Investors and businesses can learn much from a first principle - check out the return on capital. Image Credit: Shutterstock

In 2001, as the internet boom turned into a bust, the MIT ‘Journal of Economics’ published an intriguing paper that concluded trading activity was systematically based on overconfidence in self-ability, and devoid of fundamental research.

The subsequent tech boom demonstrated a hunger for growth, and growth purchased largely through debt. When you borrow a lot to create prosperity, you import the future into the present. Leverage buys you a glimpse of prosperity that hasn’t really been earned through underlying earnings growth, and the return on capital is lower than the cost.

Rising interest rates further deteriorate the fundamentals, which means inflated valuations fall to earth as companies that have long lost money in their quest for growth struggle to raise further amounts.

Growth is often achieved at the expense of return on capital, and so does not create any value for shareholders. This problem was largely ignored by investors hungry for growth, particularly in certain sectors where superior growth rates are such a significant part of the rationale for investment.

When market mania takes over, shares rise, despite the fact underlying companies make an inadequate return on capital (defined as one below its cost of capital) and therefore are destroying value. Despite the exuberance, the rules of mathematics eventually take over, and thus money-losing companies see their valuations suffer the most (the likes of SnapChat, DropBox, Uber, BeyondMeat, Spotify, etc).

Shrink to grow?

Far from growing and employing more capital, shareholders should want such businesses to shrink operations and return any cash liberated as a result. The tech sector is replete with such examples, where investors continue to tolerate suboptimal returns over domestic companies that have generated superior rates of return on capital and yet been ignored (until recently) by the investor base.

This ignorance is actually good news for patient investors who can capitalize on such value discrepancies (how money losing companies like Spotify can be valued higher than consistently profitable companies like Emaar and Empower attests to the value being left on the table).

The same applies to the real estate sector as well. Generally, offplan properties (specifically in mid-income space) are offered at a discount to ready properties, given the opportunity cost of rent over the cycle of investment. In recent years, that situation flipped, with offplan prices shooting up by as much as 70 per cent over ready median prices.

Despite the qualitative improvement in new-builds, investors are burdened with rising cost of mortgages as well as giving up higher opportunity costs of rising rents that transpired throughout the year. This has been a worldwide phenomenon, and we know that housing markets are the slowest to react. But react they do, as exuberance gives way to rationality.

Offplan prices will revert to being offered lower than the ready market, and opportunities abound for investors to capitalize on (the recent launch of a buy-to let fund offers a glimpse of what further activity to come in this space).

Follow the consumer spend

The common theme is one of shareholder value creation in a time of rising cost of debt, and it is here the value of the UAE capital and real estate markets come into play. The former has now been getting more attention. Why investors should care is about not only growth in the population, but also the rise in consumer spending in companies that generate high returns on capital that are sustainable.

From consumer staples to utilities to healthcare, these companies have generated high returns due to their combination of brands, pricing power, distribution and control of their supply chain, and regulation that helps fend off competition. The real estate market has already gained critical mass and attracted global flows, and there is more knowledge available such that institutional money flows are starting to gain traction.

But, regardless of market size, investors should focus on the facts rather than the biases of the commentators, or the latest fads that dominate the discourse (NFTs, peak oil, anyone?). Over longer periods, the facts assert themselves and the cash return on investment parameter rises to the top of the pile. Yet most investors seem to regard this idea of redeeming capital to provide income as the road to perdition.