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Should Value Investors Pay Attention to the Macro Picture?

May 29, 2012 | About:
GuruFocus

gurufocus

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Should value investors make their investment decisions based on the macro picture, such as if Greece will exit the eurozone? Or if all Spanish banks will be nationalized? Or Germany will agree to the idea of a euro bond?

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.


Rating: 4.0/5 (16 votes)

Comments

mcwillia
Mcwillia - 2 years ago
The deeper one dives into fundamental company analysis, the more macro one ends up seeing and studying. Like yin and yang, one leads inexorably to the other. To truly know a company is to know how macro issues bear upon it, even when dealing with secular or defensive companies.

Buffett has always paid close attention to macro issues, despite his famous quotes to the contrary. Just like he usually pays attention to growth, as a component of value. In his early career, he could essentially take the whole macro analysis for granted. The U.S. had the best financial system, political system and market position on the planet, no need to go into meticulous analysis. He could assume it away. Only in the late Seventies did he begin to really revisit macro themes, as inflation began to really eat away at real earnings. His analysis of See's candy business shows a fine appreciation and concern for the macro forces bearing down on his businesses and the effects of inflation. And yet, this macro is all in the context of analyzing a single business.

So macro is always crucial. It permits one to know how inflation, availability of credit, consumer spending habits, inventories, raw materials prices, regulatory trends, etc. affect a particular company and bear upon the price at which its shares may be had.

Value is so tied up in macro issues it cannot be separated. IMHO of course. (long BRK) (And Carthage must be destroyed...)
Cornelius Chan
Cornelius Chan - 2 years ago
Well put Mcwillia. Your brief comment displays a tremendous depth of knowledge re. investing.

By the way, what is Carthage and why must it be destroyed?

A friend of mine invested a huge chunk of his cash into stocks on March 16, 2009 and he sold all of them off sometime between September and November of 2010. Another friend of mine told me point blank he was wrong to sell so soon. Well, if you make 2X your money in a year and a half, what exactly is wrong with that? The whole secret to my friend's investing is his deep focus on value, value, value. Stocks were significantly undervalued in the Spring of '09. Then, in the Fall of '10 they were somewhat overvalued. So, being a cautious and conservative investor, he sold "too early." If he would have held, he would have made almost 3X by the Spring of 2011.

The way I see it, macro events are always around us influencing stocks up and down. It is not the macro events themselves that are important. What counts is the ability to spot significant undervalue (natural margin of safety) in the macro market. That is when the endless evenings and weekends analyzing the best stocks bears much fruit.

The 3rd position of Howard Marks is right on the money. Being focused on the valuation of stocks in aggregate in the present is the only way to know what the heck is going on. I really don't have time to read about what is happening to Greek bonds or Spanish debt, nor is that a special interest of mine. I only care about how cheap or expensive the stocks in my blue chip watchlist are.

AlbertaSunwapta
AlbertaSunwapta - 2 years ago
I agree on Buffett. Everyone should read his article: How Inflation Swindles the Equity Investor. It shows his incredible macro perspective from the mid 1970s.

Anyway, every day the market moves up or down in unison and even companies that would experience no impact from that day's "news" get impacted. Essentially buying and selling of units of pools (ETFs, indexes and some funds, etc.) impact innocent bystanders. Moreover, people and particularly the media try to ascribe to the whole market's movement one single cause. They try to reverse engineer in the worst way, a cause from an effect. It's somewhat ludicrous, but this creates opportunity.
mcwillia
Mcwillia - 2 years ago
Carthage quote...

Roman Senator Cato the Elder said it after every speech, whatever the subject... my ancient equivalent of 'yada yada yada'...
Davidash76
Davidash76 - 2 years ago
Question:

If the market is modestly over valued as it is today, does this mean don't buy or can value stocks continue to be found? What I am asking is if Buffet works his formula GNP to total market capitalization, and finds the market to be over valued maybe even slightly, does he or a successful value investor hesitate to purchase a stock even if it appears to be undervalued?

Can undervalued stocks exist in an over valued market? If so, why do we care the market is over valued as a whole? What does that have to do with individual companies where research including industry study and comparison with competition reveal deep value? Not being condescending just trying to get my head around the concept of determining market valuation as a whole and using that information when valuing a company and stock. Is it simply using the total market information to select correct ratios in analysis of individual companies (e.g Schiller P/E)

Thanks for any insight that can be provided. Great article and comments from other readers.

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