If you invested in Amazon in 2001 with this opinion and remained steadfast in your ownership, we are guessing you probably did okay. Even then, we would argue that for you to have maintained conviction in Amazon, you must have had at least a partial macro-opinion. Maybe not of where interest rates are headed but perhaps of how the internet would change the world and how the penetration rate of e-commerce would evolve in the decades ahead. In this piece, we will define what we mean by macro and explain the two dimensions of our macro view: the “inside view” & portfolio positioning. We will conclude by discussing the considerations that affect our current portfolio positioning.
The Inside View
Let’s start with a basic fact about ourselves. We are in the prediction business. Most investors do not freely admit this. Probably because predictions by their nature involve error, probabilities, and uncertainty. Whatever one decides to call it, our job as value investors is to properly forecast a company’s future cash flows. To be more precise, our job is to properly forecast the range of potential cashflow outcomes and the rough shape of the overlaying probability distribution linked to these outcomes. Will we ever get it right? We can say with confidence, probably not. But getting close can work spectacularly well especially when others have a much different viewpoint. Having a good “inside view” of a company is necessarily partially a function of having a good “outside view.” Outside views (or top-down) is usually referred to as macro and inside views (or bottom-up) are called micro. How we define macro: anything that affects a company that is not within the scope of the company management’s control: interest rates, demographics, consumer preferences, investor sentiment, industry changes, etc. Essentially, what are the underlying social, cultural, technological, regulatory, and/or financial realities that allow the company to continue to exist and potentially even thrive? For example, if you are analyzing a fishing company you will want to know how consumer preferences for seafood are evolving globally, what ecological trends are impacting the region, how excessive fishing elsewhere is having an impact, energy cost cycles, technological changes pertaining to fishing equipment, regulatory uncertainties, financing uncertainties and a host of other factors. Having a good understanding of how the world is changing (and how it is not changing) will lead one to better evaluate the potential success of company strategies, products and overall competitive positioning. A thorough outside view will lead to a formulation of key trends that is a source of insight over other market participants and provides a necessary foundation to better predict the likelihood of future company cash flows. Expect a full treatment of the analytical framework we use to achieve this in further writings.
Since we only invest in equities, portfolio positioning for us is essentially a question of when to have a good amount of cash in the portfolio and when we should be fully invested or even employing the use of leverage. Our “offense/defense gauge” is updated regularly and runs from 0 to 100 with the upper end indicating that we are using 25% leverage. Although we care about relative returns over long periods of time, we care about our portfolio’s absolute return all the time. For example, having a 0% return when the market is up 30% in six months is a preferable evil compared to losing 30% when the market is also down 30% in six months. Understanding that markets have cycles and tilting towards an offensive portfolio positioning when early in the cycle and more a defensive positioning when later in the cycle will tilt the odds slightly in our favor.
The global ebbs and flows of capital markets are akin to a sea of liquidity. A flutter in one corner of the world can translate quickly to forced selling here at home. There are few things as satisfying as having deployable cash on hand during a market panic. How do we try to time this? We don’t and would never try to. However, we have an understanding of cyclical factors that can cause us to slightly notch up (or notch down) our level of offensiveness (or defensiveness). The set of determinants we use to arrive at this decision are generally always changing in number and importance. There have been multiple academic studies that attempt to create a link between market drawdowns and what the academic world calls “endogenous factors.” The best that we can glean from these studies is that a multi-factor model approach is best and the set of factors that have the most explanatory power tend to be changes in Valuations, Credit Growth and the Yield Curve (“The Factors”). Once plugged into a model, they help explain only ~40% of the variation experienced in market drawdowns of greater than 20%. The takeaway is that while we should always be mindful of The Factors, there will always be other confounding curveballs to contend with. Given this, our assessment of the macro landscape involves a constant assessment and re-weighting of The Factors while also being rationally paranoid about new risks. A new risk can really be anything, a hedge fund blowing up, geopolitical tensions, sector bubbles etc. To use a recent example, the short squeeze on Gamestop may have presented an outside risk to our financial system if several hedge funds were at risk of imploding which could cause their prime brokers and other counterparties severe financial strain. In a globalized and interconnected financial world, the risk of contagion is always present.
We began the year with our offense/defense gauge at 100, which means a quarter turn in leverage, and as of this writing, we have reduced our gauge to 70 leaving us with close to a 15% cash position. Although credit growth is important, given households have relatively low leverage ratios historically and high government debt is not likely causing a crowding-out effect anytime soon, we do not currently see signals that are cause for concern here. The reduction in our risk-taking is due primarily to our assessment of valuations and yields. These two factors are always relevant to our market view and especially of greater focus now given it could be argued that they are both at the far ends of their spectrum.
Valuation & Yields
As of this writing, the forward P/E ratio on the S&P 500 is 21.8 with the ten-year at 1.4%. The 25-year average P/E is 16.6 with the average ten-year yield over the same period standing at 3.6%. Looking only at P/E ratios, the market appears overvalued and is trading around 1.5 standard deviations away from its norm. If you use more normalized methods of comparing earnings ratios like the CAPE, we observe only 1.25 standard deviations away from normal. If we begin to incorporate the level of the ten-year to give us more context, we realize that low-interest rate environment should rationally produce a higher P/E all else being equal but by how much? To answer this question, we ran valuations on three different types of hypothetical company-generated cash flows: 1) high growth 2) sustained growth 3) value. The result are purely theoretical, that being said there are two important takeaways:
Growth names in general have more cash flow on the back end. Industry speak for this is “higher duration.” Interest rate movements, all else being equal, have a disproportionately greater effect on higher duration equities. (see table below)
All else equal, interest rate movements in a low-interest rate environment have a greater effect on equities than proportional interest rate movements in a high-interest rate environment.
Regarding the less well-known number 2, whether you are talking in percentage terms or absolute terms this still applies. For example, if yields start at 1% and go up to 1.1% (go up by ten percent) this will theoretically have more of an impact on equities than if yields go from 5% to 5.5%. To sum up our findings in plain speak, all else equal, bond yield volatility will generally have more of an impact on equities in a low-interest-rate environment than a higher interest rate environment along with disproportionally affecting high growth companies more than low growth companies. Keep in mind “all else equal” cannot really exist in the real world. It is impossible to control for the myriad of factors that are impactful yet differ across interest rate regimes. There is no substitute for critical thought.
Does this mean if yields go up the market is going to go down? Not exactly. Historically speaking, rising yields are generally accompanied by a boost in economic activity which is good for equity markets. Yet if yields are rising primarily because of inflation expectations this has historically resulted in downward pressure on equity markets. Currently, we have a mix of both inflation expectations rising along with an economy that will likely surprise to the upside. What makes matters more difficult is that we are coming off record low-interest rates rendering historical comparison misleading. Given this, we have decided to hedge our bets just slightly. When the rate markets begin to normalize, we will most likely start to add to the positions currently in our portfolio. Until then, we will continue our research and writing on different names we are considering.