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Value Investing and Macro Themes


rick_v
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Most value investors despise the concept of understanding the Macro picture. This is obviously due to the belief that when searching for undervalued securities the intrinsic value should be so apparent that in a stable or normalized economic environment the macro doesn't really matter.

 

I believe that in the current environment understanding the Macro is important. There are only about a few people in the world who I admire when it comes to Macro thoughts, the leading one is a gentlemen by the name of Albert Friedberg. Friedberg is a commodity trader from Toronto who has been a commodities trader his whole life. In addition to owning a commodity trading firm he runs a hedge fund which has generated absolutely incredible returns over the past decade. He is up about 70% in just the last two years. He's been absolutely right on the Macro picture and I highly recommend his insights. He's even got a little buffet in him, worth around 600m$ yet lives in the same house on the same street forever.

 

Back to the current environment, there are certainly some factors that must be considered, and I think an astute investor in the next 20-30 years will have to incorporate them into their overall investment thesis. The most important point in my view is this ridiculous concept that a central bank can all of a sudden decide to reduce interest rates to levels never before seen in any period of history and believe that there will be no repercussions.

 

Here are some words from Friedberg.... Enjoy!

 

 

http://www.friedberg.ca/c/htmlos/001508.3.1615748909916047517/push/2nd_Q_2010.pdf

 

And some more although not being entirely credited to Friedberg, the smart ones know who writes this stuff being their largest shareholder:

 

The Gold Market  8/10/2010

In our view, the next leg up in the gold price is imminent. The deflation scare we have been predicting is now in full

bloom, right on schedule. The Keynesian inflationist economists are using this fear to gather support for an

expansion of the Federal Reserve balance sheet in the form of further quantitative easing (“QE”). More stimulus

spending by the US Treasury is unlikely given the current level of concern about the deficit. But Federal Reserve

expansion of the money supply is what the Keynesians believe is necessary to revive a failing economic recovery

and most of these economists work for Wall Street or Washington, both of which are intent on preserving the status

quo at any cost.

The deflation scare has supported a bear raid on gold which has fallen 7% in price from its all time high in late July

2010. Sentiment on gold is intensely negative. We believe this development is temporary. In our view, the Federal

Reserve is about to attack deflation, undermining the dollar and just about every other vehicle for protecting savings

and wealth – other than gold.

Let us be clear that deflation is largely an American concern. Much of the developing world is struggling with rising

inflation especially the BRIC countries of Brazil, Russia, India and China. These countries attempt to maintain their

currencies in a narrow range against the US dollar. As more dollars are created, and as more dollars flow towards

these stronger economies, they will be forced to create more of their own currencies to absorb these dollars and

prevent major revaluations. Thus, if the Federal Reserve expands its balance sheet as we expect, the US will once

again export significant inflation to the rest of the world.

In our view, those who (sincerely) fear deflation are misreading the signs. Is there a real threat of deflation if the

Continuous Commodity Index is at a new two year high (which it is)? Is there deflation if central bank reserves are

nearly 10% above their 2007 highs? And if there is deflation, would we not expect the US dollar, the world’s reserve

currency, to be rising? In fact, the dollar index is down precipitously from its June 7, 2010 high as deflation fears

have mounted. Yes, US Treasuries are up in price but is that a signal of deflation or anticipation of more Federal

Reserve purchases to come?

In one sense, the reality of the deflationary threat does not matter. The Federal Reserve is going to act on it and

defeat deflationary forces real or not. But a misreading of deflation is important in one respect; if there is no real

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threat of deflation, as we believe, then new measures from the Federal Reserve could substantially increase financial

instability, enhancing what is already a growing role for gold in investor portfolios.

What is the evidence for deflation? Economists point to low consumer price inflation, falling asset prices

(particularly residential and commercial real estate) and a large output gap. The output gap is the difference between

the economy’s potential performance and its current level, a gap which reflects a combination of weak end demand

and excess productive capacity. We will examine these deflationary forces in more detail.

First, let’s be clear about the current economic situation. We are two years into the collapse of the biggest credit

bubble in history. In a credit bubble, asset prices and debt outstanding chase each other higher. Cheap, easy credit,

the necessary condition of a bubble, bids up asset prices which in turn provide more collateral for further borrowing.

Because interest rates are low in a credit bubble, investors are encouraged to reach for yield by taking on more risk,

often more leverage. Investors are encouraged to speculate rather than invest. Savers are encouraged to spend rather

than save. Much of the cheap, easy credit goes to support consumption, or poor investments that do not generate a

reasonable return. The end result is a series of unstable imbalances. Asset prices, debt levels and leverage are too

high. Cash flows and investment income are too low.

When the bubble collapses, prices, debt levels and leverage must come down. Excess capacity needs to be wrung out

of the system. Spending needs to slow down and savings need to increase. Debt needs to be restructured and repaid.

The reconciliation is painful but necessary. The real problems begin when governments and central banks try to

prevent the reconciliation by supporting consumer demand, propping up asset prices and discouraging savings.

Clearly, most governments and central banks have been trying their best to re-inflate the bubble and suppress the

reconciliation process. In the US, we have had programs to support end consumption such as “cash for clunkers”

which have simply added to the deficit without any economic benefit. Similarly, we have had a myriad of programs

to keep people in homes they cannot afford and to subsidize new home purchases, never mind the enormous efforts

being made to bring mortgage rates down and facilitate more lending. Despite low interest rates engineered by the

Federal Reserve to encourage savers not to save, households are consuming less and trying to rebuild their balance

sheets. That’s where we are today.

Does low consumer price inflation represent a threat to the economy? In the late nineteenth century, America

enjoyed the strongest period of economic growth in its history. Substantial investments in new technologies reaped

huge productivity gains, real incomes rose and corporate profits went through the roof. During this same period, the

general price level fell substantially. The money supply grew more slowly than the economy thanks to the benefits

of the gold standard. Savers and wage-earners prospered.

Do falling asset prices mean deflation? We would argue that asset prices are simply finding the correct level where

they represent economic value. Yes, this means restructuring and outright default. Restructurings and defaults do not

reduce the money supply. Credit availability may be reduced but this is part of the deleveraging process. Credit and

money should not be confused; they are not the same thing. In our view, deflation should mean an increase in the

comparative value of money due to its relative scarcity and we are not seeing any evidence of money scarcity.

One of the arguments the Federal Reserve is likely to make in favor of new QE is the money supply. M2, the Fed’s

preferred measure of money, is growing at the slowest rate in 15 years. However, M2 includes money market funds

and time deposits which are securities, not money, and must be sold to acquire money. The slowing in M2 is largely

the result of a shrinking of these non-money components as savers flee from them due to their low returns. More

narrow and exact measures such as True Money Supply, a yardstick prepared by the Von Mises Institute, show

continued strong growth in money supply exceeding 10% annually although the growth rate is down in the last six

months as QE1 slowed to a halt. There is no evidence to suggest that there isn’t sufficient money to support

current prices.

As for the output gap, the theory is that we need to see strong economic growth which reduces economic slack and

increases end demand to the point where it strains capacity before we can have inflation. This is the reigning

economic theory and it is an elegant one. Unfortunately, it fails to explain nearly every major inflation of the past

hundred years, most of which occurred during severe economic contractions.

Consider the Weimar Republic’s hyperinflation of 1921-3. After WWI, a defeated and demoralized Germany was

faced with high unemployment and onerous war reparations to pay. To stimulate the economy and to help pay the

vast debts outstanding, the German central bank steadily increased the money supply. For two years, nothing much

happened. Due to the uncertain political and economic outlook, German citizens and institutions hoarded their cash.

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Then, within a period of few weeks, and without any warning, the population changed its mind. Suddenly, savings

no longer made sense and Germans began to spend. They lost faith in their government, their financial system and

their currency. Germans decided that it was better to hold real goods rather than money. The output gap had nothing

to do with it. Serious inflation is an issue of confidence in money; it is not primarily an economic phenomenon.

The purpose of this narrative is not to compare the Germany of the 1920s to America today. The point is to highlight

the extraordinary importance of central bank credibility, especially as the Federal Reserve moves towards its next

phase of QE.

In the QE process, the Federal Reserve purchases securities using freshly printed money. In the first wave of QE

which began in March 2009 and ended one year later, the Federal Reserve purchased $1.75 trillion in mortgage

securities, agency debt and Treasuries. These purchases were added as assets to the balance sheet while the new

dollars were recorded as liabilities. To the extent that these purchases were from commercial banks, the results were

not inflationary because the banks had to rebuild their balance sheets and so they kept most of the money as reserves

on deposit at the Federal Reserve. However, many purchases were made from private market participants and thus

new money entered circulation.

It should be noted that prior to QE, the Federal Reserve had only ever purchased non-Treasury securities when they

also had a re-purchase agreement requiring the seller to buy the securities back. In QE, this was not the case. The

Federal Reserve became one of the largest owners of residential mortgages and the largest holder of liabilities issued

by Fannie Mae and Freddie Mac, two bankrupt government sponsored agencies. Not the sort of investing that

increases the perceived strength and credibility of the world’s largest and most important central bank. What will

QE2 do to further weaken confidence in the Federal Reserve and its currency?

Many of those who argue for deflation point to Europe as another source of the problem. The EU has decided upon a

series of austerity measures for its membership which are intended to prevent the restructuring of European

sovereign debt. To its credit, the European Central Bank has greatly curtailed its purchases of securities and thrown

its weight behind the need for budget cuts to finance debt repayment and improve the credibility of sovereign debt

and the Euro. In our view, these well-intentioned efforts will ultimately fail because they require the sacrifice of

citizens and their living standards in favor of bondholders.

The time for deflation fears was two years ago when the US dollar soared in response to the initial collapse of the

credit bubble and gold fell 30% to less than US$700 per ounce. The gold price is now telling us to expect inflation

and we are confident that the Federal Reserve will succeed in making inflation the biggest risk that investors face. In

our view, deflation is most unlikely in a democracy with a fiat monetary system where unlimited money can be

created at zero cost. Governor Ben Bernanke has told us (in his now famous November 21, 2002 speech to the

National Economists Club) that deflation will not happen here because the Federal Reserve has a printing press. We

believe him. Nonetheless, there will also be significant debt restructurings and defaults. Gold remains the best

protection against both risks…debasement and default. We expect these risks to become more prominent in the

months ahead and we expect a dramatic response from gold.

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  • 4 years later...

If you read Buffett's article from the 1970s called How inflation Swindles the Equity Investor, you'll see that Buffett has clearly looked at macro or aggregate themes and sought to understand them well.  Earlier and later writings of his also revealed a focus on macro perspectives into institutional behavior and aggregate institutional investment themes. His articles in Fortune in the late 1990s and early 2000s were discussions of macro themes. Also note his discussions the pension plans allocations of capital to equities or bonds or gold. 

 

Additionally, Buffett's description of derivatives as being Weapons of Mass Destruction (WMDs) is wholly focused on a macro theme. (As he stated then, he owned derivatives and would continue to buy them, but the major or systemic risk was very different than his individual risk.)

 

Grantham, and other successful investors regularly focus on macro themes.  Howard Marks even wrote a piece on the necessity of monitoring the macro environment.

 

 

What brought me to this thread was the following article.  A macro theme.  Quite unexpected on my part as I would have assumed business in aggregate is being opportunistic in this environment of record low interest rates.  Instead either poor credit access, a mediocre economy, or a case of fighting the last battle may be driving these results.  Or some other condition as companies building their balance sheets in preparation of leveraging up at the last chance before or as rates rise?  Or is it the simple arithmetic of looking at averages and not median company?

 

To me, such macro themes are suggestive of future themes affecting international competitiveness, current and future capital spending booms, etc. Things to keep in the back of one's mind as a range of outcomes but not to incorporate into any buy/sell analysis.

 

The decline in S&P 500 leverage is unprecedented

 

SAM RO, MAY 12, 2015

 

 

http://www.businessinsider.com/sp-500-leverage-2015-5#ixzz3a1xGzuh9http://www.businessinsider.com/sp-500-leverage-2015-5

 

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I dont know where the idea of not paying attention to the macro came from.  It is certainly not the way I see Buffett, or most other value investors.  In my mind it is more important than ever before to follow macro trends with the increasing speed of creative destruction. 

 

I dont know what to make of the article on S&P leverage.  Mostly what it says to me if anything is that companies are not in a hurry to increase production capacity.  I also think the effect of low interest rates on juicing the economy is now suffering the law of diminishing returns. 

 

I bet that jacking the interest rates a little would go further to juice the economy than the status quo.  After the initial shock, of course. 

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Most value investors despise the concept of understanding the Macro picture. This is obviously due to the belief that when searching for undervalued securities the intrinsic value should be so apparent that in a stable or normalized economic environment the macro doesn't really matter.

 

This has never been my understanding of the typical value investor's viewpoint on macro stuff. I don't make any investments without at least getting comfortable with the macro environment and the dynamics of that specific industry. I think the point Buffett has tried to make is that there are many, many macro things that are simultaneously affecting any single company and it's damn near impossible to predict how all those things will come together a year or two down the road (or longer). In my opinion it's still important to understand the major macro stuff, but macro tailwinds that may or may not come to fruition shouldn't be used as an excuse to overpay for stocks.

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In my very humble opinion it depends on whether you have permanent or temporary capital, and whether you have annual cash flow outflows to support.

 

Buffet, owning Berkshire, raking in cash every year to invest no matter what the market climate has no need to think about macro or its implications.

 

An open-ended fund manager who will experience significant outflows due to market underperformance, may benefit from managing risk based on macro factors...not that she will succeed, that is a different conversation.

 

A pension fund manager who has annual, un-even cash inflows, outflows and fluctuating funded liabilities should also be keenly aware of the interest rate environment and market structure, and may need to closely manage volatility at the cost of future cash flows.

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