Value Investing – Concepts of Economics and Business Models (Lesson 19)
“No nation was ever ruined by trade.” – Benjamin Franklin
There is no single statement or overriding concept that equates to defining economics. There are about a half dozen or so concepts that the average person would state as a definition of economics. The most commonly accepted definition of economics is the balance of supply and demand. In effect, it refers to determining the relationship between needs/wants against limited resources. With value investing, understanding the concepts of economics allows for a more comprehensive elevation of thought related to financial analysis. There are literally hundreds if not thousands of forces at work at any given moment impacting the market price and of course a value investor’s intrinsic, buy and sell value points.
The study of economics is done at two levels. The macro level refers to the study of economics as a whole. It focuses on how different characteristics impact the overall ability to efficiently produce and delivery goods to consumers. Think of the impact the federal government has related to laws that in turn affect production and consumption of goods and services. For value investors, there are many different macro level decisions that affect financial analysis. These include decisions made by the Federal Reserve, specifically related to interest rates. Others include unemployment, tax rates, and governmental expenditures especially for capital improvements.
The second level is called micro economics. This brings in all those macro level changes and their respective impact on individual businesses and industries. As an example, a simple increase in the interest rate by the Federal Reserve affects the interest rate related to long-term leases. In the immediate short time period, there is very little change as leases have cycle time frames before they the lease’s interest rate changes. But, in due time, it will affect the interest rate which in turn impacts certain industries. A single railway leases thousands if not tens of thousands of railcars. An interest rate increase will in turn up how much cash outflows for leasing purposes. Ultimately, the railroad will raise their revenue per mile of tonnage which increases sales to offset the outlay of money for a lease.
The overall idea is that every macro decision is like a rock getting tossed into a pond, the ripple effect kicks in and ultimately it reaches the shore line (consumers). The larger the rock, the more likely the ripple will cause some shoreline erosion. In most cases, the shoreline can easily absorb the impact of the ripple. Large rocks or boulders are world level events like war, sudden resource shortages (OPEC reducing their output) or significant government decisions (Britain’s decision to leave the European Union). Smaller rocks such as natural disasters, increases in tax rates, tariffs etc. affect certain industries and certain companies more than others.
Value Investing – Market Forces
As for value investing, there is one economic concept that dominates an investor’s thinking. It is called the ‘Market’. It is a place where owners of securities come to sell and buyers of securities are there to scoop up good deals. A value investor is involved in both roles. The goal is straight forward, buy low and sell high, remember the primary tenet of business. A value investor’s job is to understand this market related to a particular business, i.e. one of many investments in a portfolio.
While in the market whether buying or selling, those other economic forces impact the market’s thinking as a whole. A good example is an interest rate change. In general, anytime the interest rate increases, it reduces the overall economic production. The cost of capital increases, the economy slows down. However, it is beneficial to certain industries, especially banks. For banks, their primary source of revenue is the difference between the interest earned and the interest paid for the money they lend out; read the banking model in Calculating Intrinsic Value of Banks for a more comprehensive understanding of this principle. Increases in interest rates generally improves their net interest revenue. It can cause long-term issues because as interest rates go up, there are less loans made. But in the immediate time period, interest rate increases are a boon to banks.
It is essential for value investors to understand all these forces and their impact on the market for particular investments a value investor evaluates. This is done via financial analysis.