Happy Holidays to you and yours!
Here’s a small post before the holiday festivities.
Enjoy!
I care about the economy, as most people do. I want the economy to grow. A growing economy means more jobs and higher salaries. More money in people’s pockets means more people can afford a home. Profitable businesses can re-invest in their growth and hire more people. Higher tax receipts mean the government can spend more on education, healthcare, and infrastructure. A good economy brings prosperity and raises the standard of living for everyone. That’s the wealth creation process. Or to put it plainly, “growing the pie” so you can have a bigger slice.
However, when it comes to investing, people are fixated on the economy. They tend to rely on forecasts to make investment decisions. This is extremely difficult. You have to get a couple of things right. You have to 1) Correctly predict an event, 2) Correctly structure the investment, 3) Correctly time the market, and 4) Correctly understand its implications and the chain of events.
Making predictions is the easy part. Calling a recession is easy. Pointing out that high-interest rates will lead to higher defaults is easy. Claiming that a company is overvalued because of the lack of growth is easy. Identifying that large deficit spending leads to inflation is easy. But getting the timing right, and the depth of the outcome, that’s tough.
And if you don’t structure your investment properly, that can be costly. Let’s say you found the perfect short candidate, you then have to find and borrow the shares to short. That can be expensive. Or instead, you buy put options. That comes with a specific target price and expiry dates. Again you have to be great at market timing. Remember, John Maynard Keynes gave us this warning: “The market can stay irrational longer than you can stay solvent.”
Worse, you nailed a prediction but the market went the other way because you misunderstood its implications. Even worse, you made a prescient call on a company’s sluggish fundamentals, and despite the lackluster results you watched the stock rally. It happens all the time. The market doesn’t care about your brilliant analysis. The market doesn’t owe you an explanation.
When you place money on a prediction, what ends up happening is that you become so obsessed with the outcome that you lose sight of what you are supposed to do: buying incredible businesses at a reasonable price and holding them for a long time. Even if it’s a little bit of money, the “bet” consumes your energy and time. It’s a distraction. The opportunity cost can be high because you could be doing something else with that money.
Let me dig deeper. Investing on predictions is a mistake. First, acting on predictions means you are deviating from your financial plan and sound disciplined investing. Second, nobody can accurately answer these questions: What’s the GDP forecast for next year? Will there be a recession? Will the economy have a soft or hard landing? Where will interest rates be next year? Will the central bank cut or raise rates at the next meeting? How many rate cuts are priced in for next year? The unemployment rate? Will inflation be within the central bank’s target? Where will the S&P 500 close? Nobody gets this right or the full extent of the implications. And putting money on the outcome is gambling, not investing.
Forecasters get a lot of attention. Their financial bite sounds good on TV. It drives headlines. But they are wrong, all the time. Nobody knows what the future holds. Matter of fact, where are the experts that correctly predicted the current state of the economy you are in? The strong consensus of the past couple of years was proved entirely wrong. It was a done deal that we were supposed to be in a recession right now. Nope, the economy is still strong. Just look at interest rates. No economists last year called the current level of interest rates. Sure, once in a while an economist will nail a prediction. If you predict 13 of the last 5 recessions, you will eventually be right.
I don’t ignore the economy and macro stuff. I quite enjoyed it. I read the news. I stay informed. I have an idea of the state of the economy. Understanding how an economy works is important and useful. But I’m not obsessed with it. I’m aware that I could be 110% wrong. And more importantly, I don’t make investment decisions based on economic forecasts. I never sold a stock because some economists think the GDP will shrink next quarter.
The economy is like the weather. People always try to predict it. Here’s what you need to understand: Some days it will be cloudy. Some days it will rain. On other days there will be a hurricane. Then it will be sunny. That’s the economy. Earnings will go up and down. Inflation will go up and down. Interest rates will go up and down. The market will gyrate up and down. The economy will grow and retract. Once you understand that, there’s a better approach.
Instead of calling for a direct event, prepare for possibilities and probabilities. Focus on companies that are prepared for everything. Since guessing is unreliable, it’s probably better to invest in a company that can withstand a recession. Or even better, companies that can roar out of a recession stronger.
The position you are in when you enter a recession will largely determine how you come out of it. Why invest in a company that would fall like a house of cards at the first sign of distress? Or a company that constantly needs external capital to stay in operation. What happens when that money source dries up? Would you rather enter a recession holding Berkshire Hathaway, a company in a position to get great deals because certain businesses are desperate for money, or a company that’s vulnerable to an economic contraction? Isn’t it preferable to hold companies that could perform well across all environments?
Nobody wishes for a recession. Recessions are terrible. The economy contracts and people can lose their jobs and their homes. Recessions happen. Does that mean you shouldn’t be invested in a recession? If you invest for the very long term, you will live through many economic cycles. I stayed invested through many cycles and I benefited. It’s not easy. A bear market is a fraught experience. But staying invested is superior to the alternative, which is getting in and out of the market. Long-term investors that stay the course, and can withstand the storm, are eventually able to reap the rewards.
Recessions can offer investment opportunities. It’s during these fearful times that you can buy high-quality companies at reasonable prices. If an asset is out of fashion, it means it’s cheap. What are they? Typical criteria to look for are a solid balance sheet and a steady business. They generate strong cash flows, maybe they pay a dividend, and their business is recession-resilient. Too simple? Well, how does a business go out of business? It dies because it runs out of cash. As a start, make sure your investment doesn’t run out of cash. When researching a particular company, go back in time and find out how it fared in the last recession. That should give you an idea of the character of the business.
A great investment shouldn’t be different during a recession or not. Some might disagree with that statement. Some said that during a downturn, you should seek “safe-haven” or “defensive” investments. And during a bull market, you should invest in growth. I take issue with that reasoning. It’s not necessarily wrong, but it’s flawed. Let’s say the consensus calls for a recession, well it’s probably too late to buy those “defensive” investments because the recession is price-in (e.g. “everybody now is the time to buy gold”). If you overpay for an asset, it loses its defensiveness and you are taking more risk.
Of course, when you invest in a business, you are dealing with the future. And when you deal with the future, you have to make certain assumptions. You have to determine future cash flows and how the business will evolve. You will likely be off. That’s why you should apply a large enough margin of safety. To protect yourself from unforeseen things and misjudgment. Unforeseen circumstances are part of life, aren’t they? A margin of safety can take many forms, like paying a discount to those future cash flows or making sure there are enough assets backing your investment.
At the end of the day, recession or not, the goal is to buy excellent businesses that generate growing free cash flow at a reasonable price and hold them for a long time. That’s the approach I recommend if you want better performance. It’s a better approach than calling direct events and marketing timing. If economists are so great at forecasting, why ain’t they rich?
Article by Brian Langis
