A formula for long-term investing

For most people, the challenge of investing at the outset is to accumulate wealth over a relatively long time. The job of the investment industry is to build strategies for these investors that generate attractive returns over the long term. While numerous studies show the value of long-term, buy-and-hold approaches to investing, these approaches clash with the short-term behaviour evident in today’s equity markets.

That greater focus of equity investors on the short term is shown by the decline in the average holding period for stocks on global exchanges. In the US, the average holding period of a stock on the New York Stock Exchange was around seven years in 1940.² By the time of the tech bubble in 2000, it had fallen to about one year. Now the average holding period globally is less than three months.

A key issue that feeds this short-termism is the habit of most sell-side analysts to focus on short-term earnings projections. In fact, while the overall number of analysts covering large-cap global stocks is growing, the focus remains disproportionately on near-term earnings forecasts. Few analysts covering global stocks forecast greater than three years ahead.³

With the greater short-term focus of market participants and sell-side analysts, coupled with guidance from companies, the equity market has become relatively efficient at pricing near-term earnings expectations (as measured by a declining error rate in one-year IBES forecasts 2006-11).⁴ The corollary to this is that the market is less effective at evaluating longer-term earnings, thus neglecting the longer-term value of companies exposed to structural growth drivers. This represents a clear opportunity for investment strategies that can exploit this market failing.

Stock outperformance is driven by either superior earnings growth or a higher valuation multiple being applied to the earnings profile of a company. Over short holding periods, changes in valuation multiples are the key driver of returns since earnings expectations do not typically change by large amounts in the short term. However, in the long run, the opposite is true. Performance is increasingly explained by changes in earnings growth and the importance of the valuation multiples at which stocks are traded diminishes. With the knowledge that earnings are more important than multiples in the long run, how should we go about assessing the long-term value of companies?

Earnings multiples are commonly used to make snapshot comparisons between similar companies within industries or to measure value versus sector or market averages. For companies sensitive to the business cycle, these measures run the risk of overstating the value of the business based on peak earnings in periods of strong economic activity.

Discounted-cash-flow analysis is an alternative method of valuing a company where the value of an asset is defined as the present value of its estimated and discounted future cash flows. Instead of trying to project a company’s cash flows to infinity, however, a terminal value is applied to cash flows beyond the next few years (at which point forecasts drastically peter out in any case). 

In these models, 60% to 75% of the value of a company is typically determined by this terminal value and great care must be attached to its calculation. For many high-quality businesses, the calculation of this rate can be sensibly informed by their exposure to structural growth themes, which, in turn, can justify higher growth rates than GDP.

by Hilary Natoff, co-Portfolio Manager of the Fidelity Global Demographics Fund - November 2013

Important information

References to specific securities should not be taken as recommendations.

1  Dimson, Marsh and Staunton (2002) showed dividend paying stocks outperform. Fama and French (1992) showed stocks with high earnings/price ratios earn higher returns.
2  New York Stock Exchange.
3  This can be partly explained by availability bias (mentioned above) as there is a wealth of information available at any point to inform short-term forecasts.
4  IBES.
5 DataStream, as at 29.07.2013.
6  International Diabetes Federation, 2012 Update
7  Novo Nordisk Annual Report 2012
8 Research papers from Goldman Sachs, (The Die is Cast April 2011) and Credit Suisse (‘HOLT Wealth Creation Principles: Was Warren Buffet Right: Do Wonderful Companies Remain Wonderful?’, June 2013) support the point.

Indices:

The Australian All Ordinaries Index has moved down decreasing by -1.0% since closing last Friday to 11:00 pm today.

The rest of the world as measured by the MSCI index decreased -5.1% in A$ from closing last Friday to end of trade Thursday.

Have a good weekend,

The team at IPS