To Infinity and Beyond - Part 2
Introduction
This post picks up where we left off in Part 1. If most investors are short-term oriented, and this behavior is actually the most natural and comfortable, why even try to invest for the long-term? We believe that there are six compelling reasons:
Investing for the long term is less competitive.
Investing for the long term avoids short-term noise.
Investing for the long term is not dependent on selling the investment for a higher price.
Investing for the long term eliminates reinvestment risk.
Investing for the long term reduces friction costs.
Investing for the long term protects the investor from the grave mistake of selling a great business.
This post dives into the first three reasons.
Investing for the long term is less competitive
Investing is a competitive sport, and one that is often zero-sum. In order to generate above-average returns, an investor needs to buy assets that are mispriced relative to the amount of cash that the assets will generate for the investor in the future. This cash can come from either income (dividends, distributions, or coupons) or or from selling those assets for a higher price.
If most investors are focusing on the short term (assets that will produce cash for the holder, most commonly by appreciating in value and being sold for a higher price), it logically follows that the battleground for short-term assets must be quite competitive, as assets with the potential for short-term gain are constantly being picked over by these investors searching for opportunities.
This conclusion suggests that if we want to achieve the best returns, we should look for investments where others aren’t looking, such as assets that do not pay off in the short term and thus, are not interesting to most investors.
Jeff Bezos uses a similar mental model at Amazon (just substitute investor for company), which he described in 2011:
"If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon, we like things to work in five to seven years. We’re willing to plant seeds, let them grow..."
Interestingly, the more the general investing public focuses on the short term, the higher the potential returns for the long-term investor, as the forces of short-term supply and demand cause asset prices and future cash flows to decouple.
This suggests that like the bond market, there is a yield curve for equity: as demand for investments with short-term payoffs increases, the yields (annualized returns) towards the short end of the curve move down. Likewise, as demand for investments with the potential for longer-term payoffs decreases, yields at the long end of the curve increase. In other words, this implies that returns should be higher for the long-term investor given typical investor behavior.
Source: Kaho Partners
Investing for the long term avoids short-term noise
In investing, just because short-term feedback is available does not mean that it is necessarily reliable. In fact, short-term feedback is often more “noise” than “signal.”
Over the short term, market prices (dictated by supply and demand) fluctuate more than underlying business values. Here is the 52-week high and low for the ten largest US public companies:
Source: Saber Capital Management, LLC
You would expect these mega-cap companies to be closely followed, well understood, and thus, efficiently priced. Why then have the market values of these businesses fluctuated over 40% during the course of only a year? According to Howard Marks, this is because “investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.” In summary, if you expect fundamentals to be properly reflected in short-term security prices, you will likely be disappointed.
While this is a useful lesson for evaluating individual assets, it is especially helpful for evaluating an investor’s performance. Davis Advisors studied the performance of the top 25% large-cap equity managers from 2004 to 2013 (the ones that delivered the highest returns over the entire ten-year period). They found that 95% of these top managers fell to the bottom half of their peers for at least one three-year period, and a full 73% ranked among the bottom quarter of their peers for at least one three-year period. If you used short-term performance (three years of under-performance) to guide your allocation decisions, you would have mistakenly pulled your money from the best managers.
Source: Davis Advisors
In 1970, as Warren Buffett was winding down his investment partnership, he advised his clients to put their money with his friend Bill Ruane, who ran the Sequoia Fund. If you would have followed Buffett’s advice, you would have lost 10% of your capital over the next five years, underperforming the S&P by 17%. However, if you listened to this market “signal” about Ruane’s investing prowess, you would have missed out on one of the greatest long term track records of any fund, as the Sequoia Fund has returned 14% annualized since inception, over 3x better than the S&P over the same period.
Source: Ruane, Cunniff & Goldfarb
The moral of these anecdotes is that it pays to ignore short-term “noise” (and to take any short-term pain) if you believe in the long-term trajectory of an investment. Thomas Russo, Managing Member of investing firm Gardner Russo & Gardner, calls this ability to take short-term pain the “capacity to suffer,” and we agree with Mr. Russo that it is a crucial advantage.
Investing for the long term is not dependent on selling the investment for a higher price
In order to be a successful short-term investor, you must buy cheap and sell dear. In other words, you need a “good exit.” Let’s ignore those speculators who try to buy dear and sell dear-er (to the “greater fool”). Even if you are a brilliant Ben Graham “cigar butt” investor (one who looks for unloved assets that like a used cigar, may have one free “puff” left in them), the problem with this style of investing is that you are always reliant on someone else to set both your total return and your rate of return.
Here’s an example. Imagine that you are able to purchase a “fifty-cent dollar” (an asset for 50% of its intrinsic value). While you may be certain that you can sell the asset for 100 cents on the dollar, your annualized returns are dependent on how long it takes you to sell the investment for fair value:
Source: Kaho Partners
While you would make 100% annualized if you could sell the investment within one year, your annualized returns decline the longer it takes to exit. This becomes a tough proposition given how long assets can remain mispriced, especially during times of market stress. Perhaps this is why Buffett advises investors to “never count on making a good sale.”
Interestingly, the longer you hold an investment, the more your investment returns will mirror the underlying returns on capital that the business generates, rather than the exit price. This means that if you can find a business that generate high returns on capital, and if you can hold it for the long term, you can limit your dependence on a “good exit.”
Consider the simplified example of an investor who buys a company for 10x free cash flow. This company generates 10% returns on invested capital, reinvests all distributable earnings back into the business, and has a consistent capital structure throughout the holding period. The table below illustrates this investor’s annualized returns assuming different exit multiples and holding periods.
Source: Kaho Partners
You can see that over shorter holding periods, returns are largely driven by exit price, while the longer the investor holds the investment, the more returns are driven by the business’ returns on invested capital. This reversion tendency is why in 1989 Buffett wrote “time is the friend of the wonderful business, [but] the enemy of the mediocre.”
Up next…
In Part 3, our final post on long-term investing, we will cover three additional reasons to have a long-term orientation.