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The fact we cannot predict the future is perhaps the most obvious of these fundamental truths. What makes this particularly relevant amid a research-driven arms race being waged across asset management to gain any edge, however fleeting or illusory.
This may have hit a peak last year, with the launch of an AI-driven hedge fund that pays data scientists in cryptocurrency to crowd-source updates to its algorithmic, machine learning model. But even spreadsheets can become a dangerous diversion when they feed into overconfidence. The ease with which analysts can create elaborate forecasts, incorporating an endless number of currency assumptions or monetary-policy possibilities, creates a paradox of choice. And rather than offering clarity, this scenario-building generally distracts more than it divulges.
Related to the idea that the future is unknowable is the fact that many investors can pay undue attention to macroeconomic factors. It’s not that investors shouldn’t be aware of what’s going on in the economy or understand how it can influence an investment thesis; it’s just that the odds are stacked against those who claim to have any unique insight.
There is a considerable amount of literature, for instance, that has documented the challenge of trying to predict economic trends. The Brexit referendum vote, which took the markets by complete surprise in 2016, provided yet another example. But even after economists learned of the outcome, they proved to be no better at forecasting how it would impact growth. The point is that it’s not just the “unknown” unknowns that make macro predictions so unreliable.
The inverse to relying on the “unknowable” is to focus intently on the variables that are both discernible and can be quantified. This is why true value investors take a bottom-up approach to security analysis and scrutinize, in depth, company fundamentals, business momentum and catalysts for growth. What shouldn’t be overlooked is the role of strong governance and capable management.
This is an area that has improved exponentially, post Enron. That’s not to say that lapses in governance don’t occur. The collapse of UK construction company Carillion demonstrated this last year. But with greater regulatory scrutiny and the growth of the activist investor universe, directors are generally quicker to demand accountability when companies underperform.
It’s also a misconception to think management assessments are purely subjective. What can be most telling is the analysis that goes into how management deploys available cash flow. At a high level, there are generally five alternatives. From an operational perspective, it comes down to the historic “buy vs. build” question, as capital can be deployed to either fund organic capital investments or in M&A. When these paths don’t offer a compelling return-on-investment, cash flows should be used to pay down debt or can fund stock buybacks and shareholder dividends.
Just as company management should exhibit discretion in their pursuit of growth, the same philosophy applies to investors. For instance, many “stock pickers” have shown a tendency during extended market runs to abandon fundamental analysis in favor of momentum strategies. They will pile into stocks that are already winning in the hopes they will continue to win. The growth of ETFs has only amplified this trend, as investors, without any analysis at all, will move in and out of broad categories to gain exposure to thematic trends, valuations be damned.
While momentum can certainly work -- as long as stocks keep winning -- investors expose themselves to sharp reversals when fortunes turn. Witness the $57 billion haircut to Apple’s market cap when the company revised its 2019 Q1 guidance in January, or the $120 billion in market cap that Facebook lost in one particularly brutal trading session in June 2018. Each example underscores why value investors are so focused on finding a margin of safety.
Make no mistake, these haven’t necessarily been easy times for value investors. The monetary stimulus coming out of the great financial crisis coupled with fiscal stimulus in more recent years has driven asset prices ever higher. In this environment investors simply need to be in the market to generate returns.
When we begin to hear the detractors start to screech that value or fundamentals no longer matter, this is typically a sign to double down on our philosophy. We’re already seeing indications that the next value cycle has begun to take shape, thanks to Brexit concerns and trade issues.
But our approach is the same regardless of the backdrop. When we get the fundamental story right, and craft a portfolio of companies showing attractive value characteristics, strong business fundamentals and catalysts for growth, we can eliminate the uncertainty of trying to find a new path.
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