Time-Horizon Arbitrage (Part 1)

The real time arbitrage is beyond what most investors can stomach

Samuel Lee 31.10.2013
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This article first appeared in the Morningstar ETFInvestor – August 2013.

To be rational means to be sane, in possession of all your faculties. My main job is to keep clear-headed, even when it hurts. Markets can be over- or undervalued for years at a time, and even a well-executed process can produce bad results over the short run. Often the rational thing to do is to suffer a bit now for a lot more gratification down the road.

To be rational also means to be guided by reason. It implies a willingness to consider evidence and, if the evidence warrants it, to change one’s beliefs. When I examine a strategy or fund, I look for its underlying economic intuition, and whether the evidence speaks persuasively in favor of it, by which I mean a record of success over many decades and in many different countries. This approach is stringent by the standards of typical investment analysis, but it’s critical. An all-too-common mistake many investors make is extracting too much meaning from small data sets, which is why they’re often poleaxed when a star manager massively underperforms or a “safe” asset implodes.

It’s no secret I like to dig through the finance literature. The evidence therein is of much higher quality than what you’d find almost anywhere else. I admit unless you’re a bit strange, it’s not the most entertaining reading. (As it happens I am a bit strange, sparing you the pain.) But the scientific method and, by extension, the literature it spawns is one of the best ways to acquire genuine knowledge. The great thing about the scientific enterprise is that it’s always trying to poke holes in the received wisdom, correcting itself. I happen to relish this, because I enjoy finding the folly of crowds. It would be hypocritical of me to not turn that lens on myself sometimes, too. In this spirit, I try to be forthright with my readers about my limitations and screw-ups.

Rationality implies a lot of things. It implies cool-headedness and a willingness to consider evidence, to change one’s mind, and to do so in a disciplined, scientific manner. This is what I’ve always strived for in the newsletter. While the tagline has changed, the underlying philosophy hasn’t.

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Warren Buffett

Buffett must have had those words in mind when he and private-equity firm 3G Capital offered to buy out H.J. Heinz Company for a hefty 20% premium to market value. At the time (not too long ago), con-sumer staples stocks were widely thought to be expensive. Eyebrows were raised, and some went as far as to say he and 3G overpaid. A few months later, he confounded expectations again by agreeing to buy out NV Energy at a 23% premium, again when the consensus was (and still is) that utilities were expensive.

Buffett learned from Benjamin Graham that all assets have an intrinsic value, and the goal of the intelligent investor is to buy assets at a substantial discount to it, with a margin of safety. It’s clear Buffett’s estimates of Heinz’s and NV Energy’s intrinsic values were substantially higher than the market’s.

I think many observers were surprised because they associate Buffett with value investing, commonly defined as buying statistically cheap stocks. Rather, 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. In my opinion, this is a better definition of value investing—call it intrinsic value investing.

For the past few decades Buffett has favored the future earnings side of the intrinsic value calculus thanks to the influence of his partner, Charlie Munger. If you have to lump the duo into one of the commonly accepted styles of investing, Buffett and Munger are best described as “quality” or “growth-at-a-reasonable-price” investors.

Both Buffett and Munger declare 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.                                                                            

Of course, many managers claim they take the long view, bypassing Wall Street’s quarterly earnings game. It sounds great in theory, but the nature of the investment-management industry makes time horizon arbitrage nearly impossible. Few managers can live through more than a few years of massive underperformance. Beyond 10 years? Forget it. You’ve long since been fired.

This is a critical flaw of the investment-management industry, because the real value of most firms is not in their next 10 years of earnings, but the 20 years after that. The real time arbitrage is beyond what most investors can stomach.

In part 2 of this article, we will explore time-horizon arbitrage in more details.


Samuel Lee is an ETF strategist with Morningstar and editor of Morningstar ETFInvestor


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Samuel Lee  Samuel Lee is an ETF strategist with Morningstar and editor of Morningstar ETFInvestor

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