Definitely – I have rules and examples. Let’s talk about a few example trades where I entered a position based on the macro view, and then my three awesome rules for making safer wagers on macroeconomic conditions.
Know Thy Customer
When you want to make a play on general economics (economic growth or contraction) you have to know the business’s customer. This is the starting point. If we’re going to play the macro outlook, then we have to know how the macro affects a particular business, which necessitates the knowledge of the business’s customer.
Here are a few things you need to know about any potential investment:
- Who is the average customer? – Is the average buyer a 20-something male, or a 50-something married couple. There’s a big difference between the potential rebound for companies that sell to a 20-something and those that sell to a nearly-retired couple. Think income. Unemployment is horrible for 20-somethings, so any economic improvement favors a company selling products to younger people more so than companies that sell to older people.
- How does the customer make money? – Does the company’s core customer earn a salary? Is the core customer in management, sales, or do they own their own business? This is key. People who work in management, sales, or who own and operate their own business usually have some kind of leverage to the upside in the form of pay raises, bonuses, or improving earnings for their small business.
- Who buys the product, and why? – Are we talking about luxury goods, or something simple like hand soap? Again, luxury good consumption increases and decreases at a far faster rate during economic expansion and contraction.
- How does the customer buy the product? – This can fuel or slow sales considerably. Let’s say you own shares of stock in a company that sells some kind of crazy sunscreen at luxury resorts. Such a company has discrete upside or downside, since the economy has to reach a certain level of improvement, which I’ll call so-good-I’m-going-on-vacation, to provide for any increased sales.
- What is the per-unit price? – I favor rebound companies that sell something with a smaller per-unit price. There are far more people that can afford a $100 golf club as a luxury than a $40,000 vehicle. I can expect to better “trap” any upside in the economy by selling thousands of golf clubs than a few extra, higher-end vehicles. Think about the basic tenets of personal finance. People reportedly spend $150 a month on coffee with far less concern than a $150 a month car purchase.
- How does pricing compare to competitors? – This is, again, something where I prefer a brand to be just about average. Ideally, it’d be the lowest cost “brand” above all the other generics, knock-offs, or whatever you would like to call them. Being the first step up the chain, it’s the business that benefits first and often the most from economic improvement. Consumers often reject the most expensive brands, but purchase repeatedly from the second tier when incomes rise.
So let’s run through a macro-play of mine based on these questions – Adams Golf. I liked the numbers with the company, but more importantly, I liked the macro-play:
- The average customer is older, wealthier, but still at an age where he or she is heavily invested in the stock market, real estate, and his or her career.
- People who play golf have larger investment portfolios and tend to work in management or own their own business. This means that any recovery affects the golf market more than other consumer product markets.
- Customers buy the popular Adams hybrid clubs to improve their game. As an “add-on” to an already full set of clubs, this makes for a great “feeling good” purchase as an inexpensive luxury item.
- The company is priced well below it’s higher-end peers. Per unit prices are just over $100 for the hybrid clubs.
This question and answer session is something you should do with yourself after already identifying a potential investment with or without the macro-play.
Beer + Buddy = Capitan Obvious
Any play on the macro environment, for me, has to be an obvious one. Buying the S&P500 index because I think the economy will get better in the future is not attractive to me. I have no way to know how an increase in GDP affects profits at S&P500 firms. I just don’t. Is there a way to know? Probably, but the best thing I ever learned is that I can’t learn everything.
You have to be able to explain your rational investing process to someone who does not understand the market. This is a must-do step, no exceptions!
I like for my macro plays to be logical, and obvious. The macro should be something I could explain to my friend with no interest in the market over the course of two brews at my favorite trashy bar. My friend has business experience that I can sum up with a few words: manceptionist at a salon.
If I can explain it to him, and he can see it as obvious, then I know it’s a go. This is criteria #1 for whether or not you should play the macro environment – test your theory on a friend with no business experience. Coincidentally, people with no business experience make up the largest segment of realized business valuations on Wall Street.
Where you go from here?
The example above was a past play. It’s gone and done – sold to the highest bidder. But what if we want to keep playing the macro environment? How do you enter into a new investment?
- Bet on a downturn? Corporate cash suggests companies can live for a very long time without additional sales.
- Bet on a recovery? How much of that is already priced into the 25% gain since Fall 2010?
You’ll notice I’m not playing the macro with stock any more. No way, dudes. The best time to play the macro is when you know brighter times are coming back. I don’t know for certain – not like I did a few years ago – that brighter times would show through. I’ve moderated my portfolio, and continue to look for firms with less cyclicality and discounts that are due to events on the micro level rather than the macro.
Transocean? Macro-play made safer with options and the fact it essentially “locks in” oil prices as contracts are multi-year. Wouldn’t touch the stock, but options gave me a margin of safety. Darling? Even with a European and Asian slowdown the firm will still make more than the twice the yield on corporate bonds. Ford? Macro-play made safer with options and the fact that people HAVE to buy cars.
When the bottom drops out and companies are STILL profitable, that’s when you play the macro. I mean, if you buy a firm with FCF yield of 10% in a down cycle, you earn 10% per year even if the economy never recovers. If it recovers and yield goes to 15% – the stock price is going to rise to compensate for that, pushing yield back to 10% and the stock price up 50%.
But now companies are betting on expansion. They’re adding expenses in the pursuit of revenues. Keeping the doors open is getting more expensive, and any cyclical bet here has far more downside than upside, especially as firms increase their operational leverage.
The 3 Must-Follow Rules for Macro Plays
- It has to be so obvious that you can explain it simply, to anyone, and do so with conviction to the point that they can repeat the logic back to you with a grin on their face.
- The company has to generate a free cash flow or earnings yield twice the return on long-dated corporate bonds regardless of economic improvement. (Use the current rate on the 30-year US Treasury bond and double it.) Don’t pay for future earnings growth you might have to live without. Buy expected earnings into the future and smile when the extra comes along as an added kicker.
- If the company is unprofitable in a down cycle, it must have enough net current assets (cash, receivables, and inventories less current liabilities) to survive at least two more years based on earnings from the most recent year with poor macro performance.
Are these rules scientific? Yeah right. They’re scientific in so far as they’ll give you a very good margin of safety. These are also the rules I try to stick to for any macro play I like. So, if all else fails, you can at least have the confidence that we’re using the same losing strategy. 😉
In all seriousness, these rules work really well. I assure you that if you qualify any investment with the decision tree above, you’ll do quite well. You’ll probably never hit extreme home runs where you turn $10 into $10,000, but you won’t ever lose your shirt, either.
In the pursuit of profits, all attention must first be paid to the preservation of investment capital. Macro plays are no different, and it is fundamentally wrong to take on additional risk solely for the pursuit of higher returns. Returns and risk have a weak relationship when investors start first with the goal to preserve investment capital.
If you enter into an investment hoping to kill it on the macro environment BUT buy at a price that is reasonable EVEN IF the macro does not provide the catalyst you expected, THEN you still win. The best way to do so is to follow the 2x risk-free rate for free cash flow. The best way to make sure the market will agree with your thesis at a later date is to test it on a friend, ideally one who does not spend an hour a day watching CNBC or reading the Wall Street Journal.