The Macro Trumps All Else

By Harris Kupperman   Jul 8 2010 10:23AM www.adventuresincapitalism.co m

When I read Security Analysis, the investment bible by Graham and Dodd, I am transported to a past era when investment life was easier. You could focus your energies on finding companies trading at less than fair value. You focused on the balance sheet and the income statement. The economy was static. It grew a few percent a year and economic life was rather uneventful. There were panics and crashes, but these were usually confined to certain industries like railroads where there had been overexpansion. Most companies were immune to these economic disturbances.

Graham and Dodd could look at the Dollars on the balance sheet and feel confident that they would not be marginalized by the next round of quantitative easing. They didn’t have to worry about the fiscal sanity of their government. It was just taken for granted that the US government finances were solvent. Governments always enacted arbitrary laws, but no one had to worry about wholesale regulatory change every time congress was in session. Regulatory regimes changed gradually—if at all. Liabilities were what showed up on your balance sheet. An investor did not have to worry about wolf-packs of ambitious lawyers descending on every company in crisis and exacting an extra pound of flesh. Tax rates were constant enough to allow for long term economic planning.

Prudent investors demanded a margin of safety before investing in a company. That margin of safety protected you from all of the above and still left plenty of room for upside. That is because most of the risks to a corporation were quantifiable. This let investors focus on their companies and ignore the newspapers. The macro world was largely irrelevant. You bought great companies at reasonable prices and waited until the share prices appreciated. World events simply didn’t matter. The business cycle only barely mattered. Buy cheap and let compounding work in your favor.

Now, investing seems to revolve around just one factor. What will the government do next? Which businesses will they clamp down on? Which will be subsidized? Who will get the next bailout? Will various tax subsidies be increased or eliminated? What new laws are in the mix? How can you anticipate all these changes?

There are no constants any longer. You cannot rely on anything. Everything seems perpetually in flux. The world economy is once again imploding. Will it be allowed to collapse? Unlikely. When will the next bailout be announced? What shape will it take? Who will the winners be? That really is the question that everyone demands an answer to. When is the next bailout? Bigger, Badder, More Corrupt—that’s our country’s new mantra. Which companies will lobby the right congressmen and be included? Which will be destroyed?

How do you invest in an environment like this? Say you look at a company. Do you want a business that’s economically sensitive—or one that has a strong and liquid balance sheet? Are you betting on them printing just a little money—or a full out Weimar style debasement? What’s the expected tax rate? It’s going up. That’s for sure. Will carbon taxes impact my businesses? What about changes in health care legislation? There are dozens of issues currently debated in congress. They all impact businesses.

Then there’s the whole wide world outside of the US. A generation ago, most businesses were regional. You could ignore what happened in China. Now China is the lynchpin of global economic growth. How can you decipher China? It’s monolithic. Will the Euro survive? Will it be debased or discarded as the component nations go their own separate way? Imagine the world’s largest economic bloc simply repudiating their currency? How do you invest for that? The whole investment climate is a daisy-chain of binary outcomes that are mutually exclusive. The middle ground seems vanquished.

These are the issues that I tango with daily. I invest in small businesses. Over the past decade, I’ve made a lot of money doing this. However, it continues to become more difficult. The rules change every day. A decade ago, I mostly ignored the macro—now I spend most of my time analyzing it. Small companies are illiquid and volatile. That has never bothered me before. Now I increasingly want more liquidity. I want the ability to react to the newest crisis. I am not a trader—now I have no choice. Every morning, I have to throw out all the old rules and start again. The macro events rule—businessmen are impotent.

I want to buy great businesses and put them away for years at a time. No longer can you trust that a dominant business will remain dominant. It won’t be a competitor that destroys the business. It will be an errant politician or a bad hedge on their Euro exposure. Volatility is destroying real businesses. Is every company now expected to hire whole trading desks to manage various exposures? How can you expect the most basic elements of a business to remain stable when the currency itself is increasingly detached from reality?

I have no problem navigating economic booms and collapses. That’s part of investing. What I strongly object to is the government increasingly inserting itself into the economy. You cannot manage an economy based on the applause meter of 24-hour news programs. You cannot manage an economy. Period. It is not debatable. Unfortunately, our government continues to corral the various market forces and lead them towards whatever myopic utopia politicians think will be needed for reelection. This creates economic anarchy. If you could run an economy based on erratic rules and crony capitalism, Argentina would be a world power. If you could print your way to prosperity, Zimbabwe would be a world banking hub. If you could command the economy to heed you, the USSR would still exist. I’m scared that world leaders have taken all the worst lessons of the last generation of economic thought and bundled them together into some sort of economic doomsday machine.

I apologize for this stream of consciousness. I’m frustrated. For my whole career, I believed that a great business with a strong return on capital would outperform all other asset classes. What if that isn’t true? For the past three years, only the macro has mattered. Going forward, what if the macro is ALL that matters? What if you have to rapidly jump from asset class to asset class as the rules change weekly? I hope this isn’t the case. However, it is time to consider that possibility. 

In an age of increasing uncertainty, market multiples will collapse. Investors will demand an even larger margin of safety. Earnings will become increasingly volatile. Investors will focus more and more on the balance sheet. Unfortunately, most companies trade at many times book value. Some of the largest companies in the US have negative tangible book value. I expect to see market multiples continue to decline. Why would you risk your capital in uncertain times when you can just buy gold and ignore all the chaos around us? That’s really what I wrestle with the most. Gold will continue to go higher over time—if only because world governments seem determined to act foolish. Can you find companies that will outpace the price increase of gold? It will be difficult. The macro forces arrayed against business are just that extreme. You can no longer ignore the macro. The macro outweighs all else now.  

Harris Kupperman

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Harris Kupperman during the first five years, the fund continued to grow with the majority of the capital increase the result of performance-not inflows. This success was the result of the strategies that he talks about in this website.