Tuesday, July 1, 2008

From Joel Greenblatt to Jim Rogers, Part III: The Importance of Macro Trends

The intent of this series of posts is to put my later posts about specific investment ideas in context, by describing the evolution of my thinking on investing over the last year and a half, as I've made mistakes and tried to learn from them. I'm going to break this up into a few posts, just to keep each post from being too long.

The Importance of Paying Attention to the Relevant Macro Trends

Another lesson I picked up over the last year and a half was the importance of paying attention to the relevant macro trends when evaluating potential investments. It's important to remember here that the Magic Formula is a backward-looking screening system: it uses trailing 12-month data to calculate earnings yield and return on invested capital, on the theory that, more often than not, trailing data are predictive of future performance. The impact of relevant macro trends can determine to what extent this will be true. For example, a wallboard company might have had impressive trailing twelve month earnings at the beginning of 2006, due to the residential construction boom that peaked during the previous year, but those trailing earnings wouldn't have been a good guide to its earnings during the construction bust to come. Below is an example of a mistake I made last year by not paying attention to the relevant macro trend.

Anatomy of a Mistake

I originally wrote the following postmortem on the GuruFocus website on April 24th. Since then, the stock is down a little bit more (it closed at $11.78 today), but otherwise nothing has changed materially.

Recently, I've written about the importance of acknowledging and addressing relevant macro-trends when evaluating investment opportunities. This doesn't mean that I think one should only invest in a company when the relevant macro-trends or macro-environment are in its favor; I would consider investing in a company facing negative macro-trends or a negative macro-environment if I thought those negative macro-trends were fully priced-in, or if I thought those negative macro-trends were nearing an end.

One example of an investing mistake I made by not paying attention to the relevant macro-trend was my investment in Barrett Business Services Inc. (BBSI) at $24.28 per share last year in my Magic Formula portfolio. Today BBSI closed at $12.50 per share.

Barrett is a staffing/PEO firm serving small and mid-sized businesses primarily. When I bought the stock last year, Barrett Business Services was fundamentally a solid company: no debt, lots of cash, a no-nonsense CEO who had steadily built the company up over 27 years and owned 25% of the company's stock, etc. That's all still true today, but nevertheless, it was a mistake to buy the company when I did, because I didn't consider the relevant macro-trend.

The relevant macro-trend in Barrett's case was the real estate bust in California. Although Barrett has operations in several regions of the country, and clients in different industries, most of its business comes from California. Because California experienced one of the biggest real estate booms in the country, it also is experiencing one of the biggest real estate busts, and the effects on California's economy have been worse than on the national economy so far (on today's conference call, Barrett's CEO estimated that California's unemployment rate is now about 7.5%). Also, during economic downturns, outsourced/temporary workers are often the first to get laid off, so Barrett was quick to feel the consequences of this (conversely, as Barrett's CEO pointed out on today's call, outsourced/temporary workers are also the first to get hired during an economic upturn).

Ideally, the best time to invest in a company like BBSI would be just as the negative macro-trend was ending, but of course there is no way to time that exactly. That doesn't mean, however, that I can let myself off the hook for buying BBSI when I did. The magnitude of the real estate bust in California was obvious at the time, and I should have connected the dots and realized how this would lead to a deterioration in California's labor market.

On today's conference call, Barrett's CEO discussed how he would be using this economic downturn (as he had used previous downturns) to increase market share and position Barrett to do well during the next economic upturn. I have no reason to doubt that. I would consider investing more in BBSI within the next few months, assuming it's still on the Magic Formula list. It was still a mistake for me to buy BBSI when I did though, at the beginning of the current downturn.

A counter example of a stock I bought last June that was facing a positive macro trend is the oil royalty trust BPT that I posted about here earlier today and last Friday. Not surprisingly, I am up 50%+ on BPT over the same time frame that I am down 50%+ on BBSI.


Rudy G. said...

A time period of one and one-half years is not a statistically significant period to draw long-term conclusions.

As you've noted previously, the Magic Formula worked out great for a short period (after its wide-spread dissemination) and in back testing only to be dreadful latey.

Unfortunately, you can only know after the fact - what the best plan will be going forward.

DaveinHackensack said...

Rudy G.,

Thanks for your comment.

The intent of this particular post (Part III) wasn't to say that the Magic Formula won't work as is over the long term (it may), but to highlight the importance of paying attention to relevant macro trends. I think that by doing so, one can avoid making some obvious mistakes (as I did with BBSI), and, in some cases, one can position oneself to benefit from macro trends (as in the case of BPT). I'll try to make this a little clearer in my next post in this series.

Regarding the performance of the Magic Formula since its widespread dissemination, I am not aware anecdotally of any short period of great performance, and don't believe I've mentioned one here.

"Unfortunately, you can only know after the fact - what the best plan will be going forward."

Here we disagree. If I thought this were true, I wouldn't be writing this. I think I've learned some things that will increase my chances of success over the next several years. Time will tell, of course.

Anonymous said...

Thanks for the thought-provoking post. I came across it while doing research on BBSI (which happens to be a part of my LTH portfolio).

Your thesis that one can choose from among undervalued stocks those that ride a current macrotrend, seems very tempting at first sight.

The issue I have with it is that while it is easy to look back and say for example that of course, ENERGY was the clear macrotrend to stick with, it is far more tricky to try to predict a trend ahead. It may continue to be energy, but it may not (if and when demand eases). The recession might last another year or longer. But it might not. The market may rise only when the economy improves, but it may equally bottom out much earlier while the economy is still in the doldrums (as had happened many times in the past).

By trying to time the trends, one gets easily caught up in hope and fear, and thus brought back to where one would be WITHOUT a value strategy (be it magicformula or something else) - just picking stocks based on conjecture...

So I personally prefer to ignore such temptations, diversify over many industries, and focus on the quality of the companies, their value, and their long term potential.

This may mean missing on immediate term returns and being generally 'too early to the party'. On the other hand, it saves one a lot of emotions, time, effort, and the need to spend hours a day checking whether a trend is still intact and all the other things that short term investors/traders are obliged to do. And to me, that's a fair trade off.

On all the counts mentioned above, I'm happy to be holding BBSI, which is as a good a company as it gets, and add to my position if I can buy for less than now...

And in the meantime, if I need the a consolation, I remind myself that BBSI does pay a dividend, albeit a small one :)

Good luck with your investments!


DaveinHackensack said...


Thanks for the thoughtful comment. You are in good company with your approach, which is also that of most value investors (with a few notable exceptions, e.g., Ken Heebner).

To clarify one point, I don't think one needs to limit oneself to investing in companies that are currently benefiting from a macro trend; in fact, it would be even better if you could buy a stock shortly before it starts benefiting from a macro trend. Timing these things exactly is impossible of course, but with multi-year macro trends, I don't think exact timing is necessary.

Of course, I disagree that it's impossible to predict macro trends. To give a couple of examples, I am highly confident in predicting that -- even though there will be corrections between now and then -- oil prices will be higher in five years than they are now. Because of that, I confidently hold my positions in oil stocks, and a short-term correction in them or in the price of oil won't shake me out of my conviction. For an idea of why I am confident in the macro trend of the secular bull market in oil continuing for another five years, see this post.

Another example is the coming macro trend of spending on U.S. infrastructure. I am highly confident in this one as well. So even though my infrastructure stock PCR has dropped recently, I hold it with conviction. I may have bought it ~18 months too early to benefit from this coming macro trend, but the stock had other things going for it at the time (e.g., record revenues, strong backlog, and great balance sheet and valuation), and I am confident that when the money starts flowing next year, PCR will stand to profit from that wave of dollars. To get a sense of why I am confident in this coming domestic infrastructure macro trend, see this post.

As for the "recession" -- technically, we aren't in one (at least not yet), but nevertheless I think the negative macro trend of the weak U.S. consumer will continue for a year or two, due to the four headwinds I described in an earlier post: the negative wealth effects due to the real estate bust, high debt levels, lower access to credit, and rising energy prices. Many Americans spent the last decade spending more than they earned, borrowing against rising asset prices. Multi-year macro trends such as that tend to take years, not months, to correct.

For what it's worth, I continue to hold BBSI.

Scott said...

Hi, Thank you for your follow up on my posting on Seeking Alpha and on my blog, scottsinvestments.blogspot.com regarding BBSI. I absolutely agree with the macro challenges facing BBSI, however I think it is possible to look at the stock from different perspectives today given one's starting point. As of today it is a 50% loser for you. I hold no position, so I have less of an emotional connection with the share price and company. At today's price, the most appealing aspect of the company is the balance sheet and valuation, which I believe gives it limited downside. However, without any earnings growth the share price is going nowhere in the near term. That's why I think tomorrow's earnings report is very important for gauging the impact of macro trends. Clearly there has been an impact and the market has priced much of it in but it's our job to determine if the market has overcompensated or not. I think the stock is close to a bottom if not already there, but I'd like to see how tomorrow shakes out before jumping in.