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2. Long-term time horizon (both analytical and expectation to hold)
EDITOR’S NOTE: Although it has been some time since speaking live with busy colleague Vitaliy Katsenelson CFA, I review his internet material frequently and appreciate this ME-P series contribution. I encourage all ME-P readers to do the same and consider his value investing insights carefully.
By Vitaliy Katsenelson, CFA
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| The Six Commandments of Value Investing *** |
| 2. Long-term time horizon (both analytical and expectation to hold) A long-term time horizon is extremely important for value investors for several reasons: First, it is impossible predict how a stock will be priced in the short run. Short-term stock behavior is random, and thus its forecasting (at least using tools available to investors) cannot be turned into a repeatable process. Second, having a longer time horizon than Wall Street is a very important competitive advantage. The Street’s time horizon is very short – measured in months, maybe quarters, but rarely in years. Money flows into mutual funds and hedge funds are driven by recent performance, so Wall Street is obsessed with the short term. This creates time arbitrage. Stocks get punished because their immediate future may look unattractive, but if you look at them as businesses, that short-term performance is just a pimple on your long-term timeline. So, how do we embed a long-term time horizon into our process? First, we always look at earnings and cash flows at least three (often five) years out. This forces us to look at the company’s normalized earnings power and ignores the short term. All our models focus on what the company will be worth based on its earnings power in three to five years. Then we discount (bring that future value forward to today at an 18%-40% discount rate, depending on the company’s quality) to see what we want to pay for this company today. Looking at the business at least three to five years out has a very important side effect: It adds “growth” to the portfolio from earnings and dividends. Stock returns come from three sources: price-to-earnings (P/E) expansion, earnings growth, and dividends. P/E expansion is finite – it’s a one-time shot in the arm. Let’s say a stock’s P/E goes from an undervalued 12 to a fairly valued 15 – a 25% return. If this company doesn’t grow earnings and/or pay dividends, that 25% will be our total return. The risk of owning this type of “one-shot” stock is that without earnings growth or dividends, time is not on your side – you don’t get paid to wait. If your time horizon is three years, that 25% return gets truncated to an annual return of only 8% a year. But if this company, in addition to trading at a depressed P/E, pays a 3% dividend and grows earnings 7% a year, that is an additional, repeatable 10% return a year. This elongation of the time horizon embeds growth in our portfolio and also forces us to demand a much higher discount for stocks that don’t pay dividends and don’t grow their earnings. |
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