Prudent investors rely on performance benchmarking. However market capitalisation weighted indices tend to lose diversification and misallocate capital when speculators herd in the same direction. The GWA solution for portfolio managers to deal with the instability of markets is to diversify away from prices to the underlying wealth to which securities attach rights of ownership.
The distinction between Prices and Wealth
The distinction between security prices and wealth is often glossed over. Security prices sometimes approximate intrinsic value but often overshoot or undershoot intrinsic value. We believe wealth is best measured by intrinsic value and our strategy indices target proxies of intrinsic value.
Companies derives income from the sale of goods and services which is measured as Net Profit and Cash Flow. Book Value is the financial measure of the wealth that is generating this income. These measures of wealth are the basic elements of the discounted cash flow methodology used in the valuation of securities of any company.
Prices follow Wealth
The relationship between security prices and wealth is unstable in the short-term. However, in the long-term, it is stable. A simple economic truth prevails – securities prices follow wealth creation. In other words, the rate of growth of the share price of a company must mirror the rate of growth of that company’s intrinsic value. This law holds true for the market just as it does for a single company and for this reason we focus on measuring the wealth in the market rather than the capitalisation of the market.
A sophisticated definition of a broad market economy is readily available from index providers like FTSE, MSCI, Wilshire, S&P, Russell and Dow Jones. Using company Book Values, Net Profit and Cash Earnings as proxies for wealth. GWA builds strategy indices by calculating each constituent’s proportion of the total Intrinsic Value in a broadly-representative index.
In a free exchange economy, market cap weights are volatile in the short run but always move towards the wealth weights in the long run. Competition makes it so. Security prices overshoot and undershoot market wealth weights as they adjust to competitive forces that drive them towards this long term central limit. Rebalancing a Wealth Weighted Index every quarter provides a buy low, sell high bias to our process. GWA strategy indices tend to pick up a “value-premium” and a rebalancing bonus over market cap indices over long horizons.
GWA keeps fees low by using the infrastructure and expertise of world class implementers State Street, Northern Trust, Mitsubishi, Sumitomo, Mizuho and Legal & General who implement our Wealth Weighted Index series.