The economic history of Western countries is an admirable one. Their standard of living has been transformed over 200 years by consistent year-on-year growth in output and per capita income, despite the rapid growth in populations.
This has happened despite periodic wars that have destroyed life and capital, buildings and infrastructure. The invasion of Ukraine, for example, is an awful reminder of how war can destroy income-generating assets.
It will take many years — in which savings and investment in equipment and infrastructure have been lost — to make up for these losses.
But while privately owned businesses have been responsible for much of the growth in Western economies over the decades, the consumer has been just as vital a part of this story.
Companies work by expecting to earn a surplus, after the cost of production has been met. They compete on prices quality of goods and services, leveraging improvements in productivity, but always facing the risk of a loss.
Here, stock exchanges such as the JSE are crucial. They allow the ownership rights in businesses to be widely and conveniently shared. They provide the modest, average saver with an opportunity to plug into these surpluses and the wealth-creating machine that is business enterprise, usually through their pension and mutual funds. As a result, people have realised more wealth than they would have done had they put their savings into the money market, bank deposits or government bonds.
Even though the JSE has consistently outperformed money markets, it has been nearly seven times as risky, measured by the standard deviation of returns
The JSE, very much part of a global capital market, has provided excellent returns over many years. On average, annual total returns with dividends reinvested from the JSE since 2000 have been nearly twice the interest earned from cash — 13.5% a year against 7.6% (see graph).
The compounding effect has been so powerful because the returns on capital from privately owned businesses have been so consistently positive, despite the considerable risk. Over the past 20 years, an investment in the stock market has far outperformed cash in the money market.
The obvious conclusion would seem to be: “Invest in the stock market. Based on past experience it can be expected to perform well in the long term, even if there are some short-term blips.”
Yet, these short-term blips discourage investment in shares. Even though the JSE has consistently outperformed money markets, it has been nearly seven times as risky, measured by the standard deviation of returns (see graph).
This risk means that the value of your shares may well be worth much less in days or months, when you might be forced to liquidate your stock.
So where do these good share market returns come from?
The rate of return that a business makes on the capital it uses is the foundation upon which all rewards from saving are built.
Businesses try to improve the return on their capital by maximising the difference between the value of the resources in which they invest and their operating costs — measured as the internal rate of return on capital employed. It is this internal rate of return — not share market returns — that reveals the productivity of a company.
A stock market translates the future, expected streams of internal returns on capital into a current stock price.
As you’d expect, the most valuable firms are those that are expected to consistently improve their internal returns on capital. They improve the productivity of the capital they use, which attracts more capital.
These two measures of a firm’s performance — the internal and market return — are likely to be highly correlated over the long run.
There is, of course, considerable uncertainty: about flows of revenue, operating costs and returns from alternative investments. This makes estimating the value of a firm a risky endeavour, and pushes risk-averse savers to the lower-return, less risky options, such as the money market.
But the real force that has driven the extraordinary improvements in the supply of goods and services, and the stock market itself, has been the success of technology in improving the internal return on capital for years.
From railroads to electricity, from computers to the internet, technology has provided the opportunity to improve returns on capital and increase wealth.
Certainly, technology has consistently delivered far more than investors predicted. In turn, stock markets have done so well because the productivity improvements from innovative technology have exceeded expectations.
There are other questions too, most critical of which is whether humanity will continue to tolerate the share of output — the surplus — that goes to the owners of capital
The big question is, will technology continue to surprise on the upside over the long run? That’s hard to say.
Productivity has been driven by better computer power. Moore’s law, which says that computer power per dollar invested in a chip will increase at an exponential rate, has been shown to be true for about 50 years. But those increases must, at some point, run up against physical limitations.
There are other questions too, most critical of which is whether humanity will continue to tolerate the share of output — the surplus — that goes to the owners of capital.
This structure provides the risk-takers with the incentive to deliver the goods and services they do — but, for many, the shareholders have benefited to an outsize degree. Pressure may mount for this lopsided deal to change.
This, as much as anything, should be a warning sign that the towering stock market returns of the past decades may not continue in the future.
* Barr is emeritus professor of statistics at the University of Cape Town (UCT); Kantor chairs the Investec Wealth & Investment Research Institute and is emeritus professor of economics at UCT
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