Have you heard of Neurath’s Boat? It could just be the strategy that helps investors through market turbulence. Barnaby Wilson, co-manager of the Mid Wynd Investment Trust, explains.
There is in the philosophy of science a simile known as Neurath’s Boat. Conceived in the early 1900s by the Viennese philosopher Otto Neurath, it likens the development of knowledge to the rebuilding of a ship at sea.
The crew members are able to use the timber they already have, along with any driftwood they might encounter, to gradually modify their vessel. But they cannot start afresh from the bottom, because the hull remains submerged at all times.
A similar concept can be found in building an investment portfolio through both strategic and tactical asset allocation. In other words, a strategic allocation where, ideally, a number of “core” investment strategies are left practically untouched, while investors may consider tactical, or “satellite”, opportunistic strategies based on how conditions are changing.
Global equity investors can take this idea a step further. In the terms of Neurath’s analogy, they can focus exclusively on constructing a solid hull – the core of an overall portfolio. One way of doing this is to invest in a set of businesses that are capable of reliably slicing through waves for longer than the market expects.
Such stocks can be thought of as “compounders”. They are defined by an ability to generate high returns on capital and to reinvest at similar returns – a cycle that should fuel continued growth and lead to compounding cashflows over time.
Battening down the hatches
As has been starkly demonstrated during the past two years, economic storms can appear without warning. They might whip up tailwinds or headwinds, with many businesses blown off course as a result.
Several of the biggest recent squalls can be traced back to the COVID-19 pandemic. They include inflation, higher interest rates, the unravelling of supply chains and major shifts in consumer behaviour. China’s economic slump and the wars in Ukraine and the Middle East have also had major ripple effects in the world of equities.
As if for good measure, a classic example of what another great Austrian intellectual, economist Joseph Schumpeter, called “the gale of creative destruction” has further intensified the tumult. Dramatic advances in the field of artificial intelligence (AI) have become widely viewed as a threat to businesses in multiple industries.
Against such a tempestuous backdrop, any ship on the seas of investment can expect a battering at some point. So what might give investors the confidence to batten down the hatches and trust in compounders’ ability to safely navigate these storms?
We believe the answer lies in fundamental analysis. The search for compounders should be underpinned by an in-depth understanding of a company’s competitive advantages and, just as importantly, its capacity to maintain them.
Riding the waves – and beating the fade
A share price generally reflects how long the market believes a business can preserve its edge over its peers. Economic theory suggests this period of dominance must be strictly finite, since high returns attract competitors.
The reality, though, is that true compounders can “beat the fade” for longer than supposed. This is why there may be attractions in a company whose competitive advantages are entrenched but are not fully appreciated by the market.
Take IT services provider Accenture. Management has acknowledged a “significant impact from the challenges the comms, media and tech industries have faced”, but the reality is that IT is a strategic imperative for companies. Accenture’s share price was unsettled in 2022 but has since steadily recovered to near the high it reached at the end of 2021.
Wolters Kluwer is a provider of medical and legal data and analytics, as well as other information services. It was initially tipped to be replaced by generative AI but has shown the accuracy of its information and the solutions embedded in its customer workflows are not easily replicated. With the potential to generate incremental revenues from AI-enabled services, it is now seen as an AI beneficiary.
Cutting-edge healthcare providers are also ploughing through the churn. Life sciences companies Danaher and Thermo Fisher Scientific are adjusting their inventories as demand normalises post-COVID, while contract research outsourcer IQVIA has weathered a slowdown in activity in the biotech arena. Secular trends in biosimilar development provide favourable trade winds for these businesses, and IQVIA’s management in particular has suggested the skies are clearing.
The case for staying below deck
Inevitably, there are occasions when investors will need to tinker with specific planks of a seemingly impervious hull. In these instances, unlike Neurath’s sailors, they may need to get wet.
There are times when planks are broken and leaky, cannot be fixed and require replacing. There are also times when the market alters its view of a competitive advantage period, meaning a stock is no longer undervalued.
In addition, investors should constantly be looking to upgrade the quality of a portfolio. After all, there is always competition for capital. New planks should come from the same forest of compounders – but not from the very same tree.
Crucially, the North Star for every compounder’s voyage is financial productivity – the aforementioned ability to generate high returns on capital, reinvest, keep growing and compound cashflows over time. These are the characteristics of the companies that constitute a good hull.
Of course, some investors may prefer to stay above deck. But being above deck in a storm is not much fun – even if, like Neurath’s tireless crew, you can mend the mast, repair the rigging or meddle with the mizzen. Ultimately, confidence – and real opportunity – may be more likely to lie below the waterline.
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