A macroeconomic perspective on value investment: What can the Transaction Based Model teach value investors? by Balint Anton Francis
What is the Transaction Based Model?
Ray Dalio, the founder of investment firm – Bridgewater, in a 305 page document (Economic Principles, 2012), dissected the mechanics of the economic system and proposed a different model for the macroeconomic landscape. He suggested viewing the economy in a transaction-based fashion. Here is how it works:
By building the model from bottom (transaction) to the top (macroeconomic scale), a transaction is nothing more than a buyer giving money (or credit) to a seller of a good, service or financial asset. A market is defined as the totality of buyers and sellers that make such exchanges (transactions) for the same ‘things’. For example, the stock exchange is a market for financial assets for different reasons over a period of time. Finally, an economy (any economy) is the result of all transactions in all of its markets – it is nothing more than ‘a zillion simple things working together, which makes it look more complex than it really is.’ – to quote from the paper in question.
Adopting this view has fundamental implications on our understanding of demand, supply and price as the expressive colours of the three big forces: the short-term debt cycle, the long-term debt cycle and the productivity line. As a result, Ray Dalio argues that if you know the total amount of money (or credit) spent, defined as total $ and the total quantity sold, defined as total Q, you can build a well-structured picture of any economy and market. More importantly, the price of any asset will be the result of dividing the total $ by the total Q.
Of fundamental significance is the nature of total $ - it can be either money or credit. These forms of settling payments are the primary elements that dictate the economic activity because ‘all changes in economic activity…are due to changes in amounts of 1)money or 2)credit…and the amounts of items sold…’ (page 2 of the document). Changes in the amount of money or credit have a bigger impact on the overall economic performance simply because is nothing easier than to control than the supply of money and credit. Consequently, economic cycles are the products of creation or contraction of credit, money and through them, demand.
The transaction based model, as opposed to the traditional way of looking at the relationship between supply, demand and price, it takes into account the amount of spending occurred, the type of buyers and the reasons for why the spending happened. The traditional perspective sees supply and demand to be measure by the same quantity number, in other words supply=demand=quantity exchanged and the price is seen to change via what economists call velocity. However, by looking at the type of buyers and the amount of money or credit spent, we are able to identify whether the spending was made with money or credit and by what institution was conducted. This will allow us to understand whether there is more credit than money on the market and where the total $ is more concentrated: financial assets, services or products.
Ray Dalio argues that much of the total $ is in fact credit and suggests three major forces to be responsible for the mechanics of any economy. As mentioned above, these are the two debt cycles and the productivity growth line. Moreover, he argues that the movements that we describe as good or bad economic cycles are not the primary result of psychological factors but of contraction or creation of credit, i.e. spending. However, what is causing these swings in spending? Demand? Yes. But what drives demand? What drives a customer to buy product x over product y and thus leading for company x to record a profit at the cost of company y? Is it not the psychological battle between need and want that goes on in the mind of a customer scaled from the individual level to a collective one?Value investment and the transaction based economy
Naturally, value investors are conservative individuals that look to analyse businesses on their own. There are many legendary names that advocate that macroeconomic considerations are irrelevant, at least in long-term because if you have done your research and as a result, you have identified a company with a solid economic moat then other factors that rest outside the zone of your control are irrelevant. However, before dismissing the importance of macroeconomic considerations we need to look if they cannot help us make more accurate decisions in our investment ideas.
For the sake of clarity, I define a value investor anyone that treats risk not as market volatility but as the probability that permanent loss of capital will occur should he or she allocate funds to that particular financial asset. Moreover, the individual will aim to avoid such risk by purchasing the asset at a discount from its intrinsic value (the monetized value given by its usefulness, its reputation and the need for it). Therefore, what can we adopt from the above view of how economies work that can improve on our investment philosophy?
Firstly, by understanding that the amount of spending that occurs comes primarily from credit, i.e. from promises to settle transactions at a future time for more money, makes us even more cautious in valuating companies, especially in a loose monetary policy environment with interest rates close to 0 and low inflation. Therefore, it has a positive impact on our emotional attitude towards ‘bull markets’.
Secondly, by looking at the three forces that drive economies, the two debt cycles and the productivity growth, we can gain a better understanding of why they occur and when. For example, the short-term debt cycle happens when the rate of growth in spending grows faster than the rate of growth in productivity and this leads to prices to increase until the rate of growth in spending is curtailed by tight monetary policy, at which point a recession occurs. Moving forward, the recession ends when the authority responsible for setting the quantity of money and credit, usually the central bank lowers interest rates in order to reduce debt service costs, lower monthly debt payments and make equities look more attractive. Seeing the picture so clear we can make sense of the steps taken by the market authorities and other actors when we decide to invest.
Finally, the transaction based model offers a very structured way to break down a seemingly complex and endless field of numbers. Remember that it starts with a simple transaction – looking at why the transaction happened, between which parties and in what market, it can make the difference in deciding in what asset class country to invest. Moreover, value investors look to buy in times of panic and ‘depression’ – knowing or at least sensing when these times happen can give you a ‘wizard-like’ edge in foreseeing the future and saving capital for these situations.
Transaction Based Model - Conclusions and forward thoughts
This is nothing more but a reflection of my trial to combine one of the creations of Ray Dalio’s mind with a long-lasting and well-tested strategy and philosophy for investing. I understand that some ideas can be