Is this a Good Time to Be a Value Investor?

A reader of The Safal Niveshak Post sent me this email yesterday…

For the last few days, one question is worrying me. As a value investor, even if I choose value stocks after thorough analysis of the business, how do I factor in general macro-economic environment, global slowdown, etc.? How do I know these macro-economic factors will not keep markets subdued for years to come? How do we identify if it’s not great depression again?

Just to add, is there a wrong time for value picking, or is it always the right time as long as there’s thorough analysis and sufficient margin of safety

Very important questions, I must say.

Traditionally, value investors have tended to ignore macro-economic issues and have focused on bottom-up investing.

This was based not only on the idea that if you purchase a great business at a good price the investment will work, regardless of the macro-economic forces at play, but also that the economy cannot be predicted with enough accuracy to be useful.

However, the economic gloom that erupted in 2008 and that is now four years into running has shaken the belief of even the longest of long-term investors.

Now I hear many long-time and long-term investors challenging and questioning this long-held view that studying macro-economic picture while analyzing stocks is not required.

I suspect their latest view has been triggered by the fact that many of them have seen their portfolios get crushed (or remain stagnant) over these past 3-4 years.

So the question is – should value investors make their investment decisions based on the macro picture – GDP growth, inflation, interest rates, currency volatility, and economies going bankrupt in Europe?

See, these are tough questions, and finding the right answers is tougher.

Any of these macro-economic factors can impact the market dramatically, at least in the short term. Also, it would be great if one could predict these factors and their impact on stock prices, and invest accordingly.

3 ways to deal with the ‘macro’
From my personal experience as an investor and from reading what successful value investors like Warren Buffett have to say on this subject, there are three key ways of dealing with macro events such as the economy and politics:

1. Predict these events and then take a call on whether you want to invest or not, or completely stay out of the market. The problem here is that historically no one has been able to predict with any accuracy that is better enough than random occurrences.
2. Acknowledge that macro-economics is totally unpredictable, and give up completely. Even this I believe has its problem as you can’t just close your eyes and ears to what is happening around you that can impact stock prices in a major way. However, I have seen investors who follow this track and completely ignore any kind of macro-economic prediction, and instead always remain fully invested, constantly investing using the SIP method.
3. The third way is not to predict the macro-economic future at all, but make investment decisions based on where stock market valuations are instead of where they might go.

I believe this third way is the best way for investors.

But why does this make sense?

You see, it is too hard to predict what the world might be like (I have failed in doing so for nine straight years while I have been an investor).

But it is much easier to know where we are today. We can make decisions based on where we are today.

Just like instead of worrying about how your stocks will do 10 years down the line, you must worry more about whether you have the right stocks in your portfolio ‘right now’.

Warren Buffett has said many times that he has no idea of where the economy or stock market will be next month or even next year. But he does pay attention to where the market valuation is compared with historical valuations.

Buffett uses a metric known as “market cap to GDP” to ascertain whether the stock market valuations are overvalued or undervalued as compared to the economic condition, and as compared to their past.

According to Buffett, if the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you.

If you see the chart for India’s market cap to GDP, the point from where the markets have taken off over the past 10 years rests at around 60% (excluding the post-dot com period when the ratio had dropped to a mouth-watering 25% levels).

We are currently at around 65%…which indicates that this is indeed a good time to start considering buying stocks.

Data Source: RBI
This – market cap to GDP – is a good indicator in telling us where the market stands against the economy.

One argument I often hear is – “If I had foreseen the macro picture of the economic and stock market crash, I would have avoided deep losses in 2008. So wasn’t studying the economy then so important?”

Well, that might be true.

But if you noticed that the stock market was quite overvalued at the start of 2008 as measured by the market cap to GDP ratio (see the chart above; the ratio was then over 110%), and managed your portfolio accordingly, you would also have avoided losses.

Therefore, paying attention to where we are with market valuations is, I believe, enough in your pursuit of taking a macro-economic call with respect to whether you should invest or not.

What should you spend your time on?
Keeping abreast of macro-economic news is good practice regardless of whether you are an investor or not. I learnt this practice from my father, who is an avid reader of business papers and magazines despite not being an active investor himself.

But for long-term investors (not speculators or traders), focusing too much on the buzz of Spanish debt, or France’s credit rating, or the possibility of another round of quantitative easing, or what those business channel experts have to say about the direction of the market can put you at risk.

It’s like distracted driving.

Sure, you can get away with a phone call here and there. But the more time you spend texting or talking while driving, the more likely you are to miss a turn, or to find yourself suddenly parked on top of someone walking on the street.

So, instead of worrying about economic or stock market forecasts that don’t matter at all, you should spend your precious time trying to know what’s happening on the ground – with the companies whose stock you own or want to own.

• If you own auto stocks, get interested in knowing used car prices.
• If your own hotel stocks, you ought to be interested in how many people are building hotels, how many are occupying hotel rooms, and at what prices.
• If you own stocks of steel companies, you ought to be interested in what’s happening to inventories of steel.
• If you own stocks of consumer goods companies, spend time studying what’s selling and what’s not in a shopping mall.
• If you own stocks of IT companies, look at what’s happening on the hiring front.

These are some important “macro” facts you, as an investor, must try to look out for. The deeper one dives into fundamental company analysis, the more macro one ends up seeing and studying.

Like yin and yang, one leads to the other. This ‘macro’ stuff is all in the context of analyzing a single business, and all things that could impact its future.

But that crystal ball stuff – forecasting where the GDP, rupee, index of industrial production, or inflation is headed?

I don’t think that works!

Of course, I factor in a certain level of long-term inflation expectations when deciding how much return I want from my investments (returns that must beat inflation), as a value investor I avoid the difficult (and impossible) task of predicting macro-economic events.

Instead of worrying reading the headlines that flood the business media daily, I keep an eye on the overall market valuation – and whether it is offering an opportunity to invest or divest – while spending most of my time researching individual companies.

Like how I am spending my time now, working on finding good stock ideas (that are available for good margin of safety), and adding to my ongoing SIPs.

Is there a wrong time to be a value investor?
To answer the above-mentioned reader’s last question of whether there is a wrong time for value picking, yes there is one wrong time for value picking – when the market is in such a manic situation (as was in 2008) that you are not able to find any value anywhere.

At that time, you might be tempted to buy a stock at a P/E of 25 times, thinking it as a ‘value’ pick among other similar stocks that are trading at 40 times P/E!

But always remember that relativity does not work that perfectly in the stock market.

What works best is the absolute performance of a business, and whether you are able to pick up its stock at a good margin of safety vis-à-vis its intrinsic value.