“Don’t fight the Fed”
This has often been a saying, for years, among investors. But, the past 2 years have validated this saying more than any other period in history.
Yes, I’m familiar with what they did in 1970’s to combat inflation and in 2008 to save our economy from the next Great Depression. But, never before has monetary response been as aggressive as their response to COVID. The underlying response, as investors have found, was a liquidity fueled bubble. This was most apparent in ARKK’s innovation ETF where it strongly resembled the 2000 NASDAQ bubble.
Today, we’re dealing with the hang over. If you’re a growth stock investor, or a stock picker in general, you likely bought a stock higher in 2021 than where it’s trading at right now. Obviously, with the exception of Energy and FAANGM.
The purpose of this publication will be to discuss how stock picking has changed and how to combine both macro policy with growth/innovation investing
It’s Nearly Impossible to Wrap my Mind Around Value Investing
When I mentioned growth and innovation, many people would first think of Cathie Woods. However, Cathie has a fundamentally different strategy. She is more focused on the convergences of various technologies based on secular trends. In her case, I trust her research to identify which trends are emerging. But, I believe her stock picking ability could be more focused on secular compounders with…. A profit margin?
Let’s re-define exactly what growth stock investing is.
It really is more “stock picking” really good businesses that could growth for years, and years, into the future.
At the very root of what stock picking is, the goal is to yield superior returns over the S&P 500 on a 3-5 year basis based on company’s that will likely grow revenue and earnings. It’s a lot like being in private equity and quite literally, yielding a return on your capital. For example:
A Lemonade Stand down the street needs capital to run, in this case it will be $100. They promise to give me 10% of the company’s returns if I give them $10. They anticipate that they can make $10 per day for the next 5 weeks (because it will be hot outside). Since I am entitled to 10% of the revenue, that means I will own $1 per day, or $7 per week.
The Lemonade Stand owners also mention that they believe they will actually be able to keep, as profit, $.30 of every dollar in revenue they make. The other $.70 goes to paying the workers, buying supplies, paying for systems, etc. This means that over the course of a week I am actually MAKING in REAL RETURNS of $2.10 per week.
On a real returns basis, over the course of 5 weeks, I am expected to make $10.50 in earnings which will be $.50 more than my initial investment. This is the whole purpose of earnings, P/E, and growth. It’s the return on capital designated to the share holder.
The idea of stock picking is to find companies that are growing and are profitable, or soon will be, in the anticipation of generating real returns. These growth companies offer an opportunity to buy at a discount compared to future business performance. From this perspective, what if you could pick a lemonade stand that will grow for 10 years and you’re still allocating the same amount of $10 @10%? Imagine that stand grew to being worth $1,000. Your $10 is now worth $100.
A Stock Picker does the research needed to understand the business, the market it operates in, competition and leaderships ability to execute. It’s all about picking a company that has the ability to grow to a larger valuation in the future.
In this case, I am investing in the businesses ability to grow from its current size.
In a Perfect World this is How it Would Work
The problem with the concept above is that there’s a big ecosystem called the economy. In the economy, it’s constantly changing and evolving where the outlook can look worse or better during certain periods of time. This outlook of the economy can impact what a growth businesses valuation might be, especially if years of growth are baked into the price upon initial investment.
Understanding this environment is a crucial piece to investing
This is called Macro Economics. It’s the study of the broader economic conditions that change over time. The market, in this case, is always a forward looking piece to the broader economic picture.
Understanding these flows are everything to a growth stock investor. The reason why, it helps you identify when you’re going through booms and busts. In other words, the times where you should consider cashing in on your investments or loading up on new opportunities. The best businesses change little during these cycles, especially if they’re a true secular compounder with a strong competitive advantage. However, their valuation and value does.
Let’s talk today, what in the world is going on and why do we care about the Fed?
The Horse and Buggy is the perfect example. The reason why, it can be easily related. The Horse, being the Federal Reserve, move the Buggy, Economy, forward. The Horse Caddy, being JPow, sets the tone and controls the Horse.
Essentially, if the horse wanted to go fast it can and it sends the economy moving faster. If it wants to slow down, it can slow down. In other words, accommodative monetary policy puts the horse in gear and moves the buggy (economy) faster. In a tightening economy, it would be equivalent to a horse slowing down and possibly even moving backwards (a recession). The person all in control, the Horse Caddy or in our situation JPow.
We are currently going through a time where the Federal Reserve is going to slow down monetary conditions and tighten them even. This has created a massive contraction in growth stock valuations because the economic outlook does not seem as “hot” compared to late 2020 and early 2021.
Combining Knowledge of Both Macro Economics and Stock Picking
When researching stocks, you typically have to vet out what would be “good” compared to what would be “bad” from a company perspective. Take a look at one of my SubStacks:
In this, I go through the process of stock picking and what exactly you should look for when finding growth stocks. It covers financial statements and helps provide a guide to picking competitive, disruptive, companies.
There are two things that move stock prices: stock earnings and liquidity.
Some investors only focus on one over the other, but it becomes a much more comfortable environment when you’re able to fully grasp that the combination of both of these reign true. Businesses grow, especially the best businesses. When these companies grow, they attract more capital because capital is being returned to share holders in the form of earnings. This creates a more attractive place to be which appreciates the stock price as investors continue to buy the businesses stock.
The ability for a business to produce earnings alone can grow their market cap (valuation) and can become so large that they compose of a major part in an index. A specific example is Apple which composed of around 10% of the NASDAQ. This single business can now influence how the entire stock market moves or is perceived.
On the flip side of this, liquidity is equally important. The Liquidity puzzle piece is where the Federal Reserve comes in. In this case, the Federal Reserves adjusts monetary policy to create economic activity or contract it, to control inflation. By paying attention to monetary policy and the direction, you get a better idea of how the economy will develop over the months/years.
By understanding how monetary policy is evolving this helps you adjust your portfolio for risk. You can put on more risk during an accommodative period and take risk off during a tightening cycle bringing forward market beating alpha.
A New Investing Strategy Emerges
This isn’t a new strategy, but it’s one I have found passion for and one I post about frequently. This is why I post about both growth stocks and Macro Economics; it’s the pursuit to superior, life changing, long term returns and to share my research/findings along the way with all of you.
By combining macro outlook, we get a good gauge on where the markets are heading (almost like a crystal ball) and doing the right fundamental research on businesses, we find ourselves investing into the future. Make sure to subscribe if you aren’t already:
If you’re considering becoming a member, there are a few things you get:
Access to 1:1 conversations with me
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Access to exclusive writings and guides that often produce significant value/insight
You’re all appreciated and I look forward to this next market cycle.
Stay tuned, stay classy
Dillon
Great stuff as usual. I really appreciate the insights! Congratulations as well on your marriage! All the best to you and your lovely bride!