First and foremost fund managers pick stocks, but how much of a bearing does the macro have on their investment decision-making?
“I’m a bottom-up stock-picker” is a favoured refrain of many active fund managers. The message is that they look through the macroeconomic “noise” - GDP figures, inflation data, commodities pricing – to look at the pure value in a company. This enables them to be long term in their approach and not to be distracted by short-term fluctuations in data or markets.
The most influential proponent of this approach is Warren Buffett, whose favourite holding period is, famously, “forever”. He is also fond of reminding investors that “the stock market is a manic depressive”. In other words, it will move from elation to depression in short order. Far better, he believes, is to look at the inherent value in a company and work from there.
This is undoubtedly sound advice, and no one would want to disagree with the Sage of Omaha, but while it may be possible to ignore market noise, is it really possible to ignore macroeconomic conditions? After all, companies can be profoundly affected by macroeconomic events – seen most recently with the pandemic and its impact on economic growth.
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Can a stock-picker completely ignore the macro?
Certainly, there will be companies where earnings can stand independent from broader economic conditions: those who supply essential services such as water, for example, or infrastructure. However, there are plenty of companies that see their earnings ebb and flow with economic growth – energy, airlines, consumer discretionary stocks (those that sell goods and services that are deemed non-essential). When making a judgement call on future earnings for these companies, an awareness of the direction of economic growth is presumably important.
Equally, company performance cannot necessarily be disaggregated from factors such as interest rates. When rates are low, companies can support higher borrowing costs, but higher rates may bankrupt an indebted company. Inflation will push up input costs, while tariffs might influence end demand for a company’s products. All these are macroeconomic factors that can affect the performance of individual companies.
Interest rates will also influence the “risk-free” rate, ie, the rate investors can expect to be paid for investing at zero risk, which in turn is important for the way a stock is valued. If the risk-free rate is low, it pushes up the value of future cash flows. In the current environment, a low risk-free rate has propelled rapid growth tech stocks to higher and higher valuations, while lower growth or value areas have languished.
Hard to separate the micro and macro
As such, it can be difficult to separate the micro from the macro. Rob Burdett, joint head of multi-manager at BMO Global Asset Management, believes most fund managers recognise this. He says: “In our experience there are very few managers who dismiss the macroeconomic environment entirely, and those that do will still tend to have a ‘trend’ assumption for broad GDP for their country or region of expertise, or for things that affect how they look at a certain sector - the oil price perhaps.”
Burdett points out that it is often difficult to determine which factors influence a manager’s decision-making: “If the oil price is currently below trend and the manager likes an oil stock, are they subliminally applying an oil-price view? Or at least is their stock-specific investment case augmented by this factor?”
Gareth Rudd, co-manager of the Chelverton European Select fund, also doesn’t believe that stock-pickers can completely disaggregate companies from their economic environment. He says: “Investment processes should implicitly marry company-level micro-considerations with broader top-down considerations.
“Prospects for a given company cannot fully be understood or valued without putting the business into the context of its broader economic environment. For instance, is it economically sensitive? If it is, then the stage of a given economic cycle for its geographic markets must be fully understood. Generally, macroeconomic issues such as taxation regimes, geographical regulation, subsidies to alternative service/product providers, location and influences on supply chain all need consideration.”
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The ability to stand aside from macroeconomic conditions will partly depend on the fund manager’s approach. If a manager is looking for companies that display structural growth, then they can more readily ignore short-term macroeconomic trends. They may instead look for long-term themes – deglobalisation, demographics, technology adoption – to guide them to areas where companies may have a headwind.
“Value” managers, in contrast, may need to have a greater focus on economic conditions. This is particularly true at the moment when beaten-up, economically sensitive companies are providing the main hunting ground for value investors. Equally, stockpicking may also be more important in certain markets. For example, smaller companies usually have more stock-specific risk, whereas many larger companies will reflect broader global economic trends.
Just because a fund manager is a stock-picker doesn’t mean they won’t reflect on the wider economic environment: Rudd says: “The weightings and concentrations of defensive holdings (such as consumer staples or pharmaceutical companies) versus economically sensitive areas (financials or industrials) will definitely vary depending on their top-down view of the stages of economic cycles.
“Perhaps out-and-out technology investors will see themselves as being less concerned with bigger picture issues. That said, having superior technology alone is not a guarantee of success or performance if, for example, the company in question is serving sectors that are cyclical, or the company is domiciled in a territory that is subject to governmental change and taxation revisions.”
The key is what is driving the returns. Ramesh Mantri, adviser to the Ashoka India Equity Investment Trust (LSE:AIE), says: “We have a balanced portfolio construction approach (mix of procyclical and countercyclical), which ensures that alpha is driven by stock selection and does not get easily overwhelmed by non-stock specific risk factors such as market timing, sector rotation or other such factor exposures.
“The crucial distinction is that our effort is to understand the structural macro environment in which a company is operating and focus on the ‘micro’, while analysing a business and assessing its intrinsic value, and not to ‘predict’ and ‘bet’ on any short-term tactical macro variable.”
Burdett agrees: “I think a stock-picker can naturally reflect on the economic outlook, but that won’t be the key driver of their returns.”
Anna Macdonald, co-manager on the TB Amati UK Smaller Companies fund, says the pandemic is a good example of where macroeconomic factors have forced a reappraisal of long-term growth trends, which in turn has been reflected in managers’ stockpicking. She says: “'Value stocks have struggled and are now trading at the largest valuation gap to growth companies for generations. Many growth stocks that were doing well before the pandemic struck, such as e-commerce and video-gaming plays, received an incredible boost in demand during lockdown. Some of this adoption will stick, for example, online shopping will likely remain a bigger part of the overall pie.”
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Judging a true stock-picker
How can you tell if a manager is focused on the macro? Burdett says that a high turnover can suggest a manager is more focused on macroeconomic factors, sentiment and momentum. “Low turnover might suggest a bias to stock selection, where greater patience may be required in general. Those managers with the lowest turnover (below 25% per annum) are in my experience most likely to say they are at least agnostic on macro factors, due their unpredictability and complexity.” It is also possible to look at areas such as alpha score, beta or information ratio to understand if a manager is adding value through stockpicking.
Equally, it is important to note that there is nothing wrong with either approach. Done well, a stock-picker can be successful, but looking at the macroeconomic environment can provide additional insight. Problems arise when stockpicking is badly done, or the fund manager starts moving the portfolio around with each piece of GDP data, adding cost and diminishing returns.
Nitin Bajaj, manager of the Fidelity Asian Values (LSE:FAS) investment trust, concludes: “Fundamental analysis and owning good businesses, run by competent managements at attractive prices will continue to be important. If you can combine businesses that can grow revenues through time while earning high returns on capital with attractive purchase price, it should go a long way.”
In other words, stockpicking does the heavy lifting.
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