A rare macro view

Dear Reader,

As my first post, I feel somewhat obliged to start with a macro theme. Experience suggests cocktail parties rarely start with intricate stocks picks...folks are often more opinionated on macro issues and hence find the theme more entertaining. I should point out immediately that our investment style is not macro orientated. We take the stance publicized by the First Eagle Funds - we invest bottom up, but consider top down risks, and their affect on bottom up valuations.

I therefore start by attempting to put a personal light to an often heard quote expressed by clients:-

"But my money is doing nothing, we must invest it now or we will move it!"

Blaise Pascal said that all humanity´s problems arise from his inability to sit quietly in a room alone. We couldn´t agree more. There are times when it is simply better to do nothing than something, anything. But there seems to be a fear to doing nothing - perhaps a feeling that someone may be doing something and you are helpless to stop them advancing relative to you? This feeling can be reduced by taking decisions with a clear criterion. Investment is as much to do about discipline as information loading or raw intelligence.

In later blogs we shall present our own investment portfolio, but over the last three months we have processed only two transactions - a single sell and a single buy transaction. It is frustrating as a dedicated investment advisor to do such little business, but as I say to my colleagues, it may be uncomfortable holding so much cash, but it is more uncomfortable to make a silly mistake. Let me highlight why we are overweight cash at the moment:-

If someone asked me what two macro factors should combine to provide a great environment for stocks, I would probably say a perception of long term low interest rates and a fear of short or medium term inflation rising starting from a low base...

One can´t help thinking we are close to that general perception at the moment. Indeed, this was one of the reasons we were heavy buyers of stocks at the start of 2009. Though this reasoning may suggest we are positive on stocks today, using a bottom up approach we are finding it increasingly difficult to buy stocks at attractive prices. We will not buy, in today’s economic environment, the equity of companies having to assume a growth rate greater than that demonstrated on average over a business cycle. Therefore, though macro factors may be positive for stocks at the moment, current pricing carries a growth rate we feel uncomfortable in assuming. Should the macro conditions change, or there be a perception that they may change, we feel they are more likely to be negative than positive for the valuation of risk assets.

What could trigger a negative change in the macro factors? We cannot help fearing the consequences of a weak credit expansion environment in the developed economies, which it still burdened by a heavily leveraged private sector. In short, the most probable consequence of this in your author’s eyes is a higher saving rate. This will reduce consumer spending, the life blood of many developed economies in recent history. This reduction in demand is likely to be negative for the operating margins of corporates, meaning they will make less profits from selling the same volume of goods. We do not feel this is being factored into stock prices at the moment. Indeed, analyst forecasts are generally assuming large earning increases as economies recover over the next year, leading to higher sales and margins. This opinion has generated much momentum over the last year, fueled spectacularly along the way by government money and moral support. The authorities have shown explicitly to the market that they are willing to do all they can to ensure growth is back. But we need to see evidence of demand growing which is not government led – weakening currencies are helping developed economies receive that demand from abroad. We see this scenario continuing but feel this is a zero sum game. Not everyone can gain equally from devaluing their currency. We wait and see. What we do believe with great conviction is that over the next few years there will be a large divergence amongst countries as some recover faster than others. This will be evident in the results of different countries government statistics and the performance of the financial securities of that country.

An interesting question is which macro factor will change first? We suspect the authorities of developed countries will not be keen to increase base rates due to their huge debt burden. It is more probable they will increase when the market forces them to do so. We feel this will be led by the market demanding a larger yield on government bonds. However, though we feel this is a very probable scenario, the time it can take to occur can be slow - as we are currently finding out having started saying this over a year ago.

What can change more quickly is the perception of future inflation. We feel this can generate more violent changes in asset prices. Much has been written over the last two years about the de leveraging process now occurring within developed economies. This has led to the private sector borrowing less and banks lending less, as a result, this has affected business volume in a negative way. The authorities have attempted to compensate by borrowing and printing money to ensure growth can continue during this period. As a result, public fear of de leveraging has been reduced. One particular example we find of interest, and we feel has contributed to this uneasy calm, has been the decision to change the accounting methods of banks with regards to the recording of loans and other financial assets on their balance sheets, relative to the methods used prior to the economic slowdown. Though we do not suggest this accounting change is better or worse - we do not have a better solution as an alternative - we do highlight that this authority led change has helped financial institutions receive capital at a lower cost. Such authority led changes have altered the market’s perception of what a bank is worth. Should accounting do that? Should governments do that? Indeed, we believe the aggressive role the government has played recently in the market has created a distortion in the valuation of risk assets in general.
However, we ask ourselves, will those bad loans disappear as a result of a change in accounting, will it make banks give more loans to customers? We suspect in the long run the accounting changes will do little to change the economics of the situation, though in the short term it may add a valuation boost. We do not want to buy during this short term boost because we are long term investors who buy because of the economics of the business; we try and steer clear of the business of economics.

As a result of this, we feel one dollar in cash today is likely to buy more than one dollar of assets in today’s pricing, tomorrow. Let´s see if the authorities can stop this from being the case. They have done a brilliant job so far in developing a macro scenario that is positive for risk assets and positive for developing a growth environment. But our bottom up approach suggests that the growth rates one needs to assume to purchasing the average company are too high for us to feel comfortable, especially in the highly leveraged environment we find ourselves in today. Richard Koo was famous for saying that during a balance sheet recession (when asset prices fall) companies move away from “profit maximization” to “debt minimization”. If the macro picture we paint becomes even partially true, you can rest assured market prices will adjust (probably too aggressively) to ensure this is reflected.