Intelligent investing is long-term at its core.
I’m not breaking any new ground with that statement. Any number of classic value quotes will tell you so. Books have been written, podcasts recorded and 40 000-strong crowds packed into Omaha stadiums to hear the subject expounded upon.
As usual, Buffett summed it up best when he said:
“If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”
But everywhere I look today and in all the bullish narratives we are being bombarded with, the overwhelming horizon today is short-term. Fed-watching has become a market obsession.
The market is acting more like the crowd of managers Peter Lynch famously addressed and asked if there were any short-term investors present. Not a hand went up, despite Lynch knowing full well that the average holding period on Wall St had then and still has been declining precipitously. Even though short-term investing is clearly proliferating, investors know deep down it’s an embarrassing admission.
Meanwhile, we are all desperately hoping for a Covid-19 vaccine, so our elderly can be safe again and we can get on with our lives as before. There is every chance we will have one in the next couple of years and that will be great news when it comes. But on a 10-year time frame, whether we have one distributed tomorrow or 2022 will matter little to the bulk of the corporate cash flows paid over the next decade and the terminal prospects applied thereafter.
Similarly, the current all-encompassing obsession with interest rates seems a little mystifying given a 10-year horizon. I would posit that the course of rates over the next decade and their finishing point in 2030 will be a larger determinant of 10-year market returns than their current level.
Will they still be at record lows in a decade? It’s possible, but an investment strategy predicated on it is lacking a margin of safety (to say the least). And even if they are, we already have a guinea pig in this regard and it’s not pretty- Japan. It is also worth considering that the Federal Reserve slashed interest rates throughout both the major busts of this century and both times failed to prevent the market being cut in half.
Charlie Munger has famously said that the longer you hold an investment the closer your returns will approximate the economic returns of that business. However, while I take the point and am loathe to disagree with the great man, I certainly don’t think he meant it for times like the present.
Today’s dotcom bubble 2.0 has temporarily blown these sort of norms out of the water. What was meant as a rule of thumb for a profitable, stable company is being used to argue paying absurd prices for NASDAQ darlings. Investors desperate to avoid missing the boat are frothing over 20% revenue growth, but discounting (often non-existent) cash flows at mid-single digits in their models. When that explosive growth has already been paid for, all that is left is a 5% prospective return and everything needing to go right to get anywhere near it.
I believe that the more relevant driver over the next decade will be valuation.
An equally acknowledged, but seemingly ignored, value maxim is that price paid determines return. You cannot drag forward a decade of returns and expect another prosperous one to follow. Markets don’t work that way and it is why an appreciation for market history is so important at extremes. The market memory is apparently so short that even two crashes in the last 20 years are not enough to make investors wary of new era thinking.
As with needing interest rates to remain at record lows, today’s S&P 500 longs need their companies to continue over-earning (through record high profit margins) and remain at historically eye-watering valuations to make their projected returns. A lot can happen in a decade and it’s not a bet I’m prepared to make.
I recently heard the ridiculous argument made that US stocks are cheap as current valuations could be considered trough earnings and it’s often acceptable to pay a high multiple at the bottom of the cycle. The only problem is that multiples are still ridiculously high when you cut out 2020 and use 2019 peak earnings.
My favourite measure for cutting through the market cycle noise is the Price/Sales ratio, as it removes margins (coming further down the income statement). The ratio has been rising strongly throughout this bull market and left previous market peaks in the dust.
When studying this chart , it is clear that we are in the valuation stratosphere. However, the current 2.45x multiple given reflects trailing twelve month revenues to the end of March 2020. For those not keen to use any Covid-19 numbers in the calculation, we can adjust for this by using the 2.27x figure recorded at year end 2019 and, as the market is now 7% higher than Dec 30, we arrive at a P/S(2019 peak) of 2.43x.
I hope I have demonstrated that any argument made for being fully invested in the US markets right now can only be short-term in nature. So, it follows that the masses investing on rates and vaccine based theses are playing an epic game of greater fool theory.
Broyhill’s Christopher Pavese summed it up well in his recent quarterly letter:
“If markets are trading at half of today’s levels in a year or two, it will seem obvious to everyone in hindsight, that today’s stock prices and extreme divergences were completely unsustainable. It will have also been a very painful couple years for those that ignored them.”
Much like a starving person cannot easily imagine feeling uncomfortably full again, the momentum currently on show makes it hard to picture a market that only sees the negatives. But given the extreme uncertainty in the world today and the record prices accompanying them, would it really be that strange to see the S&P 500 significantly lower? I picture a fairly collective “What were we thinking?!”, in the markets future.
But until then, human nature will continue as it always has, chasing the promise of quick riches. Everyone riding SaaS, Tesla and index funds cannot exit successfully at the first sign of trouble, even though they are all intending to. When someone shouts “fire” in a crowded hall, it’s not possible for the crowd to exit in both an instantaneous and orderly manner.
So, what does a true long-term outlook lean towards in the current environment? For me, it still involves the cheapest equity exposure I can find and some cash reserves. While the S&P 500 is priced for another lost decade, there are pockets of value left behind in many global markets, most notably EM and the UK. Many of these stocks were already cheap in February, fell much further than US stocks and have now barely recovered as prices have snapped back in the States. I would nominate KT, Gazprom and Micro Focus (all of which I own and have written up before) as examples of this.
Cash is also presently a hated asset class in most portfolios and for this reason I will continue holding some. Given my valuation arguments above, it seems obvious to me we will see future opportunities. Averaging in has proven the right decision for me thus far, as many of my loathed EM stocks have become even more so and I have had the chance to add to my holdings, while avoiding some of the carnage.
Whenever I hear cash derided, reminding myself that Buffett is holding plenty of it restores a certain zen.
Holding uncomfortable positions is a familiar stance in value and the ability to do so is what ultimately makes the strategy successful. Today that uncomfortable stance involves maintaining a true long-term horizon informed by one of the only things you can truly control- the price you pay (or don’t).
Guy
PS. As always, please do your own due diligence and seek advice if you’re unsure about your investments. My page is me chronicling my own thoughts and decisions and isn’t meant to be taken as financial advice.
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