How I think about macro

Charlie munger (warren buffett’s partner at Berkshire Hathaway) was recently asked about his views on macro and he said something to the following effect (in my own words)

“If thing are bad now, they will get better in time. If they are fine now, something will go wrong in due course. We don’t make money by predicting the timing.
At Berkshire, we're trying to swim well against the tide or with it, we just keep swimming."

If you have not heard or read about Charlie munger, I would suggest that you read up anything you can find about him. He is one the smartest and wisest person you will ever come across.

Ignoring macro ?
It was fashionable among value investors to completely ignore the macro till the crisis of 2008 – they spoke about it as a badge of honor.

The pendulum has swung the other way since then. I see a lot of investors being cautious about macro, to avoid a repeat of 2008.

 

I think macroeconomic thinking can be broken down into two elements

-       Understanding  industry dynamics and trying to evaluate the long term economics of the company
-       Understanding macroeconomic variables such as inflation, interest rates etc and trying to forecast or guess so as to make investment decisions.

The first element is crucial in understanding the company and its profitability in context of its industry. One needs to be aware of the competitive situation in the industry to be able to figure out the long term outlook for the company.

The second element which is generally reported on by media and guessed by an army of pundits, soothsayers, forecasters and talking heads is a waste of time. Very few, if any can forecast any of these variables with any level of accuracy and no one gets it right in the long run (remember oil was supposed to go to 200$ / barrel in 2008 ?)

The comment by Charlie munger should be seen in context of the second aspect of macroeconomic thinking – there are variables such as interest rates, exchange rate etc which can impact your performance, but as they cannot be predicted , it is far better to concentrate your energy on understanding the company and its industry and learn to live with the other aspects of macroeconomics  (interest rates, inflation, exchange rates etc)

The capital goods industry

Lets look at an example. The capital goods industry is going through one of the worst cylical downturns in the last 10 years. The last time the industy went through such as patch was in the 2001-2003 time frame (I remember those times !).

I don’t think anyone can predict with precision when the cycle will turn  (although a lot of people claim to be able to do so), but one can be sure that the cycle will turn eventually.

If you can understand the economics of this industry and can find some high quality firms at reasonable prices, I am sure the returns over the next 2-3 years will be good. Let me give a tip – Look at a company like BHEL or blue star or thermax and ask these questions

• Are these companies likely to go out of business soon ? (current valuations seem to say so)
• Is it likely that these companies will do well once the cycle turns ? (though we don’t know the exact timing ?)
• Are these well managed companies with competitive advantages ? ( I believe they are)

The typical talking head on TV or broker needs to be right in the next 3 months. As an individual investor, I don’t have to play by the same rules. If I can find a company which will do well in the next 2- 3 years, I can ignore the near term outlook.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

The inflation risk

I think the inflation risk is now obvious to most of us, even if we don’t read the papers everyday. Even if the government claims the inflation is 4% or so, buying a kg of potato or sugar gives a different view of reality. So what do we do in response or if we need to do anything at all.

As far as equities are concerned, I rarely do any top down analysis and so I frankly don’t have any specific plans for my current holdings based on the inflation risk. No logic of inflation resulting in an increase in interest rates, in turn driving down demand for cars and hence the sales of an auto company.

I personally plan to avoid investing in long term deposits or long dated debt funds. If the inflation risk persists and the RBI decides to raise the rates (I have no idea if it will or not), then buying long duration debt fund or a long term deposit (more than 1 yr) would lock you into lower interest rates.

I plan to put my surplus cash in short duration floating rate mutual funds such HDFC floater and others. I don’t have preference for any specific ones, as most are identical and there is not much difference between them. If the rates do rise, then these funds should cover the inflation risk on the cash.