High Quality and Time-Horizon ArbitrageLearn more about this firm
Dear Fellow Investors:
At Smead Capital Management, we love to acknowledge financial journalists who really demonstrate an understanding of the underlying truths associated with high-quality and long-duration common stock investing. The latest on the subject of “high quality” came from a Marketwatch.com piece by Brett Arends called, “To beat the stock market, buy quality” on November 12th of 2013. The latest on long-duration common stock investing came from Samuel Lee on Morningstar.com in a piece called, “Warren Buffett and Time-Horizon Arbitrage.” Arends argued, we believe correctly, that “high quality” produces alpha over long stretches of time. Here are a few snippets of Arends’ thesis:
New research has found that you could have beaten the market over many years simply by investing in the highest-quality, strongest, safest companies.
Not only did they produce higher returns and lower risk, they actually did best in times of market turmoil. In other words, they offered you something close to a free insurance policy against meltdowns like 2008.
This finding was supported by research published recently by Cliff Asness and Andrea Frazzini at AQR Capital and Lasse Pederson of New York University. They looked at the performance of nearly 40,000 stocks in 24 countries, including the U.S., since 1951. They sorted out the “quality” companies using four measures—high profitability (measured by returns on assets), high earnings growth (measured by growth over the previous five years), safety (measured in terms of low stock volatility, low leverage, stable earnings, and high credit ratings), and payouts (measured as the percentage of earnings paid to investors as dividends or through share buybacks).
Our eight criteria for stock selection include the following which we believe speak to “high quality”:
- Meet an economic need
- Wide moat
- Long history of profits and preferably dividends
- Generous and consistent generator of free cash flow
- Strong balance sheet
We would like to assume that these truths would apply over the next twenty years like they have in the past and that our specific discipline would benefit from this part of the history of the stock market.
Samuel Lee’s essay deserves some serious parsing because it is filled with gems that we think most investors overlook. Additionally, we believe Lee’s observations bring our discipline into sharper focus. To begin, Lee brilliantly explained the logic behind Buffett’s discipline of selecting wholly and partially-owned businesses for long-durations. He wrote:
…Buffett tries to buy assets at substantial discounts to intrinsic value, regardless of whether that value is crystallized in current assets or yet-to-be-realized future earnings.
Both Buffett and Munger declare that their favorite holding period is forever. This seems to contradict the fact that at a high enough price, even the most wonderful business in the world will produce less-than-wonderful returns. No doubt part of their hesitance to sell wonderful businesses at any price reflects a philosophical aversion to "gin rummy" investing. I think, though, the main reason they hold on is because they truly believe wonderful businesses are persistently undervalued by the market, even when common valuation metrics suggest otherwise.
This suggests to me that much of Buffett and Munger's edge rests in the ability to engage in time-horizon arbitrage: buying assets with long-term value underappreciated by the market.
We have argued vociferously in the last three years that the biggest mistake among active managers is being “way too active” or practicing “gin-rummy” portfolio management. Not only are they losing around 80 basis points a year in large-cap mutual funds on average to the cost of trading, but they are much more likely to sell winners at prices which can kill long-duration alpha. With average turnover in large-cap US equity at 62%, can managers be much farther from a “forever” holding period? We have been attempting to keep our turnover significantly lower than the norm as part of our regular discipline.
On the subject of long-duration ownership of “high quality” common stocks spoken to by Arends and represented by Buffett and Charlie Munger’s discipline, Lee highlights their beauty:
The goal of the long-term investor is to come up with better estimates of intrinsic value than the market and buy stocks trading for below intrinsic value and sell stocks trading above it.
However, if you plug in reasonable-seeming numbers, you quickly discover that the majority of an investment's present value is often embodied in the cash flows many years out. After inflation, the U.S. stock market has returned about 7% and grown per-share earnings by 2% over the past century. Apply a 7% discount rate to an earnings stream growing by 2% per annum in perpetuity, and you'll find that the earnings beyond the first five years account for almost 80% of intrinsic value. Earnings beyond 10 years account for more than 60%.
Lee’s writing and research confirm what Ben Inker of GMO found at the end 2003: 75% of the intrinsic value of a company comes from cash flows more than ten years from now and 50% comes from flows more than 25 years from today.
Set in the middle of the essay, Lee reveals the difficult task that makes us excited to get up every morning and practice long-duration common stock investing. As Lee postulates:
Imagine a professional investor coming up with intelligent predictions as to what a stock will be earning 10 and 20 years from now. Not only is this difficult to do, it's nearly impossible to act on when you do it correctly, because a few years of underperforming your peers (no matter how stupidly they're behaving) is a good way to lose all your clients. As a result, many analysts use higher discount rates to make the next few years of earnings matter more. By doing this, they're largely betting on how earnings surprises will evolve over the next few years. The discounted-cash-flow framework becomes more a tool for longer-term speculation.
Buffett inverts the solution, making far-flung future earnings the most important thing. He looks for firms with economic moats: sustainable competitive advantages that allow them to endure and thrive in spite of capitalism's tendency to creative destruction. The moat enables Buffett to do something that, on its face, seems insane…
One of the few parts of Lee’s piece with which we disagree is the assumption that “you lose your clients” when you underperform all your peers. Our observation over 33 years is that good long-duration managers only lose part of their clients during periods of underperformance. Why else has the share price of Berkshire Hathaway (BRK.A, BRK.B) been so non-volatile? We have made the case for five years that buying our portfolio at a discount on a First Call forward earnings basis to the S&P 500 Index is a statistical bargain. Lee argues that ‘high quality” owned in long duration works great even if your holdings temporarily get extremely rich in comparison to other S&P 500 companies, on average. Here is how Lee explained this:
The "Nifty Fifty" had long histories of uninterrupted dividend growth and hefty market capitalizations. According to Jeremy Siegel, they had an average price/earnings ratio of 41.9 in 1972, more than double the S&P 500's 18.9.
Then they crashed, and their valuations fell to more pedestrian levels. For decades, the Nifty Fifty became just another cautionary tale of the madness of crowds. In 1998, Siegel revisited the Nifty Fifty. It turns out that buying and holding an equally weighted portfolio from the mania's peak would have returned 12.5% annualized from 1972 to 1998--only a hair under the S&P 500's return. In hindsight, the lofty valuations didn't turn out to be so mad.
Let us restate this: had you bought a high quality portfolio at one of the peaks of popularity, you would have nearly produced the market’s return. Buffett has said in recent years that when he was calling stocks like Coke and Gillette “The Inevitables” in the late 1990’s, that he should have been selling and taking his capital elsewhere. Even he can use a little turnover in his portfolio of common stocks. Lee points out—if that is your biggest mistake—you are blessed among stock pickers:
Ironically, the Nifty Fifty phenomenon can be seen as a bout of temporary rationality brought on by mania. Yes, some stocks are so good that they deserve to be bought at what look like rich prices--provided you're willing to own them forever. The real task is identifying those stocks in the first place and then ignoring all the noise. The former is nowhere near as hard as the latter. Taking the long view can be excruciatingly hard at times, and for that reason wide moats will almost always be undervalued.
Munger's genius was figuring this out before nearly everyone else. Buffett's genius was listening to him and following through, enduring the long, lonely periods when the market was telling him he was a fool.
The only other part of this discussion on which we disagree with Samuel Lee is his assumption that you can’t execute this in an open-ended mutual fund. Part of Buffett’s brilliance that Lee missed is that he tries to buy into these companies when they are out of favor. Our company exists to apply that discipline and attempt to prove Mr. Lee wrong.
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.This Missive and others are available at www.smeadcap.com.
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