How Can the Macro View Help Bottom-Up Value Investors?
We have asked the question, Should Value Investors Pay Attention to the Macro Picture? We agree with what the wise Howard Marks said in his book, “The Most Important Thing: Uncommon Sense for the Thoughtful Investor” (Columbia Business School Publishing), where he suggests that investors should make decisions based on where we are, instead of where we might be.
Again, we totally agree with Mr. Marks. But during an interview with Steven Romick of FPA Crescent Fund, we got a better understanding on how the macro view can help bottom-up value investors. By the way, the transcript for the interview will be published soon.
Romick has built an impressive record with his FPA Crescent Fund. Over the past 15 years until December 2011, his fund has had a cumulative return of 273%, compared with 149% for the S&P 500. He did this with much lower volatility, too. The worst year he had was 2007: His fund was down 20%, while the S&P 500 was down 37%.
Romick did much better than the market in 2007 because he avoided all financials well before the burst of the financial bubble. His macro view helped him realize that the huge profit from big banks like Bank of America (BAC), Citigroup (C) and Washington Mutual would not be sustainable. Therefore, although financials were traded at seemingly low valuations in terms of P/E, price to free cash flow or price to book and had more than 4% dividend yield in 2007, their earnings power would diminish if things turned bad.
While Romick was avoiding financials from 2004 to 2007, many value investors, including many of our Gurus, were attracted by their low valuations and high dividend yields. Things did turn very bad and we all know what happened afterwards.
This is actually similar to what Peter Lynch said in one of his books. When you look at a company’s earnings, you should always ask yourself how the company makes money and whether it can continue to make money in the same way. The macro view involved here is not a prediction, rather an understanding of how business works in a large scale.
The lesson learned: Don’t just look at the valuation. The understanding of how business works is way more important.