Time-Horizon Arbitrage (Part 2)

Time and value

Samuel Lee 14.11.2013
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This article first appeared in the Morningstar ETFInvestor – August 2013.

In part 1 of this article, we set the stage for time-horizon arbitrage. Now we look at it into more details.

Time and Value
If we had a crystal ball that could reveal true intrinsic value, it’s virtually certain we would see many stocks are either substantially overvalued or undervalued relative to current market prices. It would be a lucky coincidence if a stock traded right at its fair value. The goal of the long-term investor is to come up with better estimates of intrinsic value than the market and buy stocks trading for below intrinsic value and sell stocks trading above it.

However, if you plug in reasonable-seeming numbers, you quickly discover that the majority of an investment’s present value is often embodied in the cash flows many years out. After inflation, the U.S. stock market has returned about 7% and grown per-share earnings by 2% over the past century. Apply a 7% discount rate to an earnings stream growing by 2% per annum in perpetuity, and you’ll find that the earnings beyond the first five years account for almost 80% of intrinsic value. Earnings beyond 10 years account for more than 60%.

Even if you increase the discount rate to 10%, lessening the value of future dollars, about half of the asset’s intrinsic value is determined by earnings generated more than 10 years into the future.

Imagine a professional investor coming up with intelligent predictions as to what a stock will be earning 10 and 20 years from now. Not only is this difficult to do, it’s nearly impossible to act on when you do it correctly, because a few years of underperforming your peers (no matter how stupidly they’re behaving) is a good way to lose all your clients. As a result, many analysts use higher discount rates to make the next few years of earnings matter more. By doing this, they’re largely betting on how earnings surprises will evolve over the next few years. The discounted cash-flow framework becomes more a tool for longer term speculation.

The Value of Moats
Buffett inverts the solution, making far-flung future earnings the most important thing. He looks for firms with economic moats, sustainable competitive advantages that allow them to endure and thrive in spite of capitalism’s tendency to creative destruction. The moat enables Buffett to do something that, on its face, seems insane: He uses the long-term U.S. Treasury rate to discount future cash flows (though I doubt he’s actually plugging today’s ultralow rates into his intrinsic value calculations). The only way to justify using such a low discount rate is to be absolutely certain that a firm will be around decades from now and thriving.

It turns out that a company with a genuine moat is so valuable that if you can identify one with certainty, you should be willing to pay seemingly silly prices to own it.

For a brief spell, Americans did just that. In the early 1970s, they were taken with the idea of high-quality, stable companies that could be bought and held forever, regardless of price. The Nifty Fifty had long histories of uninterrupted dividend growth and hefty market capitalizations. According to Jeremy Siegel, they had an average price/earnings ratio of 41.9 in 1972, more than double the S&P 500’s 18.9.

Then they crashed, and their valuations fell to more pedestrian levels. For decades the Nifty Fifty became just another cautionary tale of the madness of crowds.

In 1998, Siegel revisited the Nifty Fifty1. It turns out that buying and holding an equally weighted portfolio from the mania’s peak would have returned 12.5% annualized from 1972 to 1998, only a hair under the S&P 500’s return. With hindsight, the lofty valuations didn’t turn out to be so mad.

Siegel computed the warranted P/Es of the Nifty Fifty stocks if investors had perfect foresight. Philip Morris (now Altria) (MO) deserved a 68.5 P/E but traded at only 24. Coca-Cola (KO) deserved 82.3 but traded at “only” 46.4, and so on.

The biggest disappointments were technology firms. Xerox (XRX), Polaroid, Eastman Kodak, Texas Instruments (TXN), and Digital Equipment Corporation were all big losers. Without them the Nifty Fifty would have handily beaten the market.

Ironically, the Nifty Fifty phenomenon can be seen as a bout of temporary rationality brought on by mania. Yes, some stocks are so good that they deserve to be bought at what look like rich prices—provided you’re willing to own them forever. The real task is identifying those stocks in the first place and then ignoring all the noise. The former is nowhere near as hard as the latter. Taking the long view can be excruciatingly hard at times, and for that reason wide moats will almost always be undervalued. Munger’s genius was figuring this out before nearly everyone else. Buffett’s genius was listening to him and following through, enduring the long, lonely periods when the market was telling him he was a fool.

1 Jeremy Siegel. “Valuing Growth Stocks: Revisiting the Nifty Fifty.”

AAII Journal, 1998.


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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