A few days ago at work I was in an investment meeting that turned to a discussion of macroeconomic factors (which to me means GDP growth, interest rates, oil prices, etc.). The usual questions were asked: Will the Fed raise rates this month? What does that mean for us? Should we be concerned about what’s going on in China? By the way, what is going on in China? Is the U.S. economy starting to weaken? If it is, what should we do about it? Any word from Europe lately? The list goes on and on.
As is often the case when I’m in a meeting like this, I pretty much sat there in silence. Every once in a while I was asked to share my opinion – which usually went over like a lead balloon.
Invariably, my response was some variation of “I don’t know and I don’t care.”
In last week’s meeting, I felt my responses were poorly communicated (and came across a bit childish). This article is a redo – another attempt to explain my thoughts on this topic.
It matters
These questions have important implications, particularly in the near term. If the Fed raised rates four times in the next year, it would materially change the financials at a company like Charles Schwab (SCHW); if you’re considering an investment in Schwab, this is the single most important driver of near-term EPS growth. The significance of the macro factor may vary, but you can make the same argument for a company with meaningful business in China, a supplier or service provider for energy companies, and so on. To that extent, I’ll be the first to admit these factors have a meaningful impact on short-term stock prices.
A list of problems
Here’s where the problems start. The first one – a pretty big one, if you ask me – is that most of these things are unknowable (or at a minimum, very difficult to predict with any consistency). Just because I know something is important does not mean that I can actually say anything meaningful about it. Recognizing that fact is an important first step in dealing with this issue.
We have numerous real world examples of experts who constantly make predictions about runaway inflation, commodity prices, etc., yet rarely seem to be more accurate than you would be flipping a coin. Staying with Schwab, let’s look at a relevant example (from the WSJ):
“The [business and academic economists] on average estimated the probability of liftoff at the Dec. 15-16 meeting at 87%, up from 71% last month and 48% in October. They are in agreement with financial markets – fed-funds futures on Wednesday suggested an 85% probability of a December rate increase, according to CME Group.”
If you read that article, you’ll notice a graphic showing more than 80% of survey participants predicted a rate hike by September in both July and August of this year. You might have forgotten that Fed watchers were just as sure a rate hike was coming a few months ago as they are today (obviously they were wrong last time).
But that’s not all:
“Fourteen of 19 primary dealers [~74%] or the banks that deal directly with the Fed said they expect the first rate hike by June 2015, with borrowing costs rising to 1% at the end of that year.”
That quote is from a November 2014 Reuters article (link); with the benefit of hindsight, we can see that call hasn’t turned out so well, either. Of course, we don’t have to stop there:
“Traders now see December 2011 as the first Fed meeting at which policymakers are more likely than not to increase their target rate for overnight lending between banks, trading in Fed funds futures at CME Group’s Chicago Board of Trade showed. Earlier on Tuesday, traders were pricing in about a 61% chance of a rate hike at the Fed's November 2011 meeting.”
That’s a Reuters article from September 2010 (link). Back then, the market was pricing in a better than 50% chance of a rate hike by the end of 2011; four years later, we’re still waiting.
The people making these predictions presumably follow the Fed’s actions very closely; it’s safe to say they know a lot more about how the Fed is likely to proceed with rate increases than I do.
Yet over the past five years they’ve consistently predicted that the first rate hike was around the corner – and they’ve been dead wrong time and time again. At this point, it’s probably safe to say that the vast majority of these experts were not anywhere close to predicting the actual pace of rate hikes (or more accurately, the lack thereof).
If we start with the assumption that something is unknowable, we can focus on protecting ourselves against an adverse outcome. One of the safest ways to proceed is by requiring a higher expected return. As it relates to valuation, how large of a margin of safety should be required to account for the impact of this unpredictable – but admittedly important – variable?
Personally, I wouldn’t go too crazy here – especially if I really like the underlying business. In the case of Schwab, it makes sense to focus on normalized earnings power across a range of interest rates, and then pay a conservative price relative to your estimates. I’m less concerned with when the Fed will hike rates than I am with figuring out how Schwab will continue to build earnings power over the next decade. If you’re truly thinking long term, an adverse decision by the Fed (no change in rates) will likely produce an opportunity to buy additional shares of Schwab at a cheaper price. If you’re right on the underlying fundamentals of the business, that will likely turn out well.
With a change in perspective, Mr. Market’s overreaction to near-term events creates opportunity.
Why equities?
Let’s assume I’m wrong: as an example, we truly believe we can predict when oil prices will start moving higher. If that’s the case, there must be a better way to proceed. To the extent these things are knowable, why waste your time buying minority interests in businesses? Wouldn’t it make more sense to trade commodity futures than to buy shares of ConocoPhillips (COP)?
At the 2011 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholder meeting, Warren Buffett (Trades, Portfolio) discussed commodity hedging at BNSF; I think his commentary was insightful (from Ben Claremon’s notes):
“Traditionally, BNSF has hedged a lot of oil due to its diesel usage; Warren suggested that they should not try to guess the direction of the price of oil. If they could do that, they should not run the railroad, which is a lot of hassle – they should just trade oil.”
If you can guess short-term changes in oil prices, why waste your time owning COP? Avoid the hassle and just trade oil directly. The argument for ConocoPhillips here is really just straddling the fence: it’s a way to bet on oil prices without sticking your neck out too far. If we’re being honest with ourselves, this is closer to speculation than investing. There’s nothing illegal or immoral about speculation – but we should be honest with ourselves if we’re doing it.
What makes investing in companies different?
Of course, incorrect predictions can be made when investing in individual companies as well. How is making an investment in a business different than guessing when the Fed will raise rates?
For a select group of companies, I’d argue that a rational individual can make reasonable predictions about what will happen in the coming decade, on average, with a high degree of confidence. When combined with patience, this approach results in a much higher hit rate. Recessions and other exogenous shocks are certain to occur but at uncertain times; with a long-term investment horizon, the owner of a competitively advantaged business is likely to end up better off relative to competitors through these stressful periods.
In my opinion, a long-term horizon is critical: what happens in the next quarter or year can be meaningfully distorted by macroeconomic factors (like plummeting oil prices). As time goes by, the short term swings are less relevant than the underlying fundamentals; a company with a competitive advantage – like being a low-cost oil producer – will generate value for owners in the long run. If they can weather the storms as they come, this is ultimately what matters most.
In a nutshell, time and energy spent worrying about fleeting issues is better spent thinking about a company’s competitive position and how it is likely to evolve over time. There are plenty of investors who have successfully built their careers following this playbook.
Near-term headwinds – caused by the macro environment or otherwise – create opportunities in a world where most people can’t see past next year. Consider what Warren Buffett (Trades, Portfolio) said in his 2000 shareholder letter:
“We purchased several companies whose earnings will almost certainly decline this year from peaks they reached in 1999 or 2000. The declines make no difference to us, given that we expect all of our businesses to now and then have ups and downs. (Only in the sales presentations of investment banks do earnings move forever upward.) We don’t care about the bumps; what matters are the overall results. But the decisions of other people are sometimes affected by the near-term outlook, which can both spur sellers and temper the enthusiasm of purchasers who might otherwise compete with us.”
Conclusion
I can’t outguess others on Fed policy or oil prices; even if I spent years focused on these areas, I sincerely doubt I would be able to. On the other hand, I believe I have the requisite tools to be a value investor. Importantly, I've seen and studied others who have successfully pursued this route.
I’ll end with one more quote from Warren Buffett (Trades, Portfolio):
“We like easy. We don’t know how to have an edge betting on oil. We have no idea how to have an edge investing in commodities in general. But we know people who have an edge investing in stocks.”
With hard work and patience, long-term returns that beat the market average are possible. We should focus our attention accordingly. Time spent elsewhere is unlikely to help us achieve this goal. Until we have a good reason to believe otherwise, that’s the most logical path forward.
As always, I'd love to hear your thoughts.
