The only investment edge you can count on
The financial industry can't take advantage of this recurring opportunity, but you can if you stay the course.
In May 2015, billing software maker Gentrack (ASX: GTK) was about to commit the cardinal sin of newly listed stocks – missing the earnings forecast disclosed in its prospectus. Over the following four months, the stock would lose more than a third of its value. We upgraded it to Buy at $1.80.
We’ve held on ever since and members have more than tripled their money. What makes this recommendation special, though, is that all the information was in plain sight.
Brokers weren’t forecasting armageddon – in fact, their predictions for long-term earnings were almost identical to ours. And why wouldn’t they be? Gentrack’s customers were utilities and the company had barely lost a customer in 20 years. Cash flow was relatively predictable and contracted price increases ensured long-term revenue growth.
The profit downgrade was due to one thing: two contracts were taking longer to finalise than expected, which meant the revenue they would generate would need to be recognised in the following year’s financial statements.
If Gentrack was your family business, you wouldn’t give two hoots whether a sale was recognised this year or next. It’s an accounting issue. The delay has no impact on the company’s long-term prospects – and this was a good company with excellent prospects. Every investor worth their salt could tell you that.
The reason Gentrack lost a third of its value was that most investors and brokers are unduly focused on the short term. Their decisions to buy or sell a stock are based on what they think the share price will do over the next few months, or a year tops. This often causes an overreaction to short-term problems that have little bearing on the company’s long-term intrinsic value.
Time horizon arbitrage
Your biggest edge in investing is to have a long-term view and be willing to weather short-term volatility. When brokers and fund managers are pricing stocks for the next year, and you’re buying for the long term, you’re taking advantage of something known as ‘time horizon arbitrage’.
Most of the investment management universe can’t benefit from these mispricings, even if they know they exist. Imagine being a broker. Underperform for one year and you lose your bonus. Underperform for two years and you start to lose clients. But five years? You were probably fired a year ago.
The irony of this situation is that from an investment standpoint, the long term is almost the only thing that matters, whereas from a career standpoint, you can only focus on the next year or two.
Let’s use an example. Difficulty aside, the most accurate way to value a business is something known as a ‘discounted cash flow model’. You take all the cash the stock will throw off each year until eternity and convert it to today’s dollars with your required rate of return.
Let’s say you find a stock and think its dividend will sustainably grow at 3% forever. If you take this stream of cash and require, say, an 8% total return, you’ll find that 86% of the stock’s value lies in the earnings beyond the first three years. Half is from earnings beyond 15 years.
In other words, most of a business’s value is in what it earns over the very long term – a time horizon only individual investors can stomach. Most of the finance industry leaves all that money on the table and is content trying to guess what the stock will do between now and Christmas.
This is probably one reason Warren Buffett focuses on high-quality businesses with sustainable competitive advantages and says his favourite holding period is ‘forever’. He isn’t trying to guess what the stock will do this year or next, he’s thinking about what the business will earn 10 or 20 years from now, then trying to buy with a margin of safety.
Focusing on short-term price movements or what’s happening in the news today is a great way to become anxious while missing out on the most consistent opportunity in the market – buying high-quality businesses for the long term from fund managers and investors focused on what the stock will do in the short term.
Intelligent Investor is loading up the van and going on tour in April and May, with events on the NSW central and north coast, the QLD mid-north coast and in Perth, Adelaide, Melbourne, Sydney and Canberra. If you’d like to hear us talk about building a portfolio to weather any storm, book your spot here.
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