We’ve all heard the investment saying, “focus on the long-term,” and in uncertain times like these with COVID-19, the upcoming election, trade conflicts etc., you tend to hear it a lot. But have you ever stopped to truly dissect why this has been a winning formula for investors for so long? In our opinion, it comes down to the long-term economic growth trend built on the two pillars of innovation and incentives. These two building-blocks provide a long-term, upward economic lift that financial market participants benefit from over time. Markets may periodically get ahead or behind themselves based on short-term factors, but over the long term, these are two very important drivers of economic growth, and therefore investment returns, so are worth taking a closer look.
Virtuous Growth Cycle Pillar #1: Innovation
The first pillar of the virtuous growth cycle is innovation. We currently live in a golden era for technology, or so it seems. But innovation, in one shape or form has been around for a long time. The invention of the wheel, which now seems amusingly simple, was an enormous technological leap at the time. The same could be said for roads, ships, navigation, the steam engine, the cotton gin, the automobile, flight, the printing press, penicillin, air conditioning, the semi-conductor, global positioning satellites (GPS), cellular communications, software, the Internet and now cloud based computing to name (a bit more than) a few! Each of these breakthroughs acted like a gust of wind on the economic flywheel that led to a new cycle of economic growth and a higher plateau than before.
The flywheel starts spinning because innovation leads to an increase in productivity which in turn reduces unit costs, lower unit costs increase demand, increased demand creates jobs, more employment increase incomes. Increased incomes lead to population growth due to household formation. Household formation leads to buying “stuff” and when you acquire some “stuff” you want more “stuff” (acknowledgement to the great comedian, George Carlin, on the concept of “stuff”). The desire for more “stuff” brings us back to the beginning of the growth cycle as we seek new ways in our industries, jobs and careers to earn additional compensation through solving problems and delivering new solutions. This virtuous cycle of activity, driven by innovation, is a major reason why economies grow over time. Financial markets then ride that upward economic wave, albeit with some fits and starts and winners and losers along the way.
Virtuous Growth Cycle Pillar #2: Incentives
The second pillar of the virtuous growth cycle is incentives. Capitalism, in its simplest form, is a system that is designed to reward people proportionately for their contributions to innovation and the value it creates. Rewards can take many forms, but for many, reward for innovating is associated with wealth. That certainly seems to be the case when you look at the great fortunes amassed by innovators such as Henry Ford, Bill Gates, Jeff Bezos and now Elon Musk. Companies and individuals that innovate are rewarded with financial gains and society benefits from the innovation. It’s a very symbiotic, but delicate, relationship. However, innovation requires taking risk and therefore needs an incentive system designed to make taking risks worth it. There is a fine balance in maintaining both sides of the incentive debate, how much is enough, but we tend to know it when a line has been crossed and incentives are out of line in either direction.
In closing, the beauty of having a vibrant economy built on innovation and proper incentives is that, as investors, we can prosper from identifying innovative individuals, companies and economies. We don’t have to be the ones doing the innovating in order to benefit, but we do have to be able to spot innovation, evaluate it, value it and ultimately allocate our capital to it. It should be noted that innovation does not just refer to companies and opportunities in the information technology sector. Every investable industry has leaders who command attention as a result of the innovation and solutions they deliver to their customers.
So, the next time we say, or you read, something that encourages you to focus on the long-term, think about the economic snowball built on innovation and incentives. Recognizing that, as a result of these two pillars, the economy is not finite, can help you remain focused on the long-term and steer your portfolio towards greater odds of long-term success.