Should Value Investors Pay Attention to the Macro Picture?
These are hard questions. Any of these events will impact the market dramatically, at least in the short term. It would be great if one could predict these events and their outcomes, and invest accordingly.
In his book “The Most Important Thing: Uncommon Sense for the Thoughtful Investor” (Columbia Business School Publishing), Howard Marks lists three ways of dealing with macro events such as the economy and politics. The first is to try to predict these events. But historically no one has been able to predict with any accuracy that is better enough than random occurrences. Those who get some correct would get others completely wrong.
The second is to realize that macro pictures are totally unpredictable, and give up completely. These investors would be more passive with their investing. They are more likely to be always fully invested, and buy on a dollar cost average basis.
The third way is not to predict, but make investment decisions based on where we are instead of where we might be. Howard Marks thinks that the third way is the best way.
This makes a lot of sense. It is too hard to predict what the world might be like. And it is much easier to know where we are today. We can make decisions based on where we are today.
How does this apply to individual stock picking? Say you dig into a company, find that you love the business, the company is doing well and the valuation is reasonable. Why would the macro picture matter in this case?
Well, most likely it doesn’t. But after you have done all the research, taking a look at where we are with the market will help you to think deeper on questions like why the company can grow as the macro economy struggles. Is the growth sustainable? Where are we with its business cycle? Are you picking a stock that is just relatively cheap but actually still overvalued?
Warren Buffett said many times that he has no idea of where the market will be next month or even next year. But he does pay attention to where the market valuation is compared with historical valuations. In "Mr. Buffett on the Stock Market," published on Dec. 22, 1999, he used the ratio of GNP on total market cap to argue that the market was way overvalued and was positioned for poor returns.
By the way, based on Warren Buffett’s way of valuing the market, GuruFocus created its market valuation page, which is updated daily. As of today, the market is about modestly overvalued and is positioned to return 4.6% annually in the coming years.
Warren Buffett also pointed out, “Perhaps you are an optimist who believes that though investors as a whole may slog along, you yourself will be a winner.” A similar argument would be: Although the market is overvalued, you can always pick the undervalued stocks. Maybe you can. But knowing where we are with the market will help you get a clearer picture for your research into individual companies.
One can certainly argue that if investors had foreseen the macro picture of the housing market crash, they would have avoided deep losses in 2008. That might be true. But if investors noticed that the stock market was quite overvalued in 2007 as measured by GDP over market cap and managed their portfolio risk accordingly, they would also have avoided losses. Therefore, paying attention to where we are with market valuations will be enough.
Value investors should avoid the difficult task of predicting the economy and macro events. They should look through the headlines that flood the media daily and keep an eye on the overall market valuation and its expected returns while spending most of their time researching individual companies.