I've begun to receive a number of emails recently with the market at all time highs questioning the wisdom of keeping money invested at these levels. As the market races higher it's natural to start to think about when the next downdraft might occur and what it might look like. The most important point in this post isn't thinking about the future, it's what to do right now, when opportunities appear scarce.
There's a common cliche that value investors are to ignore the macro noise and only look at companies from the bottom up. I'm not sure where this meme started, but it doesn't seem right. It seems we should always be aware of the environment we are investing in, but we shouldn't let that awareness dictate our decisions.
The problem with macro focused investing is that one needs to get the forecast correct, but also the timing of the forecast correct. I remember one story in the Snowball where Buffett's uncle was so worried about the government defaulting it prohibited him from making sound decisions. I believe he convinced Buffett to purchase a farm just in case something bad happened. Of course Buffett continued to invest in the face of the fear, and if his uncle would have invested with him he would have been rich, instead he was poor and worried.
With the most recent financial crisis the focus seems to have shifted to investors who had the uncanny ability to predict the future and earn outsized profits. Guys like Michael Burry, who foresaw a housing crash, and were able to profit from it. In hindsight everyone "knew" there was a housing bubble. The human ability to re-write memory is amazing, I can't remember talking to anyone post 2008 who has said "I never saw this coming, I thought we were going to have a soft landing." Right now in Canada where there appears to be a housing bubble, a familiar pattern emerges. A few people are predicting a crash, most people are ignoring it, and some cable TV stations have decided to flood viewers with Canadian real estate shows. Even if housing prices are high, the question is one of timing, when will the market finally pop?
How I think of macro elements as they relate to how I invest might best be described by an analogy. My house needs a new roof, it's undeniable to anyone who looks at it. Some of the shingles have lost their grit, and in sunny spots the ends are turned up. It's been like this for a while, and we haven't had any leaks so far. I had a roof guy inspect it who said it might last two years, or seven or eight years. I don't know if it will last five years worth of storms, or two weeks worth of storms. But since I'm the thrifty type I'd rather ride this roof out until I see signs of failure. Why upgrade when I don't need to? In the meantime I'm not putting any housework on hold because of the imminent roof replacement. We have made changes to rooms directly underneath the roof, it's possible we might get a leak and need to repair it, but it hasn't stopped us. At some point I will have to fork out a LOT of money for a roof, or get up there and do it myself.
How does my story relate to investing? I think investors always need to be aware of their surroundings, but don't let the cart drive the horse. At times things might look dire, and maybe it really is worth selling everything and going cash. But my experience has been that the turning point is usually unexpected and sudden, and impossible to time. There are a lot of macro related things that are a mathematical certainty. There is too much debt and not enough money to pay it off, at some point it will need to be reconciled. At some point Japan will have to face its debt problems. At some point the US will have to face its debt/pension problems, and at some point Europe will have to decide how to handle their debt problems. These aren't opinion page ideas, by the math these things will need to be reconciled at some point, either through defaults, inflation, higher taxes, all, none, or something innovative no one has thought of yet.
When the easy opportunities start to dry up my radar goes up with regards to the level of the market. Right now the selection of net-nets in the US is poor at best. Outside of some unlisted net-nets the pickings are very slim. This isn't some sort of timing indicator, but it's just a general acknowledgement of the environment we're in. Instead of going to cash I continue to look for opportunities in offbeat places. Right now there are plenty of banks that are cheap, as well as plenty of unlisted and foreign stocks.
My only caution in the current environment is to ensure that what appears to be a margin of safety is a true margin of safety. A lot of value investors were wiped out in financials in 2008. They thought they had a margin of safety but didn't forecast what would happen. A good gut check is to ask what would need to happen to put a potential investment out of business. I have some companies with so much cash they could operate for more than a decade at current levels with zero revenue. Debt is a margin of safety killer, beware of it, it's not always bad, but it can be worse than it initially appears on a balance sheet.
When I first started to get interested in investing a common theme that re-appeared in books was that investors needed patience. Patience to purchase stocks and hold them through thick and thin for the long term. Growth investors are always being stereotyped into being short term focused watching for the latest earnings beat or surprise news. Value investors are no different, we've been hooked on the notion of a catalyst. A catalyst is a substitute for patience. When we don't have patience to actually hold a company for years we look for one with a catalyst that will hopefully shorten the holding period.
Investors need more patience, patience to wait for value to be realized, and patience to wait for more opportunities. I think a market like the current one is a great test of patience. It's hard to hold cash and wait for better opportunities in a rising market. It's also hard to hold flat or declining stocks when seemingly everything is heading higher.
Use the rising market as a gut check, assess each company in the portfolio and re-evaluate their margin of safety. If it doesn't exist anymore, or the company is fairly valued then sell into the rising market and move on. If the daily new highs are worrisome, or if macro fears are causing panic I would recommend closing down the computer and taking a walk outside. The weather has turned and it's a beautiful time of the year to get outside and relax. After-all, if your portfolio is full of safe and cheap stocks watching the market minute by minute won't change a thing, except to raise your blood pressure.
One final note, as things like this always go I'm sure the market will probably crash in a few weeks or Japan will default, or in the US rates will spike and someone will email me "I told you so!" Maybe that will happen, or maybe nothing will happen for another three years as we drift higher. I don't know, and anyone who claims to know is lying.
Talk to Nate