Why a macro-overlay is important for all investment styles

Since the dawn of asset management portfolio managers have been grouped and forced to identify themselves into two sub classes namely, top down/ macro strategy or bottom up/fundamental strategy. This unrealistic dichotomy has become entrenched in the way investor’s view portfolio managers and to some extent the way portfolio managers view asset management at large.

I believe the main catalyst has been the vast amount of finance literature written and taught on these two schools of thought. From university textbooks to the well-known certifications that have been exalted for decades students have been taught that you’re either a macro investor or a fundamental one.  Even if one was to view these two styles as extremes on a linear spectrum, they would also be incorrect and ultimately run the risk of managing a portfolio where one style would need to be selected in exchange for the other. An example would be “I’m not too confident on the macro-outlook for this stock but I’m willing to take a chance given how fundamentally sound the business is.”

A more apt conceptualisation to use would be a multi-dimensional or non-dichotomous spectrum which allows both extremes to exist at the same time.  This concept exists in physics, engineering, ecology and medicine. An example is where cases have been documented where both early stage and late-stage cancers have been documented in the same patient at the same time. In this case both a macro and fundamental strategy could be used when selecting companies to invest in. One could argue that if a hybrid model of both is not used one stands the threat of stunting significant alpha generation.

A popular subset of fundamental investing which is characterised for its disfavour of macro variables is value investing. Which first gained major prominence by the great Warren Buffet and his mentor Banjamin Graham who wrote the Intelligent Investor, a book Warren Buffet holds in high regard and one every finance professional should have on their bookshelf. Graham philosophises that priority should be placed on investing in firms that are trading at substantial discounts to their intrinsic value rather than attempting to predict broad macro-economic trends. He articulated that it is futile for investors to attempt to reliably predict the future movement of either the economy or stocks and that companies should rather be bought with a margin of safety to best protect value in times of market distress. Warren Buffet went on to adapt the strategy further by integrating a quality overlay to his investment decisions.

Theres no denying that a fundamental strategy is sound and has withstood the test of time, Warren Buffet has seen to that. The question bodes that with today’s broad access to information and the ease at which anyone can get insights into the health of economies, sectors and companies should bottom-up strategies not be coupled with some form of a macro-economic overlay?

One of the most respected and oldest surveys on macroeconomic forecasts is the Survey of Professional Forecasters (SPF) which aims to collect and publish macroeconomic forecasts from a panel of experts in economics and finance. This survey dates back to1968 and therefore functions as an excellent proxy to gage the accuracy of macroeconomic forecasting among finance professionals over time.  Studies have shown that these forecasters have been able to predict short term economic changes, with some individuals being able to do so consistently. Furthermore, research has shown the overall accuracy when forecasting inflation has been increasing in recent decades which could be due to the broad availability of data and sophistication in technology. It is important to mention though that forecasting accuracy has been seen to dissipate when the panel attempts to forecast economic variables for longer time horizons.

Another study done by the University of Kansas compared the forecasting ability of top-down and bottom-up strategists when it came to company earnings projections. The study showed that the top-down analysts were generally less optimistic and more accurate especially during periods of economic uncertainty. The bottom-up analysts showed an “optimism bias” which they suspected was due to them being influenced by company management and industry trends while not completely accounting for the macroeconomic headwinds. By factoring in broader economic realities, the top-down strategists were less prone to this over optimism and when they believed the economy was slowing down, they were more likely to make changes to their earnings forecast which in turn affected their stock selection and portfolio management.

At Helfin Global Capital we believe a sweet spot exists in this non-dichotomous spectrum. Our investment process is characterised by blending both top down and bottom up analysis across our opportunity set, which we believe ultimately results in a portfolio of global shares that are well position to outperform.

We believe that having a comprehensive view of world macroeconomics aids in identifying the countries that are well positioned to grow from a GDP standpoint. A nation with a strong balance sheet, stimulatory business environment and stable inflation has all the right ingredients that conduces significant growth for the foreseeable future. Subsequently, sectoral research is conducted to identify which themes are best poised to outperform over the medium to long term. Once we decide on our set of sectors, we begin a deep analysis to find the companies with the greatest comparative advantage and propensity for growth.  This process encompasses the macroeconomic part of our strategy with the aim of reducing our opportunity set to a handful of stocks that are well positioned to grow from a macroeconomic standpoint.

Henceforth, we begin a stringent comparative analysis where we analyse the fundamentals of each company within each sectoral subgroup.  Financial ratios are compared in order to identify the most profitable companies as well as the most financially sound that are efficiently making use of capital, ultimately resulting in a set of quality companies that we believe are well poised to grow earnings. We proceed by valuing the top candidates using our in-house valuation models. We forecast free cash flows for the next four to five years using prudent growth metrics that are below consensus and as a last suppressor we assume a terminal free cash flow growth rate of zero. This provides us with what we believe to be a tremendously anaemic valuation, which we use to assess if the stock is undervalued relative to the market price ensuring we have a margin of safety if we buy the share. Lastly, we make the call to either enter the best candidate or several, depending on our conviction in the sector and the top candidates as well as at what prices we feel comfortable to do so.

We believe that following this framework exposes our clients to a portfolio of shares that stands to benefit from the merits of both a fundamental and a macro investment strategy. The companies selected, we believe, are well positioned to benefit from macro tailwinds and PE expansion with less chance of sizeable drops in price given the margin-of-safety that is present.

There is no denying that fundamental strategy is a sound and has earned its stripes time and again, its principles are deeply rooted in the tenets of capitalism itself. That said with globalisation and technology having created a more interconnected world market over the past five decades where investor sentiment has become a driving force for market movements perhaps a macro-overlay strategy is beginning to earn its stripes too.