The Capital Cycle Podcast - The Tyranny of the Index

Episode Date: February 27, 2026

History tells us that long-term equity returns depend on the starting valuation level. Edward Chancellor talks to Alex Duffy, an Emerging Markets Portfolio Manager.For more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Hello and welcome to another episode of the Cap Cycle podcast. This is Edward Chancellor, and I have with me Alex Duffy, who's an emerging markets portfolio manager at Marathon Asset Management. Hi, Edward. Thanks very much for having me along again. So Alex, we're going to talk about a piece you've written called The Lessons from History and the Tyranny of the Index. You've been reading a publication that I'm very keen on called The Gets. Global Investment Returns Yearbook, which is nearly 300-page volume put out each year by the

economists at London Business School, Dimps and Marsh and Staunton, used to go out with Credit Suisse and is now published by UBS. And this yearbook, I think, is really one of the most important publications or source materials, people who are interested in big-picture investment, because it gives the returns on equities, bonds and currencies with inflation detail over the last 126 years, going back to 1900, covering 20 or 30 different markets. So you can see what the returns of South Africa have been since 1900s, which is actually pretty good. And as far as I remember, I think Sweden is the top performer over that period. Anyhow, last year's, we're not talking actually about the new one because the new one hasn't come out yet,

but last year's global investment returns yearbook has given you some ideas about how you invest in emerging markets. Yeah, so I think one of the great challenges that active managers often face, equity managers face, is that you're presented with constant information overload, there's lots of news, and you're very close to what's going on in markets at all times. And actually pieces such as the global investment returns yearbook enable you to take a step back, look at the bigger picture and actually then contextualize the current environment that you're investing within versus history.

I think one of the parts that always interests me about investing is what truly are long-term returns, how should one think about real, hurdle rates and real return expectations from equities, and then to take those findings into individual companies, markets and the portfolio and put together and seek to build a portfolio that can drive in both an absolute sense towards beating the long-term return thresholds, that we also think can deliver returns that are differentiated and better than the index over the long run. My point really in the article was that there are periods in time when markets

deliver exceptional returns which are very difficult to keep pace with in the short term. But over the long run, it's that long run hurdle rate, the importance of the compound and the dividends and actually the absolute real returns that companies generate, which will determine the outcome for the portfolio. And having some perspective is often quite helpful in thinking about how you approach that problem. Yes, I mean, so one of the things I take away from the yearbook on looking at it is first the convergence of returns from these miscellaneous markets around a norm, right, 6 to 8% real returns. So I mentioned earlier Sweden and South Africa, South Africa, you know, what we call an emerging market actually has put in historically a very

high, decent return. And even though emerging your area, if you look at that yearbook, it had a bad first half of the century when Russia and Chinese markets disappeared. But over time, even emerging, pulls back towards the constant expected return. Now, you point out in this piece, let's talk about, you know, you make some comment on what the real return on US equities have been and then how recent performances diverge from the historic terms. Yeah, so I think that's the critical part is that long-term returns are just that. they are accrued over very long time periods.

And so the data shows that from 1900 to the end of 2024, the real return on US equities has been about 8.5% per annum. So equity owners have been handsomely rewarded for taking equity risk over that very long time, near term period. But you say that that has been achieved with a high degree of cyclicality? Absolutely that. If you stood at the end of 1999, an investor would say, well, the last 20 years is quite a long time period. We've generated 10% returns over those two decades.

That sows the seeds for what we should expect for the next decade, when in fact the 10 years that followed delivered negative real returns. I can tell you, in the book I just gave you the Jeremy Grantham memoir, the making of a perma bear. Jeremy Grantham talks about the debates he was having with another Jeremy, Jeremy Siegel, of the Wharton Business School, author of a book called, I think it's Stocks for the Long Run, which was the bestseller in the late 1990s. And Grantham was saying, yes, we have a historic 6 to 7% return from US equities, which is what Siegel was doing. But the valuation is important. By the late 1990s, we were going into this period, a 10-year period of 30-year period of.

flat US equity returns, very good emerging returns at the same time. But it was Jeremy Siegel's of this world thought that six or seven percent return was going to continue from US equities, regardless of price. And I think that, you know, that again, is a critical point. And it's actually a critical part for Marathon's investment philosophy of capital cycle invest in. It's that equity markets are discounting mechanisms. So they capitalize expectations of future levels of profit, of future growth rates, and they discount that back to a present value today. And so at the end of 1999, you'd had 20 years of very attractive returns,

and it led to valuation multiples to expand. And in so doing, expected future returns have to be lower as a consequence. of that capitalisation of future profitability into a higher starting valuation multiple. Yeah, unless you're living in a new era with much higher than historic profits growth going forward. And the main argument against that is that every time they've called a new era in the past, it turned out to be a mirage. Alex, let's get back to what you wrote. And you're talking about how the US returns in recent past have been exceptionally good. In fact, so good that they've pushed up the historic returns of the US equity market as a whole.

It comes back to this point around the cyclicality of equity markets. So the last 10 to 15 years have been exceptional. I would argue anomalous for US equity markets. I think over the last decade, US equity markets have delivered 15% on an annualised basis. So double the long-term return threshold. And so 11 of the last 15 years have been well above long-term averages. And we would argue that when you take that higher valuation starting point with the levels of capital investment that is ongoing or started to ramp up in many industries in the US, not least the technology sector, which I'm sure we're going to come on to, it actually creates a deterioration in the capital cycle, which will potentially lead to disappointing returns in the

future in a complete contrast to what's implied in the valuations. Right. And I was talking to your colleague, my friend Charles Carter, in a recent podcast, we were going over the market of the late 1990s. And clearly what you saw in the late 1990s was record high valuation and searching CAP-X in the US and today we also see extremely high valuation depending on what measure you use it's either around where we got to in 2000 or just below but at least the second most expensive market in history with CAP-X in the US that looks be even greater than in 2000 and we've also got sectoral concentration here which you say is now much higher than historically it's been higher previously, I think of more concern is the concentration of equity returns into

fewer stocks. If you were to look at the sort of behavioral traits of U.S. equity markets, it's that crowding and concentration of returns and the participation of retail money, where since 2020, 10 stocks have accounted for well over half of S&P 500 returns. And so you know, concentration of technology is elevated versus history. It's had a 92-year high. But concentration of equity returns is even higher than it would have been historically. And that is definitely a cause of a concern we would feel. And periods when the market becomes concentrated in a handful of stocks by that handful of stocks outperforming also tend to coincide, I say parenthetically, with the performance of value strategies.

But let's go on. And one of the points you make here is that investors tend to extrapolate current conditions into the future, whereas history shows that many companies have, in fact, pretty brief lives. We looked at lots of different metrics around historic valuation levels, implied growth rates, future levels of profitability versus current levels of profitability. And what our data suggests is that equity markets are increasingly oblivious, to the potential for mean reversion of either profit margins or indeed any slowdown in growth rates, particularly capital investment in certain sectors.

And I think the best way in which you can see this most vividly is through the compression of US earnings yields. So earnings yields in the US have declined over the last 15 years or so from kind of a 7% range to under 5% currently. And in order to justify that level of valuation, you need to truly believe that future growth rates and future levels of profitability return on invested capital remain structurally higher for longer. And it's really that which is being extrapolated into market behavior. And it's really a consequence of the recency bias. You know, like the sort of Pavlovian dog, when you get used to every year a 15% return and that goes on for a decade, well, your expectation is that the next year is likely to be 15% as well. But unfortunately, markets discount that and it's in the price, whereas there are other parts, and this is sort of bring

it more to global emerging markets and the opportunity for X US equities, which we at Marathon are quite infused about in terms of the opportunity set. We've seen a material relative de-rating versus US equities over the last 10 to 15 years, a de-rating of the order of 40 to 45% or so. And at the same time, lots of stock opportunities, single stock opportunities in those markets at very attractive absolute valuation. So absolute value is on offer outside of the US and relative value is also an offer at the same time.

And I think that's quite important when one thinks about how to build diversified all-weather portfolios and the tools that we should employ in so doing? Again, the situation today is not massively different from how it was in 2000, with the US market at that time on, as we said, record valuations, but also record valuations on high reported profitability. As it turns out, the US companies were lying about their profitability, but at the time the investors were putting high multiples on inflated, profits, what Jeremy Grantham calls barbaric double counting, whereas emerging was trading at a

massive discount, which is why any prudent investor in 2000 knew that the good call was to take your money out of US and put it into emerging. Now, you raise an interesting point in this piece. As I said earlier, you've entitled your piece, the tyranny of the index. And you are looking at a different way of thinking about how to capture returns. And you even cite a mental ploy used by Charlie Munger, which is to invert in your approach to expected returns and performance. So tell us a bit about that. That really comes back to this point around long-term returns. So if we think that over the long run, 8% is the real returns that equities can deliver. Maybe it's a little bit lower in some markets going forward because valuations are higher. Maybe it's higher in other markets

because valuations are lower. But long-term global equity markets don't deviate from what they've delivered historically. So in seeking to achieve the client's required outcome, which is to beat the index return, actually what you're really being asked to achieve is to beat the 6 to 8% plus any fees. And so, you know, we at Marathon in the emerging markets team call that the 9% question or the 9% problem. So invert the challenge, invert the problem and say, well, rather than trying to beat the index, which goes up and down and re-rates and de-rates and is prone to, you know, manias and hysterias, how can we drive towards a 9% type return profile? And what are the components that go into achieving that? And then,

rather than worrying and fixating on the short-term durations of equity markets, you think about driving towards that absolute return threshold. Now, I want to talk to a bit. You mentioned some of your themes in your emerging portfolios. Now, if the US is very tech-heavy at the moment, you're attracted to more acid-heavy plays in emerging markets. And from a sort of geographic basis, you're also attracted more to Latin America. This again comes back to that point around how do we answer the client's 9% problem or mid mid high single digit problem in terms of the outcome.

What we have found is because of underinvestment or due to the underinvestment that we've seen in Latin America over the last five to 10 years that we've seen in parts of emerging Europe, Middle East Africa. And at the margin in Southeast Asia, we would argue as well, you just have very depressed. asset prices. So high starting dividend yields, companies which have recognized that they're less able to reinvest cash flows at rates of return above that which are implied in their share prices. And so they're not reinvesting the capital. They've tightened capital disciplined. It's leading to supply tightening in a whole range of industries from cement plants to telecommunication stocks to mining companies. And actually we're being presented with a multitude of opportunities where businesses, assets trade at discounts to replacement value. And therefore,

profitability needs to increase significantly in order to encourage reinvestment and therefore damage the supply side. And we're also receiving high dividend yields whilst we wait for that improvement to occur. And that's quite an attractive setup from our perspective. So briefly, from an example, we've talked actually in earlier podcasts about mining. We talked about Southern Copper, which since you spoke about it has done very well. Your colleague Laura Five talked about Latin American telecoms in a recent podcast. You mentioned here on cement. You mentioned Semex.

Just a brief word on that. Yeah, so Semex is one of those interesting companies. We've followed it for a very long time. It's been through a deeply painful period of balance sheet repair over the last decade. there's been management change and particularly a change of emphasis around how they think about value creation. And then around them, the industry has been deeply underinvested. So the replacement cost of a cement plant would be 40 to 50% above where the assets are trading at in the marketplace. And so companies have stopped investing. And then you've had the

ESG cycle, which has actually meant that if anyone were mad enough to, try and build a new cement plant inside the US, they're actually not allowed to. And Semex has got a balance of operations across Latin America, but also plants inside the US. And so you have a very constrained supply side with an industry which has gone from excess capacity or surplus capacity to a deficit of capacity. So, Alex, finally, your point is that the businesses which haven't made it into your portfolio are not inherently bad businesses. Yeah, our point here is that our emerging market portfolio looks very different to the index.

So we often get asked, why do we not own such and such large company, which attracts a lot of media attention and investing attention? So Alibaba, Chinese internet companies as a case in point, some of the big technology companies in Asia, you know, 60% of our portfolio is invested in asset heavy industries, financials, materials, industrials, and so on. what we used to call old economy in the 1990s. Smokestack. Yeah. The smokestack industries. A third of our portfolio is invested in Latin American equities. And it's really because we've approached this problem from an absolute mindset.

It's not that we think the businesses we don't own are fundamentally flawed, bad businesses. In many cases, they're not. They're good businesses. It's just that they're priced at levels that already reflect that, if not something even better in the future. Whereas the stocks that we own offer, we feel, a much better balance between returns that come through dividends plus a discount to intrinsic value, particularly for the asset heavy, it's discount to replacement cost. And they're also operating in industry structures which are far more supply constrained and consolidated. And so the equity risk premium for our companies is much more favourable we feel than the equity risk premium for the companies that we do not own. And that is an absolute outcome that we think can achieve a positive relative outcome, but we've approached it from the absolute perspective.

Okay. I think we'll wrap it up at that point, Alex. And very nice speaking to you and speak to you again soon. Thanks, Edward. Thank you. Thank you for your time today. I hope you will listen to the next edition of the capital. cycle. This communication is provided for information purposes only. Please refer to Marathon's website and the Global Investment Reviews for further information, including important disclosures.