It is tempting to rely on the macroeconomic outlook when deciding where to invest. For example, some investors may use recent economic data to decide how much risk to take with their portfolio. Meanwhile, other investors may determine which stocks and sectors to buy based on how economic forecasts suggest they could perform.
However, it may be more valuable to consider the micro level instead of the macro level. This means focusing on the strengths and weaknesses of companies in what is also known as a "bottom-up" approach rather than using a "top-down" strategy that takes macroeconomic data and forecasts into consideration.
Known unknowns
The unpredictability of the economy’s performance is a key reason why investors should ignore the macro level. Previous recessions and depressions have not been widely predicted during periods of growth. Likewise, many economists and commentators fail to accurately forecast a recovery during challenging economic periods. As a result, relying on economic forecasts when managing a portfolio can prove to be little more than guesswork.
By contrast, the micro level can be extremely useful in deciding where to invest. For example, facts and figures such as company debt levels, past profitability and return on invested capital can provide guidance on a company’s financial strength, economic moat and overall strategy.
They can suggest to investors which companies may be in a strong position to overcome, and even benefit from, a recession. Similarly, they can highlight which companies may be best placed to capitalize on favorable economic conditions.
Munger’s view
Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Vice Chairman Charlie Munger (Trades, Portfolio) has previously discussed his preference of focusing on the micro level, rather than the macro level. He once said:
“I find by staying abreast of our Berkshire subsidiaries and by regularly reading business newspapers and magazines, I am exposed to an enormous amount of material at the micro level. I find that what I see going on there pretty much informs me of what’s happening at the macro level.”
Of course, mistakes can be made when assessing the micro level. Even highly profitable companies with sound finances can struggle in a variety of economic conditions. Therefore, it is imperative to always own a diverse range of stocks from a variety of sectors to reduce the negative impact of one stock on a portfolio.
Moreover, it is imperative to always obtain a margin of safety when purchasing a stock. Past financial performance is never perfectly mirrored in the future. New threats and challenges can derail even the most attractive businesses – even if macroeconomic conditions prove to be relatively benign.
An efficient strategy
Of course, focusing on the micro level also provides investors with a greater amount of time to build specialized knowledge of particular sectors. This can be used to better understand the risks and opportunities that may be ahead on a micro level. It may also enable investors to more easily identify the strongest companies within specific industries so they can have a better chance of generating superior returns relative to the wider sector.
Over time, they may build a significantly larger amount of detailed knowledge simply from having more time available that would usually have been spent considering the economic outlook. This may allow them to allocate capital more efficiently over the long run.
