Tuesday, April 15, 2008

Widen the Lens

As earnings season swings into high gear, last week’s “shocking” results from GE provide a useful lesson for investors that goes beyond the narrow value of current earnings analysis.

For the GE numbers and resulting stock market reaction go to the heart of investment strategy and investment decision-making and why, for well-diversified portfolios, grasping the big picture matters at all times, but in particular when fundamental change is underway it is vital to investment performance.

The problem is that by taking a traditional analytical approach to company analysis, far too many bottom up analysts (and investors) tend to miss the forest for the trees as the analytical tools used are not calibrated for the thematic and trend impacts emanating from macro forces such as the credit crisis. Therefore, when macro thematic and trend factors outside the traditional silo approach to company analysis, the element of surprise comes into the after-the-fact equation. I believe it is this failure to understand and therefore incorporate macro thematic issues like the credit crisis into the industry and company specific research work of most industry and company specific analysts that has led to the outrageously optimistic earnings projections for 2008 by most bottom up analysts. Which is another way of saying, there will likely be many more earnings “surprises” in the quarters ahead.

Investment Strategy Implications

Many years ago I learned that for well-diversified portfolios, just as the asset allocation decision trumps when and what an investor buys, sells, or holds, so, too, does the axiom that the macro environment trumps the micro environment – a point made all the more important when the macro environment is in transition as it is today. Therefore, a failure to widen the lens to incorporate thematic macro mega trends such as the credit crisis (which is far more significant than merely a subprime problem) guarantees a constant state of shock for investors relying on traditional bottom up analysis alone.

Widen the lens. There are more earnings surprises ahead.

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