High jinks - Whether you are analysing companies or countries, cash remains king


Ian Kelly

Ian Kelly

Fund Manager, Equity Value

The instructions from Eurostat, the European Union’s statistical office, that illegal activity such as drug-trafficking and prostitution should henceforth be included in member states’ GDP calculations stirred up some excitement in the financial pages, offering as it did the chance to touch on subjects more normally found in other parts of the press.

Estimated at an annual €170bn (£138bn), the sheer scale of Italy’s ‘black’ economy meant it attracted many of the headlines – and in passing suggested the UK’s criminals, who can apparently only muster £10bn or so towards the country’s GDP, must try harder . However, because everyone will presumably start restating prior years to include illegal activity, the move ultimately does not change very much.

Tinkering with GDP calculations is nothing new – last year, the US moved to include research and development spending in its own numbers – and arguably has its benefits. After all, when you are weighing up the economic performance of different countries and regions, it is helpful to be able to compare like with like.

If, for example, you were looking to analyse consumer spending growth in relation to GDP or tourism in Europe, you could obtain a more accurate picture if you did not have to factor in what is legal in the Netherlands but not in France. Just because the thrills on offer in Euro Disney are of a different kind to those available in Amsterdam, it does not necessarily follow they should have different GDP metrics.

So there can be perfectly sensible reasons to include all sorts of economic activity in GDP calculations. Our concern, however, is that market-watchers these days are increasingly fixated with the ratio of government debt to GDP and what this latest development effectively means is that GDP numbers are being massaged up in a non-cash manner.

Think of it this way – while the GDP metrics of lots of countries now look set to rise, their tax revenue to GDP ratio is going to fall by an equal and offsetting amount. That is because, unless those countries introduce some fairly interesting new legislation to allow, say, money-launderers to convert drug-trafficking profits into taxable revenues, then really this is all little more than an accounting gain.

In other words, this is what the equity investment world would regard as a quality of earnings issue.
Say two businesses had identical capital structures but one generated $1m of revenue and profits making and selling widgets and the other generated $1m of revenue and profits crystallising an asset that had no intrinsic value – for example, through the sale and leaseback of the company’s HQ.

In this example, you would clearly value the business with the recurring revenue more highly than the one that made the accounting gain, and there is no reason to view countries any differently. Whether you are a company or a government, it is cash that drives the sustainability of your debt so investors would do well to focus on that rather than being distracted by any accounting sleight of hand.


Ian Kelly

Ian Kelly

Fund Manager, Equity Value

I joined Schroders European equity research team in 2007 as an analyst specialising in automobiles. After two years I added the insurance sector to my coverage. In early 2010 I moved into a fund management role, and then took over management of two offshore funds investing in European and Global companies seeking to offer income and capital growth. 

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