Scott Bessent, Former Chief Investment Officer for George Soros’ family office, said: “People always forget that 50% of a stock’s move is the overall market, 30% is the industry group, and then maybe 20% is the extra alpha from stock picking.”

The answers to the riddle of successful investing has many authors. Differing views on ‘what works’ in investing is after all what makes a market. Scott Bessent’s argument reflects the views of a macro investment artist describing broad drivers of stock price performance.

Assuming he’s broadly right, how then might an investor allocate their research time between the market, industries and individual securities when evaluating investment opportunities?

Let’s take a look at each of these three elements in turn.

Picking the direction of the overall market

Predicting whether markets are going to rise or fall, and importantly, when this might happen is incredibly difficult to do in a sustained, repeatable fashion. Not impossible – George Soros and his colleagues have built multi-decade long successful careers doing just that – but difficult.

How difficult became apparent in recent weeks when a combination of factors led to the Japanese Nikkei 225 Index plunging -12.4% on the 5th of August. This was the worst single day move in Japanese equities since October 1987. It then rebounded over 10% the next day. The sharpness of these moves suggests many investors had clearly not foreseen this market event. Some investors would’ve profited from these moves. Many would have lost money. The sophisticated structure of financial markets where information is processed and investment decisions made in nano seconds arguably accentuated the magnitude of this move.

If predicting market moves over short term, or daily, timeframes is difficult, what about predictions over longer term, monthly or yearly time frames? This too, is not easy.

The New Zealand equity market, for example, had been in the doldrums for months in the run up to July 2024 when compared to many other share markets globally. Persistent inflationary pressures had led to the Reserve Bank of New Zealand (RBNZ) lifting our cash rate faster and higher than a number of other central banks. This RBNZ medicine had pushed the NZ economy into recession, and likely was a key reason behind the equity market weakness (especially listed companies dependent on the domestic economy).

By July, numerous data points pointed to an acceleration of these negative economic trends. This caused the RBNZ to adopt far more dovish rhetoric. This in turn ignited the share market in July and sent the S&P/NZX 50 gross index up 5.9%, outperforming many global equity indices. We have since seen the RBNZ cut interest rates in mid August – a lot earlier than they were signalling only a few months ago.

The equity market is forward looking, so, in spite of the worsening economy, the stock market rallied. The market is already looking to better times ahead when the anticipated series of interest rate cuts is expected to have stimulated the economy and consumer spending once more.

Investors avoiding the New Zealand equity market during 2024 because of the weakening economic backdrop would have had to be very nimble to anticipate and invest ahead of the sharp rebound in July.

And what if the market is being premature in anticipating a rebound in the NZ economy? What if other factors, as yet unconsidered, conspire against it and the economy falls back into recession once more? Would that cause the equity market to fall once more? Maybe, maybe not.

As Warren Buffett once remarked, forecasting the direction of the market often tells you more about the forecaster than it does about the market.

How about investing in ‘the right industries’?

Not all industries are created equal from an investment standpoint.

Some industries are awash with a broad, fragmented range of competitors making it harder for companies to differentiate their product offering from their peers. Some industries, whether due to competition, regulation or an absence of product differentiation, lack pricing power. When the macro-economic stars align, they make money. When the stars don’t align, profitability sinks. These industries make for difficult investment propositions over longer time periods.

Airlines are a great example of this. They’re capital intensive – it is expensive to build and maintain a fleet of aeroplanes. Fuel is a large cost, and they have little control in managing this key cost. There are many competitors from discount to full-service operators. Pricing power across the industry is therefore low. It’s no wonder that through economic cycles, airlines often deliver disappointing returns. Even Air New Zealand, which has an effective monopoly on many domestic routes, has returned 7% p.a. over 14 years since 2010, underperforming the NZX50 index which returned 10.5% p.a.

In contrast, the insurance broking industry, as boring as it sounds, seems to be a far better industry for investors to consider. Insurance brokers fulfil a critical role bridging the insurance needs of businesses with insurance companies – the providers of the insurance. The brokers own the client relationship by understanding the individual client needs. Accordingly, they find suitable policies to meet those needs. Along the way, they earn commissions, without having to shoulder the underwriting risk. This is an essential service required in good and bad economic environments. The industry has also consolidated over the years which has reduced fragmentation, providing competitive and scale benefits on the brokers that have led the consolidation.

Over the 14 years since 2010, Australian insurance brokers AUB Group and Steadfast and international listed brokers Arthur Gallagher and Marsh & McLennan have each returned between 15% - 22% p.a. for their investors. They have all proved to be sound long-term investments.

Spending time and effort evaluating the attractiveness of different industries seems like a worthwhile endeavour.

And this brings us to the plight of the individual listed company

Within industries, performance amongst individual companies can vary tremendously. A company carrying too much debt can run aground irrespective of how attractive the industry is. A company allocating capital poorly by, for example, expanding outside of their core business or overpaying when acquiring a competitor can also perform terribly.

Evaluating the people, governance and considering the track record of the management teams are all important elements to consider when evaluating investment opportunities. It is not enough to just have a business ‘with good bones’.

For investors trying to productively allocate the research time in their day, they clearly need to consider a range of factors. However, I think they are better served focussing on industries and individual companies rather than in trying to predict ‘the market’. As a famous financier (JP Morgan is often credited with this) was reputed to have said when asked for a market forecast:

“I believe it is going to fluctuate.” Indeed.

This article was originally published in the NBR on 20 August 2024 (paywalled).

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