A book review from Paul Sinclair, highlighting Andrew Smithers’s challenge to orthodox cost of capital thinking. Questioning the usefulness of the equity risk premium and arguing that real equity returns mean revert around a long term constant, Smithers offers a provocative rethink of how markets function, one that valuers may find both unsettling and refreshing.
This book caught my attention when Martin Wolfe highlighted it in the Financial Times as one of the best economics books of 2022. He said: “It is a head-on assault on consensus economic models of how finance and the economy interact….Effectively, he argues that consensus models are more a religion than a science. A brilliant book.”
Andrew Smithers is a well-known financial analyst with a distinguished career who had been studying economics and stock markets for over 60 years when he wrote this book in 2022.
Is the idea of an equity market risk premium helpful?
As a valuer (and not an economist), I was particularly interested in Smithers’s argument that the return on equity reverts to the mean (and has serial negative correlation), whereas an equity risk premium does not (and in his opinion provides no useful data about the future). After spending too much time wondering how best to measure the risk premium and getting sucked into related puzzles, such as whether to apply a small company premium, I found this is a fascinating book.
This book is controversial, arguing that the current neoclassical economic model is flawed and led to the financial crisis of 2008, the recession which followed and the subsequent slow economic growth. He has support from a number of eminent economists.
Smithers rejects the neo-classical economic assumption that short-term interest rates, long-term interest rates and the cost of equity capital are co-determined, resulting, in his view, that the EMRP provides no useful information as there is no relationship between these three components of the cost of capital. This is based on his analysis that supports his belief that, over the long term, the real (post-inflation) return on equity is constant, whereas short-term fluctuations are random and unpredictable.
He provides data which indicates that the long-term return on equity has a negative serial correlation and reverts to the long-term mean, which he estimates at 6.7%. His analysis covers periods of changing growth, leverage, demography and the proportion of the return paid to shareholders. It appears that fluctuations of these variables have offset each other because corporate behaviour responds to the stability of equity returns that follows from investors’ risk aversion. The return to shareholders comprises dividends and buybacks net of new issues (the “broad dividend”) together with share price appreciation. The relative proportions of the broad dividend and share price appreciation will depend on the company’s level of investment.
Why should the real return on equity revert to a long-term mean?
In contrast to the neoclassical economic model, Smithers considers a distinction in the private sector between companies and households, putting the behaviour of company managers at the centre of his analysis. This is in contrast to the neoclassical view that the corporate veil is flimsy and that only the behaviour of the companies’ owners (households) needs to be considered.
He argues that the main concern of corporate managers is not to increase the value of corporate assets, as the neoclassical economic theory assumes. Rather, their first concern is their careers and this focuses them on relative share price performance which they believe investors use to evaluate them. This means that they have little interest in maximising the value of their companies or, as a consequence, on their cost of capital.
Corporate managers also do not want to have to raise fresh equity capital for steady continuing operations as they believe this will damage investor confidence. This means that they respond to changes in long bond yields, borrowing and increasing the broad dividend to increase company leverage when yields are low and reducing the broad dividend to reduce leverage when rates are high.
Smithers believes that the main constraint on a company’s leverage is the managers’ fear that they will need to raise fresh equity for normal continuing operations rather than the caution of lenders. This is because such an equity raise is a threat to managers’ job security, which will come before a potential bankruptcy, the main risk of lenders. This results in a stationary real equity return on equity based on the managers’ attitude to risk.
Smithers notes that, although his conclusion of the mean reversion of the real return on equity cannot be proved conclusively and can only be shown as probable, it is supported by two other economic variables: the produced fixed tangible capital output ratio and the labour share of output. The three variables are mutually consistent and the latter two variables are important constants in economics.
Why shouldn’t short-term and long-term interest rates and returns on equity move together?
Smithers argues that households save for rainy days and for eventual retirement. They will have individual preferences for: the amount of short-term funds they hold for rainy days; and, for their longer-term savings, the balance between equities and long bonds. These preferences will depend on their risk tolerances.
He believes that, based on this model, there are at least three separate economic equilibria in the economy: one for short risk-free rates which allows forecast net savings to be balanced; the long bond rate which balances the supply and demand for equities; and the return on equity which reverts to a long-term mean.
Households’ risk tolerances will establish their portfolio preferences for the proportion of their longer-term savings they wish to have in bonds with a duration similar to the period until they wish to draw down retirement funds and infinite duration equities. This focus on duration means that they are largely indifferent to long-bond rates. Companies are sensitive to long-bond rates and this allows the supply and demand for equities to be balanced.
Conclusions
Smithers argues for a new economic model which takes into account the impact of the stock market on the economy based on detailed research and data analysis. His objections to the current neoclassical economic model are based on his detailed research and data.
He provides data to support a real return on equity capital that reverts to a mean of approximately 6.7%. His assertion that the level of bond yields and equity returns are not co-determined implies that the equity risk premium can vary over time.
This analysis also argues that the lack of growth in advanced economies partly reflects the lack of corporate capital accumulation, which is rooted in the short-term behaviour of companies’ mangers and investors. The performance of the stock market is at the centre of this behaviour: both managers and investors are focused on share price performance.
There is much more of interest in this book, including Smithers’s views on stock market returns over the short-term, the Miller-Modigliani Theorem, tax, investment and intangible assets, among other things.
It is a worthwhile read, even if at times it can be a difficult read for non-economists.
*the views expressed are the author’s and not ICAEW’s