We are often asked what is more important, the bottom up or the top down, the micro or the macro. Without question, we are bottom-up investors. We feel that the best approach to protecting and growing capital is to find companies with an identifiable business franchise available at valuations which afford a margin for error. This is the best way to take advantage of an often-but-not-always efficient market.
To complement this, macro economics plays a significant part in our investment process. The primary purpose of macro is to make sure that we have identified as many risks as possible. Key to the margin of error in investing is arriving at a reasonable approximation of the value of a franchise. Miss out one or two key risks and your attractive franchise isn’t so attractive anymore. For all the analysis of a company and its industry, there are always risks that come from the greater economy. For every new competitor that might come along, there is also a recession that can kill demand for one’s products or a scarcity of credit to interfere with the financing of projects.
We spend a lot of time considering the context of the global economy and where the risks lie. What is the state of government financing? What is the strength of the financial system? What effect will demographics have on the economy? What is the political mood regarding business and the market-based economy? What effects are likely from technological changes? What are the risks of natural or man-made disasters? We place no faith in our ability to predict exact events or exact timings. We do believe that thinking about the bigger picture is an intellectual exercise that can aid us to detect more risks. This should help us to identify investments which have larger margins of error, which should in turn lower volatility and raise returns for our investments (we have been pleased that our volatility has traditionally been approximately 60% of the index).
Lastly, macro-economic analysis should give us an understanding of how risk is being priced, cheaply or dearly, as well as giving us a context as to how much risk we feel we should be taking on. We always look for undervalued assets but will build in even-higher margins for error when risks are abundant and underpriced. There are times to be greedy and times to be fearful.
History plays an important role in this exercise, as humankind is still driven by the same emotions, desires and fears that have affected us for the last few thousand years. The length of time for macro-economic eventualities to play out can be extraordinarily long; blind spots develop as risks get “forgotten” for being irrelevant (i.e. falling for the failure of logic: “it hasn’t happened yet therefore it won’t happen”). Thus, a useful context for viewing risks to the financial system in mid 2000s was not the last 20 years (the basis for many financial and trading models) but perhaps the 1920’s, a time of prosperity with reasonably low interest rates and rising asset prices masking an increase in systemic risk. Or the late 19 th century, the last golden age of globalisation. We are always fascinated to notice that history may not quite repeat itself but it does rhyme. History provides the longer term perspective to decrease the likelihood of falling for the current blind spot.
How do these macro-economic issues affect our investment process? As one example, take our view on the oh-so-topical debate on Keynesianism. We are concerned on three levels: firstly, that we need this much stimulus in the first place; secondly, that this strategy is very much untested and unprecedented; and lastly, because we have a bias against government efficiency, or lack thereof. Improvements in the standard of living come from innovation and efficiencies, doing more with less. Neither of these are traditional strengths of governments. This leads us to be wary of being too fully invested as we think the global economy is unlikely to recover quickly.
A second example could be the banking industry at present. We are wary when “extend and pretend” appears to be their key bad-loan strategy, and when total bank loans appear to be shrinking in many parts of the world (banks profit and grow from loans – if they’re cutting back on loans, for whatever reason, it is an inauspicious sign). This gives us comfort that having no investments in banks within the portfolio remains prudent (for now).
Developing an understanding of the major currents which drive our economy gives us perspective to make well-informed investment decisions, and a context for assessing risks. We are bottom-up investors first and foremost. We will retain an avid interest in macro economics, because it helps with the bottom-up, and because we enjoy it.