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I strongly concur with the article authored by my colleague Jared Nishida, Cognitive Dissonance: 5-Irons and Chasing Performance, which highlights the dangers of performance chasing. My role of selecting Oxford's active equity managers would certainly be easier if performance chasing was effective. My experience, however, confirms Jared's observation. If trailing performance is of minimal benefit (or even detrimental) in finding future outperformers, one must identify other factors which lead to success in investing. A deep and experienced investment team is clearly important, as well as strong alignment of interests. Perhaps less obvious, I've found that most successful long-term investors cite a similar factor as a critical source of their investment success: time horizon arbitrage. In a low return environment, capturing the opportunities available to those with a longer time horizon will significantly improve the probability of investors reaching their long-term goals.
Time horizon arbitrage refers to the opportunity that is created for long-term investors due to the short-term fluctuation of market prices. Many investment managers believe that the greatest inefficiency in the market today is the different time horizons of market participants. The fair value of an individual business should be determined by its long-term cash flow generating potential. Stock price fluctuations on a daily, monthly and even quarterly basis often have very little to do with the fundamental value of the business. Investors who are skilled at valuing businesses view these short-term fluctuations as opportunities.
Stock market prices have been increasingly driven by short-term forces. This is best highlighted by the average holding period of a stock traded on the New York Stock Exchange. From 1940-1960, the average holding period for a stock was nearly seven years. In the past decade, the average holding period has been slightly over one year, meaning there has been nearly 100% turnover of stocks every year!
There are many explanations for the increased activity and shorter average holding periods:
Long-term investors embrace the volatility created by these short-term influences. Many view their purchases of stock as the purchase of a fractional ownership in the business and evaluate that business as if they were purchasing the entire company. They analyze fundamental drivers of long-term value which often includes the following:
Ultimately judgements in these areas will drive an assessment of the company's potential for generating cash flow, which will in turn inform a view on the firm's overall value. For a typical business, expected cash flows over the long-term (ten years out, and more) will account for more than half of the company's present value. Short-term noise has little impact on long-term fundamentals or the fair value of the business. Short-term volatility in a stock price movement, however, can create a gap between current market value and long-term fundamental value – an arbitrage opportunity which can be exploited.
Astute investors in publicly-traded securities enjoy the benefit of a schizophrenic seller (the market) who at times offers to sell at irrationally low prices or buy at irrationally high prices. Ben Inker at GMO suggested in a recent quarterly update, well over 90% of the volatility of the stock market cannot be explained as a rational response to the changing value of the stream of dividends it embodies.2
Private Equity buyers purchase from a knowledgeable seller, intimately familiar with the long-term business fundamentals and compete with investors analyzing the business with a similar long-term perspective. Investors taking a private market value perspective within the public markets can take advantage of irrational short-term pricing.
Studies have highlighted the benefit of a longer term horizon. Managers focused on long term drivers of a business's value typically have lower turnover and longer average holding periods. A recent paper, "Patient Capital Outperformance: The Investment Skill of High Active Share Managers who Trade Infrequently" by Martijn Cremers & Ankur Parrek, highlighted the benefit of a longer time horizon.
The benefits of high active share managers have been previously highlighted in a 2009 study.3 Cremers & Parrek's study further dissected the mutual fund universe, evaluating average holding periods within high and low active share managers. The data showed that managers with longer holding periods outperformed within both high and low active share managers. High active share managers with holding periods of more than two years outperformed on average by 2%.
Investing is a zero sum game and therefore, after fees, the majority of active managers will under-perform. In evaluating managers that do outperform over the long term, it’s clear that their time horizon is a key source of the success. Cremers & Pareek noted, "US equity markets provide opportunities for longer-term active managers, perhaps because of the limited capital devoted to patient and active investment strategies." The inefficiencies available to those with a long time horizon are unlikely to be eliminated soon due to the increases in allocations to short-term trading strategies and continued pressure for short-term performance. Finding investment managers committed to placing their clients' long-term interests first will be essential in achieving one's goals in what is likely to remain a challenging environment for investors.
1Zweig, Jason, "Why Hair-Trigger Traders Lose the Race", Wall Street Journal, April 10, 2015
2Inker, Ben, "Keeping the Faith", GMO Quarterly Letter, 1Q16
3Cremers, Martign & Petajisto, Antti, "How Active Is Your Fund Manager? A New Measure That Predicts Performance"
The above commentary represent the opinions of the authors as of 5.31.16 and are subject to change at any time due to market or economic conditions or other factors.