Why is there such a big gap between stock pickers and macro investors?

I have lived both lives and as a consequence, I now look at the market diagonally. This is my passion, and I will start sharing thoughts on this and investing more generally, to play a role in filling what I see as the equity knowledge void.

Knowledge is intelligence plus direction. This series will help you think in new directions.

Here is the first piece:

Beware making decisions on PE ratios

This is not a note for those who have a career in fundamental equity analysis as this cohort would not make a decision on relative PE alone. The target audience is macro investors, many of whom have had great success with trend following strategies. I wrote this post having seen a few articles appearing, by macro strategists, where the recommendation was based on PE ratios at a country or sector level.

If you are comparing aggregates, like countries, by PE ratios you are on dangerous ground. Why do many macro investors treat equities like bonds and make this mistake. Maybe it is because for many years it didn’t matter much. It all started to change in the 1990s, helped by adoption of software like SAP and increasingly by non-physical asset competition.

Post GFC this kind of equity analysis is troublesome. Part of the problem is the lack of use of readily available tools to correctly aggregate equities and see where returns are significantly different to the cost of capital. And now we have inflation clouding the analysis, if not properly accounted for.

Remember that growth creates value only when a project return is above the cost of capital. Companies are layers of projects (each project can be treated as a bond). For a steady state, a stock valuation can be expressed as a function of the return on capital and the reinvestment rate.

Where has value creating growth occurred in the World? Huge value creation in NASDAQ since the GFC. Not much to find elsewhere.

What is the right PE for the magnificent seven? You need to work that out backwards. It depends on a probability distribution. One based on the future return on capital and reinvestment, not on some arbitrary backward looking PE heuristic.

If you are making macro equity calls, level one intelligence would split an index into financials and non-financials to better understand the valuation signal. Level two would compare sectors. Level three would use the right maths and then partition and compare by return on capital and growth cohorts, cognisant of the importance of business models.

HOLT is one available tool to visualise this. For example, here is (level one) Europe v USA non-financials real return on capital in blue and the reinvestment in pink:

Europe is basically a close to cost of capital economy, so growth does not add much value. Europe has a quality problem. That is why it has an advantage of operating leverage in good times and decrementals in bad times. The US is very different. It achieved 10.2% real returns in 2022 and if you didn’t hold management accountable for cash held on the balance sheet the return would be 12.8%. Europe achieved 6.3% and 7.5% respectively.

Europe is made up of high returning Sweden, Switzerland, Ireland and Netherlands and low returning Spain, Finland Germany, Italy and Norway with France, UK, Belgium and Denmark in the middle. One can related Price to Book to Return on Capital and for no growth a investment should sit on a 45 degree line. So if your cost of capital is 5% and you make 5% then why pay more than 1x book. For 10% you should pay 2x and for any value creating growth the multiple increases.

Here are developed markets (ex Financials) with price to book on a replacement cost of asset basis (inflation adjusted) on the y axis:

Denmark has guess what? Novo Nordisk, which is now 12x the size of the second biggest Danish stock. But it is not just about Novo as 19 of the 37 stocks in this calculation have a real return on capital above 10%. This gets you to the right framing for asking how much is now priced in?

Here is Denmark’s improving return on capital, from a level consistently above the cost of capital even in 2009:

Denmark has been a steady outperformer of Europe (even keeping up with the S&P) and had a real COVID boost with its corporate mix:

There is a lot of cutting and slicing that can add value and answer macro questions. With this approach you can create baskets of similar business models, or value chains.

In Denmark we can create two cohorts of high and low return business models and compare those on a like for like basis to other opportunities. Then you can better understand why you are buying Denmark and if you want the broad index or a custom basket. Furthermore, you can then track the related opportunity set you turned down. Why do we not see more of this kind of analysis?

Aled’s asset management industry experience spans research, fund management and executive roles. He has developed and managed innovative new products and processes and is sought for his insights on the future of asset management and markets. He managed an award winning Global Equity Fund for 16 years, managed multiple investment teams, built an impact fund manager and latterly worked on as deputy CIO of a macro hedge fund macro. He extols the use of data, factors, and most importantly the aggregation of stock level data to monitor and price thematic change.

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