The role of expectations
For the investor with a short term outlook, things are undoubtedly improving: unemployment is slowly decreasing from high levels, order levels are improving, interest rates are low, inflation is not a concern, the euro area seems to have stabilised, and while economic growth remains slow it should continue to pick up as we move through the year. On this basis, the world looks like a benign place for the next 12 months, which should bode well for risky assets.
However, a long term investor might have a very different outlook: debt levels in Europe and the US remain dangerously elevated, especially at the government level. Entitlement programs over the next 20 years will bankrupt western governments and will require either much higher taxation, a default on promises to the beneficiaries (pensioners, the poor and the ill) or high inflation (to inflate away the debts and reduce the real level of benefits). Using the US as an example, this is nicely illustrated by the following chart from the US Congressional Budget Office (CBO):
The difference between the two scenarios projected by the CBO relates to whether the US Government reforms its current spending (ie. they implement substantial entitlement reform and materially raise taxes) or not. The recent "fiscal cliff negotiations" largely went the way of no reform, so as things currently stand, the higher of the two projections appears the most realistic. It seems clear that we should never expect a politician to make a difficult decision if it can be postponed until the term of his successor. However, as Herb Stein famously said, "if something cannot go on forever, it will stop". It is clear that on a 10-year time frame, current spending policies in many countries cannot continue, and the longer we leave it to find a solution, the more painful that solution will be. A longer-term investor may want to avoid risky assets until the inevitable crunch has hit.
So with differing short term and long term outlooks, what is an investor to do? As always at Veritas, our view calls for a balance between the two: not to become too optimistic on the back of short term improvements to ignore the long term issues, but equally not to get so concerned about the long term that we forego opportunities that lie in plain sight. In many ways, it is better to focus more on the individual opportunities and be guided by valuation rather than attempt Keynes' beauty contest with regard to investor expectations about the macro economic outlook.
Looking more specifically at equities and investment time horizons, most equity investors would claim that their investment horizon is around one to two years with 'long term' investors looking out for three years or more. These claims are somewhat undermined by the decline in the average holding period of equities which has fallen markedly, as depicted below (using the NYSE data as an example). While some of this decline is undoubtedly a function of the rise of high frequency trading and ETFs, much is also a result of higher turnover by 'fundamental' investors.
Investor focus has become short-term
This chart indicates that investors are 'investing' for shorter and shorter time periods. With a current average holding period of around six months, investors must 'on average' be looking forward for under one year. One consequence of this is that changes in very short term expectations can lead to outsized changes in the price of the financial asset. As such, investors consider short term changes to earnings expectations to be the largest determinant of value. This is clearly not justified by the fundamentals - if a company misses or beats earnings expectations for a quarter it rarely justifies a substantial change in the share price, although that is what typically happens. Such outsized share price movements actually encourage more short termism as some momentum investors realise that if they can guess which companies might beat or miss earnings they can profit handsomely in a very short time. This then makes 'investing' a game of who can most successfully guess which companies are going to deliver in a very short period. This is not investing so much as speculating.
The recent increase in cases of insider trading where 'investors' have paid to get inside information about short-term profits should come as no surprise in such an environment.
While considering the implications of investor time horizons, we often marvel at the complete disregard of investors to 'hidden' claims on cash flows. Investors seem to completely ignore factors that represent genuine costs but will only become apparent over the long term (5-10 years), including pension plan asset return assumptions, defined benefit plans and inflation leading to depreciation woefully understating capital requirements. Again at issue is the short term versus the long term as short term investors realise that such issues will not 'hit' during their holding period. This of course does not mean that they do not impact the value of the business.
Implications for the fund Does this mean long term investing as practised by Veritas is less efficacious? The answer is no, because the trend to short termism has one very important silver lining: the focus on the short term (quarterly earnings hits and misses) combined with high volatility can provide opportunities to long term investors as the price of a company deviates substantially from fundamental value. However, with shorter term investors now dominating, it may take longer for the value inherent in such situations to become evident as it will only become priced in when it leads to the company exceeding earnings expectations.
If our fundamental analysis is correct, then over time the share price will approximate the intrinsic value and our patience will be well rewarded. Benefitting from such 'time arbitrage' requires a long term focus which is inherent in our investment process. Our two major themes, 2020 Rising Tide Industry Winners and Scarcity & Supply Constraints, both require an appreciation of long term success factors and characteristics that should allow beneficiaries to weather difficult economic environments.