the past three years during the rollercoaster ride of the equity markets is not just limited to investors. It does, of course, play a distinctive and important role in corporate decision-making. Managers, with the benefit of their education, knowledge and experience combined with company resources (analysis, spreadsheets, estimates, research) try to detect what is coming over the horizon. Is it going to be clear blue skies perfect for fat margins and capital investment, or more stormy weather which will require the battening down of the corporate hatches?
If companies and individuals lose the expectation that things are going to get better some time in the future, economies grind to a halt. Unfortunately, this is exactly what has occurred in many parts of the globe, particularly Europe.
A recent survey of Fidelity’s research analysts showed that despite generally having very strong balance sheets, companies in Asia and Europe are planning on reducing or keeping constant their capital expenditure (71%), freezing spending growth in IT and marketing (68% and 62%, respectively), and keeping employment levels constant (only 29% intend to actively recruit). Underlining the lack of positive animal spirits globally, CEOs of global companies are more concerned about government intervention and intrusive regulation than they are about inflation, wage costs, pricing issues or even their own balance sheets. Only concerns about sales volumes are causing more corporate anxiety than the likelihood of governments enacting or changing legislation or regulation that will result in a more challenging business environment.
As each research analyst speaks with the senior management of an average 30 listed companies at least every quarter - a key part of Fidelity’s ‘bottom-up’ fundamental investment process - the survey reflects the thoughts of thousands of CEOs and other key management personnel at listed companies in Europe and Asia.
Digging a little deeper into the survey results, there are regional differences. In Asia Pacific, Fidelity’s analysts believe that 32% of companies are looking to increase their capital expenditure by 10% or more in the coming year compared with last year, with 9% looking to increase their spend by over 20%. In Europe, only 21% of companies are looking to increase their capital expenditure by 10% or more in the coming year compared with last year, with 5% of companies looking to increase their spend by over 20%.
European companies are starting from a much lower base than their Asian counterparts. Capital investment in Europe has been extremely low for two to three years now and it would seem the animal spirits in Europe are particularly negative.
Financial market watchers attempt to read animal spirits using other indicators – the VIX index, for example (short for Chicago Board Options Exchange Volatility Index), which tracks the bid/ ask quotes on the US Standard & Poor’s 500 Stock Index. As it is based on the assumption that, other things being equal, options will trade at higher prices when expectations of volatility rises, it is sometimes referred to as a gauge of investor ‘fear’. However, this again is at best a ‘current time period’ indicator, as the ‘fear’ needs to have been passed through the corporates themselves to the investment markets. Assuming that markets are semi-efficient, what is being reflected in the VIX is also being reflected in other risk indicators across financial markets. Another general stress indicator used, the Bloomberg Financial Conditions Index, combines yield spreads and indices from the money, equity and bond markets into a normalised index. The values are then converted to represent the number of standard deviations that current financial conditions lie above or below a given historical range. Again, this indicator is dependent on prices in the financial markets currently, giving little advantage to those looking for an edge. Patently then, being able to accurately ascertain the animal spirits of the corporates themselves can give a significant time advantage over those who simply watch market indicator gyrations.
Bringing the analyst survey results into the real world, corporate animal spirits are poor. This is not just a theoretical finding - it is causing corporates around the world to resist increasing their spending despite the recovery in their balance sheets since 2008/09. In turn, this resistance to spend is having a multiplied effect on local economies – money is not spent on local suppliers, which don’t employ, those employees therefore don’t have the money to spend in local supermarkets, which don’t employ, and so on. In Europe the situation is exacerbated by the lack of confidence between financial players. While there has been some lowering of interbank rates in accordance with the lowering of the European Central Bank (ECB) rates, it is instructive to note that European banks are still choosing to park money at the ECB rather than lend to each other, which highlights the tensions dominating money markets. Banks deposited €299 billion at the ECB in November, the highest since the end of June last year. There is clearly still some way to go to convince those that are actually taking the credit risks – the banks themselves – that everything is roses when it comes to asset security.
Although both Europe and Asia are currently electing to sit on their hands despite their relatively fat balance sheets, it does bode well for the future. In his beautiful prose, Keynes said that individual initiative will only succeed when reasonable calculations as to profitability is supplemented and supported by animal spirits, “…so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.” In other words, individuals – and corporations – have to be able to justify taking a risk on their business based on their calculations and their expectations of the future. Quoting Keynes again – “…we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity [investment] largely depends.”
Company management are people, and are therefore subject to the changes of mind we all have. In an investment context, this can mean a very sharp change of mind from caution to optimism, and an aligned change from flat expectations to bullish expectations, with a subsequent boost to corporate spending in areas such as marketing, information technology, other capital expenditure and merger activity.
Historically, this change in animal spirits has led to hockey stick-type gains in equity market prices and corporate profitability. Currently, corporations globally have the balance sheet strength and firepower to boost the global economy; they require the positive frame of mind to wield them. But that can come when you’re least expecting it, and it’s those people who are talking to the companies themselves on a regular basis who are most likely to pick up that change of sentiment first, re-align their portfolios accordingly, and reap the benefits.
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