As one who has fought with global equity markets during the past 20+ years, I remain confused by the typical value investor’s belief that “top-down” issues are not worth contemplating. Why is it that Graham and Dodd investing (as practiced by many value investors) downplays the role of context in the investment process? Wouldn’t the prudent investor want to understand risks and uncertainties relating to the environment in which he/she is investing?
Perhaps because I have spent a great deal of time investing outside of the United States, I have never had the luxury of dismissing macroeconomics, politics, or the actions of other investors. Consider Indonesia before and after the Asian Financial Crisis. Investing in the best companies at reasonable prices did not protect you. The utter bloodbath in the currency markets destroyed dollar returns. Likewise, many value investors faced steep losses during the second half of 2008 and the first quarter of 2009. Herd behavior and self-fulfilling dynamics unfortunately drive these dynamics.
Most of the time, Third Avenue’s Marty Whitman is correct that macro-factors are neither predictable nor important. However, this is not always the case, and just as extreme valuations merit attention, so too might macro extremes matter. How can we value investors effectively determine if we are at an extreme, and should therefore worry a bit more about the context? Surely it is worthwhile to know if a particular asset class is a bubble about to burst. Such an insight might allow us to tilt the balance of the errors we inevitably make towards errors of omission, rather than those of commission. While we may miss gains, we might avoid painful losses.
I am not suggesting that we value investors abandon our focus upon the analysis of individual securities. We should not. Finding margins of safety from intrinsic values remains the most sensible method of investing. I am merely suggesting that when we do invest, we should be cognizant (rather than dismissive) of the environment and context in which we are operating. As eloquently summarized by Seth Klarman, we should all “invest bottom-up, but worry top-down.”