AWI: All Weather Investing

Published on 10/19/20 | Saurav Sen | 3,143 Words

The BuyGist:

  • We’re in for a period of low returns, according to investing legend Howard Marks.
  • But we don’t do this kind of Macro prognosis because, frankly, it doesn’t affect our investing strategy.
  • We go Micro…as Marks himself has often recommended.
  • We’re subscribers to the concept of “Expectations Investing”, which we think is good for all investing climates – that’s what this worldview piece is about.

Howard Marks predicts bad weather.

Legendary investor Howard Marks wrote a memo suggesting that we’re in for a period of low returns in almost all asset classes. This bummed us out because we pay close attention to anything Marks says. In fact, we have a whole Mental Model based on his “teachings” – and we often rely heavily on these lessons. In fact, he’s the one who eloquently said this:

“I’m firmly convinced that (a) it’s hard to know what the macro future holds and (b) few people possess superior knowledge of these matters that can regularly be turned into an investing advantage. There are two caveats, however: 1) The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. 2) With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies. Thus, I suggest people try to “know the knowable.”

It seems odd, then, that he spent so much time…focusing on the Macro. I guess I don’t blame him. It does all seem Macro nowadays, doesn’t it? It’s all about the pandemic, elections, fiscal stimulus, China,…the list goes on. Marks takes all that into account and arrives at this conclusion:

“As I’m sure is my bias, I lean toward defense at this time. In my view, when uncertainty is high, asset prices should be low, creating high prospective returns that are compensatory. But because the Fed has set rates so low, returns are just the opposite. Thus the odds aren’t on the investor’s side, and the market is vulnerable to negative surprises. This is how I described the prior years, and I’m back to saying it again. The case isn’t extreme – prices aren’t grievously high (assuming interest rates stay low, which they’re likely to do for several years). But it’s hard in this context to find anything mouth-watering.”

Marks uses 2 charts – almost straight out of Finance 101 textbooks – to depict his prognosis:

Marks’s point is well taken. “Reaching for yield” has made many investors pay more for assets than they would have otherwise. We think Marks is a legend, so it’s rather odd for mere mortals like us to argue with him. But we asked ourselves whether his prognosis changes anything in our investment process. The answer is No. There are 2 points in Marks’s memo with which we disagree:

  1. The “market” is inflated.
  2. Opportunity cost is measured in relation to the risk-free rate.

Pockets of the market may be inflated.

The S&P 500 is at all-time highs, which is weird at a time when economies around the world are reeling from a pandemic. And that’s the disconnect Marks is talking about. He does, however, point out the main driver of the market resurgence: Big Tech and many Software-as-as-Service stocks. That leads to the first point of slight contention we have with his memo. Pockets of the market look inflated. Check out the dispersion of year-to-date performance in across a few regions and industries:

We agree with Marks that certain parts of the market may be overpriced. But clearly, many pockets of the market have had a rough time. The point is that “the stock market” is not a monolithic entity. Yes, it can be at times, but this is not one of them. Mark’s prognosis may be useful to broad asset allocators – like a sovereign wealth fund – but to us it has limited value. Our vantage point and return requirements are different.

For starters, most of us mere mortals have constraints. We like easy execution. We like liquidity. That narrows our choices. We can’t, for example, delve into Marks’s domain – high yield and distressed bonds. At The Buylyst, we stick to equities because they’re liquid, and transactions costs are basically $0. Within equities, however, we are mostly unconstrained – by region, country, sector, market cap etc. Our main constraint is ease of execution. Within our wheelhouse – Global Equities – we suspect there will be promising pockets of returns over the next few years.

Having said all that, Mark’s “warning” can’t be ignored. Has monetary policy been too accommodative? Possibly. Have Institutional Investors been reaching for yield? Probably. Does that mean that the market overall is overpriced? Maybe.

But our approach to investing is agnostic about these Macro and, frankly, uncontrollable factors. If Marks is right, maybe our opportunity set of investable ideas shrinks. But that’s about it.

Expectations Investing keeps us grounded.

Marks framed the world of investing in very academic terms. He used the Capital Market Line to depict a general framework of choices that investors make – between bonds and stocks, between risk-free bonds and risky bonds, between public and private equity, and so on. This is a framework about Opportunity Cost.

He’s right that investing decisions are made on the basis of Opportunity Costs – what is my next best alternative to this? And the list of alternatives is generally put on a Risk vs. Return scale. Marks’s academic Capital Market line may work for academics and big sovereign wealth funds. But it doesn’t work for most of us. Our approach is different. Our Opportunity Set is different.  

As mentioned before, our opportunity is limited to equities because of easy execution and liquidity. So, our Opportunity Cost spectrum is not really concerned with other asset classes. Yes, we keep an eye on them because everything is connected one way or another, but we don’t obsess over “relative value” decisions across asset classes. Now, you might ask: “but how do you know if equities are overpriced?” Good question. We do because we abide by the principles of Expectations Investing. Let’s get into it.

Like Marks, we also put things on a Risk-Return Spectrum. But there are 2 main differences:

  1. Our Opportunity Cost is static and has a lower bound.
  2. Our measure of Risk is different – much closer to the Buffett/Munger approach.

Compare our typical Risk-Return spectrum to Marks’s Capital Markets line above:

A few differences pop out:

  1. We like a 30% “required return” always – regardless of market conditions. Yes, we may stoop down to 25% on certain occasions, but that’s about it. Our “return requirement” is never dependent on other asset classes.
  2. Our Prospective Return measure on the graph is based on bottom-up fundamental analysis – figuring out a company’s competitive advantage and translating that to estimates of sustainable future cash flow.
  3. Our Prospective Risk measure is not Volatility or Standard Deviation. It is also based on a company’s fundamentals and on the principles of Expectations Investing. Risk = Implied Growth times Probability that the implied growth will not materialize. A higher number is more risky.

What is “Expectations Investing”? In a nutshell, it’s investing based on back-solving implied market expectations from the price of a stock (or bond or whatever asset). This requires some basic assumptions, but the objective is to answer the question: How overpriced or underpriced is this asset? It focused on the Prospective Risk side of our spectrum.

Now, many Wall Street Analysts do this by using industry comparables or “comps”. We’ve always found this approach to be somewhat lazy. No two companies are alike. And if an industry is dominated by 2-3 behemoths because of their respective competitive advantages, “industry averages” (no matter what metric we use) don’t make much sense. In fact, at the risk of being too audacious, we may say that we don’t agree with Marks’s “comps” or relative value analysis. We agree with the spirit of what he’s doing, which is to answer the question “is this asset overpriced or underpriced?”

We believe Expectations Investing answers the question in a more efficient and logical way. Instead of answering the question, “is this asset overpriced or underpriced?”, it answers the question “what do we need to believe about growth in this company to buy its stock?” In other words, we reverse-engineer the process. This approach has a few advantages:

  1. It doesn’t require us to assume what the relative value of an asset class “should” be compared to other asset classes.
  2. It doesn’t require us to assume any “industry averages”.
  3. It doesn’t require us to “predict” specific future cash flows of a firm.
  4. It doesn’t require us to “settle” for “the best alternative” in a clearly speculative market.

All this makes Expectations Investing “all-weather”. It’s not really tethered to current macro-economic variables or any academic notions of relative value. It is very bottom-up, tethered to the fundamentals of a business. The way we apply Expectations Investing is by:

  1. Holding our “required return” (not annualized, but cumulative) consistent at 30%.
  2. Holding our “risk premium” (annualized) consistent at 5%.

More on our valuation process here. But let me highlight the point I’m trying to make: We try not to be tethered to the current economic climate when evaluating a business or its stock. Why? Because valuing a business or stock means discounting future cash flows – from now to eternity. Economic conditions change. Competitive Dynamics change. Interest rates change. Investor sentiments change. We just don’t bother with reading the tea leaves about these variables every time there’s a new headline in the papers. We focus on “sustainable” performance – how a company is likely to perform in all conditions.

Expectations Investing doesn’t require us to plot capital market lines or worry about whether the “overall market” is too frothy. If Marks is right, then we will still spot it – but from the bottom-up, not from the top-down. Our own Risk-Return Spectrum will then look something like this:

If Marks is right, then we won’t see too many investment opportunities – we’ll see too many prices that imply hard-to-believe growth rates. In fact, that may even compel us to sell some holdings that look massively overpriced. Expectations Investing backs into what is implied in prices rather than arrogantly proclaiming “this should be the price”, especially by using questionable models.

Yes, we do have target prices at The Buylyst. But they are, at best, rough markers. They are not scientific appraisals of value. We think the term “intrinsic value” is too philosophical. This may surprise you, but it’s impossible to find the true “intrinsic value” of an asset. It’s a mirage that looks different too different people. At best, you can use a rough estimate of intrinsic value to check if something is wildly overpriced or underpriced. Most assets, most of the time, are about fairly priced. Occasionally, we find something that’s out of whack. And if it’s severely underprices, we pounce. With Expectations Investing, you take market price, which is given, and back into what growth assumptions are factored in. Then you ask yourself: “is this believable? If you do, then dig in to confirm. If not, move on.

We just don’t worry about what Jerome Powell at the Fed or what politicians in Congress will or will not do tomorrow. We worry about the future economics of the firm over the long-term – regardless of macroeconomic policies of the day. Policies and interest rates will keep changing. There will be misjudgments made by politicians. There will bad economic times and even good ones. How will the firm perform on an average, sustainable basis? That’s what doing deep research is all about. And it’s only mildly connected to these uncontrollable macro factors.

The goal of Expectations Investing is to find something that is obviously cheap or expensive. If it’s not obvious or easy to believe, move on.

Learn from the Master of Expectations Investing.

We already have a Mental Model for Michael Mauboussin – the creator of the concept of Expectations investing. But I recently came across an interview of him in which he lays out some of the principles of Expectations Investing. I took some notes, and I was glad to see that we, at The Buylyst, adhere to each one these principles. Here are my notes (I’ve paraphrased what he said):

  1. Focus on CASH earnings, not Accounting Earnings like Net Income or Earnings per Share.
  2. Competitive Strategy and Valuation are joined at the hip.
  3. Try to figure out what is implied in the stock price.
  4. Discounted Cash Flow models are intellectually correct, but they are just models – garbage in, garbage out.
  5. Expectations Investing reverse engineers the process. It’s less garbage in, so less garbage out.
  6. If you simply rely on DCF ( a lot of potential garbage in), you may find “cheap” stocks. But they are either cheap for a good reason (like a declining company) or they’re cheap because expectations are very low. You’d rather pick the latter.
  7. In DCF models, the denominator – cost of capital – is where the maximum cases of “garbage in garbage out” occurs. Try to triangulate using many methods and be consistent.
  8. Try to answer the question: “what has to happen for me to by this?” And then think about the probability of that. Estimating probability is what takes time and effort.
  9. Then apply Ben Graham’s margin of safety approach – buy something for much less than what you think it’s worth – just to be safe.
  10. Nowadays, more and more companies have their value in intangibles (like intellectual property) rather tangibles (like oil fields). This makes “base rates” (industry averages) less relevant. The less commoditized a product is, the less relevant “comps” are.
  11. There is a constant Value vs. Growth debate. But that is a false dichotomy. They’re academic factors, created by academics. Focus on the “value creation” of the company, not on a label given to its stock.
  12. Ultimately, buy low expectations.

That’s the punchline – buy low expectations. Buy when implied market expectations of the business are much lower than yours – especially when they’re lower because of myopic macroeconomic reasons.

Don’t take our word for it…

“Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)”

“Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.”

“When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.”

- Warren Buffett

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