Boombustology and Value Investing: Why Context Matters
As one who has fought with global equity markets during the past 20+ years, I remain confused by the typical value investor’s belief that “top-down” issues are not worth contemplating. Why is it that Graham and Dodd investing (as practiced by many value investors) downplays the role of context in the investment process? Wouldn’t the prudent investor want to understand risks and uncertainties relating to the environment in which he/she is investing?
Perhaps because I have spent a great deal of time investing outside of the United States, I have never had the luxury of dismissing macroeconomics, politics, or the actions of other investors. Consider Indonesia before and after the Asian Financial Crisis. Investing in the best companies at reasonable prices did not protect you. The utter bloodbath in the currency markets destroyed dollar returns. Likewise, many value investors faced steep losses during the second half of 2008 and the first quarter of 2009. Herd behavior and self-fulfilling dynamics unfortunately drive these dynamics.
Most of the time, Third Avenue’s Marty Whitman is correct that macro-factors are neither predictable nor important. However, this is not always the case, and just as extreme valuations merit attention, so too might macro extremes matter. How can we value investors effectively determine if we are at an extreme, and should therefore worry a bit more about the context? Surely it is worthwhile to know if a particular asset class is a bubble about to burst. Such an insight might allow us to tilt the balance of the errors we inevitably make towards errors of omission, rather than those of commission. While we may miss gains, we might avoid painful losses.
I have developed a five-lens framework for identifying financial bubbles before they burst. The first lens is microeconomics. In direct contrast to established economic theories of equilibrium, there are occasionally times when higher prices generate demand (rather than, or in excess of, additional supply). Such conditions are particularly prone to self-fulfilling dynamics likely to create bubbles.
The second part of my framework focuses upon credit conditions and the cost of money. While First Eagle’s Jean-Marie Eveillard has rightly highlighted the dangers of using leverage for investors, the same concern is valid for an economy in aggregate. If the foundation of prosperity is built on borrowed funds, it is only a matter of time before instability ensues. One of the primary culprits of such excessive borrowing can be found in overcapacity/malinvestment.
The third lens in my framework is psychology. We humans are unfortunately not the strict, economic-optimizing agents that social scientists might model us to be. We are plagued by cognitive biases that manifest themselves in overconfidence and anchoring upon irrelevant numbers. One of the best indicators of hubris is found in the phrase “world record price.” Whether paid for a building or a piece of art or a bottle of wine or a commodity, such prices are usually a sign of speculative juices running wild.
Fourth, political developments matter. Governments (particularly democracies) are subject to popular sentiment and as such, are willing to change the rules and/or generate moral hazard by bailing out the least prudent of market participants. Price distortion and politically motivated subsidies, handouts, and taxes can also alter incentives in a dynamic manner.
Finally, popular sentiment and herd behavior can affect securities prices more dramatically and potentially for longer than fundamental developments might. As such, understanding the actions of others and linkages to relevant markets has the potential to shed insight upon contagion risk.
In aggregate, these five lenses provide a probabilistic framework for increasing the odds of accurately identifying bubbles before they burst. Consider the case of China today. Let’s apply my five-lens framework to China.
China today exhibits many of the tell-tale signs of a great speculative mania. Higher prices in many of its asset markets are generating demand more rapidly than supply. Consider property markets in which leverage and prices seem to be rising together in a highly reflexive, self-fulfilling manner. Higher prices are generating demand more rapidly than supply. The cost of money is inappropriately cheap, driving mal-investment and creating overcapacity. Ghost towns and vacant malls are increasingly visible manifestations of this problem. Confidence is bubbly, with skyscrapers rising, art markets booming, and conspicuous consumption on the rise. Chinese buyers have set world record prices for art, wine, pigeons, and even dogs! Moral hazard runs rampant, and national-provincial dynamics are generating GDP growth through unnecessary construction. Perfectly usable infrastructure has been destroyed and rebuilt in pursuit of GDP. Finally, amateur investors seem ubiquitous, and the largest developers today are state-owned enterprises using money from state-owned banks to buy land from the state.
Clearly, the ramifications of a Chinese slowdown would have material impacts upon commodity markets, emerging markets, and even the S&P 500’s business and earnings mix. In short, how China goes, so goes the world economy. It seems highly imprudent for investors to not consider the possibility of a meaningful slowdown in China’s economy.
I am not suggesting that we value investors abandon our focus upon the analysis of individual securities. We should not. Finding margins of safety from intrinsic values remains the most sensible method of investing. I am merely suggesting that when we do invest, we should be cognizant (rather than dismissive) of the environment and context in which we are operating. As eloquently summarized by Seth Klarman, we should all “invest bottom-up, but worry top-down.”
Vikram Mansharamani, PhD