Unconventional wisdom: The simple way to beat the market
A reminder of what really matters as results season ramps up.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: The simple way to beat the market
“Nothing matters very much, and most things don’t matter at all.”
- Arthur Balfour
Get ready for the semi-annual investing beauty contest known as reporting season. ASX listed companies will strut their stuff and inevitably some share prices will dive while others skyrocket.
History suggests what awaits investors. Mountains will be crafted out of molehills while tempests rage in teacups. Much ado will almost certainly be made about nothing.
I offer you a counterpoint to this rabid short-termism in Sir Christopher Hohn. His hedge fund has achieved an annual return of more than 18% over two decades. You will be unsurprised to find that those returns did not come from reacting to reporting season.
We are all a little too preoccupied with what everyone else is doing. As investors it is hurting our outcomes.
Most thoughtful investors know the folly of chasing performance. Most know that blindly following a stock pick without context is not a successful strategy. Yet we can’t help ourselves.
Christopher Hohn’s approach is unique in both its’ simplicity and adherence to the principle that to get different results you can’t do what everybody else is doing.
The last ‘free lunch’ in investing
In the hyper competitive world of investing Christopher Hohn believes he has found the last remaining competitive advantage – long termism.
You may think taking a long-term view can’t possibly be a competitive advantage. Most people claim to be long-term investors.
Patience is often more aspirational than reflective of our actual actions. For many investors long-term investing is something to start tomorrow – like that diet or new workout regime.
Hohn believes that most investors directly or indirectly rely on models that focus on potential outcomes over the next two or three years and ignore everything that could happen afterwards.
Many investors are preoccupied with the short-term moves of other investors by chasing performance and buying into the upside of a narrative already reflected in prices.
As Hohn put it, “The value of (a great) company is only really seen over the long term. They say there’s no free lunch in finance, but I do think long-termism in a great company is a free lunch. Because if you look at any sell-side model, they’ll go out three years – or two years. Why? Because the typical time horizon of the typical buy-side investor: one or two years. But what if it can keep being good for 30 years? Then you’re completely undervaluing that company.”
For some readers this concept may require some further explanation. A brief – and hopefully clear - foray into discounted cash flow models is in order.
Discounted cash flow model
Assets are valued using discounted cash flow models. What makes an ownership stake in a company valuable is the future earnings the company generates. Those future earnings are discounted back to the present day because a dollar today is worth more than a dollar in the future.
That approach to valuing assets is the foundation for all of finance. However, this simple concept gets complicated quickly. I’m going to provide an overview of how a Morningstar analyst creates a discounted cash flow model.
Analysts break discounted cash flow models into multiple stages. I’m going to use American Tower (NYSE: AMT) as an example since I’ve been purchasing the shares over the last several years and I’m familiar with the company.
Our American Tower analyst broke his model into three stages. For the first stage he forecast full financial statements for the next five years. Below is the income statement portion of the detailed model as an example.
The further you go into the future the less feasible it is to accurately project how a company will perform. Yet a lack of clarity doesn’t mean there isn’t value in all those future years of earnings.
To capture this value an analyst will build out a second or third stage in the model. In the case of American Tower our analyst has a second stage of ten years followed by a third stage. The third stage represents the terminal value which is all the earnings that occur after the fifteen years of stage one and two.
In stage two and three the analyst will come up with a high-level estimate for growth. For American Tower our analyst has used a 6% growth rate in stage two and a 3% terminal growth rate for stage three.
With the foundation out of the way it is time to focus on the implications of discounted cash models and the varied approaches different analysts take. This will explain why Christopher Hahn believes focusing on the long-term is a competitive advantage.
Most of the value is in the long-term while the focus is on the short-term
The following screen shot shows the estimated value for American Tower from each stage of our discounted cash flow model.
The analyst will combine them when estimating the fair value per share. What should jump out is that most of the value is not in what the company will do in the next five years or even fifteen years. Most of the value is in stage three.
Mathematically this may make sense, but it is not how most investors view the market. Most people are focused on the next quarter.
The time horizon of sell-side analysts
In the quote from Hohn he mentioned sell-side analysts. A sell-side analyst works for a broker or investment bank.
This doesn’t make them inherently bad but it does mean a sell-side analyst may be more short-term motivated than an investor like Hohn. As a result, they use a different methodology than what we use at Morningstar or what Hohn would think wise.
The short-term models don’t ignore long-term earnings. But a model that only goes out a few years in stage one may systematically undervalue the long-term potential of a company.
How a terminal value impacts valuation
The last or terminal stage of most models typically uses a conservative growth rate. This is not an inherently unwise approach. Most companies will eventually succumb to competition which will reduce growth rates.
Another reason for conservatism in terminal growth rates is the maths. A small change in the terminal growth rate will significantly change the valuation the model spits out.
Analysts will typically use a terminal growth rate that approximates overall economic growth. In the American Tower case the stage three growth rate is 3%.
Stage three for American Tower begins 15 years from now and any analyst with integrity would struggle making a compelling case about the operating environment and competition a company would face that far in the future.
Yet the fact remains that many valuation models are heavily influenced by changes in short-term outlooks – especially models by sell-side analysts or anyone using a relative valuation measure like a price to earnings ratio.
This is what Christopher Hohn is trying to exploit.
What happens if you replace an average company with a great company?
The flaw in the design of any short-term focused model is how influential short-term results are and how little influence you get from long-term excellence.
An example is illustrative. I bought Microsoft in 2012 - believe it or not for dividend growth as the yield was over 3.50%. Christopher Hohn bought Microsoft in 2017. He is yet to publicly admit he was following my lead.
When Microsoft reported earnings on January 28th the reaction wasn’t positive. The shares have dropped around 18% since the earnings release. Morningstar’s analyst maintained his fair value of $600.
Other analysts had different reactions. One analyst from investment bank Stifel downgraded the shares and cut his price target from $540 to $392. The analyst argued that Microsoft’s 2027 revenue and earnings were too optimistic.
It is readily apparent the Stifel analyst is using a very short-term model as his price target dropped 27% based on an overly optimistic estimate for next year.
Microsoft went public 40 years ago in 1986. Over those 40 years Microsoft has reported quarterly earnings approximately 160 times. There have been ups and downs based on those results and the share price has suffered at times most recently dropping 28% in 2022.
Short-term focused analysts made adjustments along the way but thanks to Microsoft’s moat the long-term growth has likely far exceeded the most optimistic of their long-term projections.
The highest quality companies can last centuries. Short-term earnings can be easily manipulated by management by delaying or cutting spending. But over the long-term what matters is finding great companies and holding them.
That scenario is the secret to Christopher Hohn’s success. Some companies continue to be great for decades. The growth rate of a long-term compounder never reverts towards the overall growth rate of the economy. It keeps growing faster.
The growth rate doesn’t have to be out of this world. It just needs to be above average for decades. For great companies the short-term models significantly undervalue the company because that terminal growth rate is easily exceeded.
While the market chases the fastest growers in the next year or two Hohn focuses on finding companies that can maintain above average growth. The rest of the market is fixated on short-term models while Hohn is focused on sustainable competitive advantages and high barriers to entry that protect a business over the long run.
The secret for Hohn is to be picky. He runs a concentrated portfolio but what separates him from many investors is his wholesale elimination of large parts of the market from consideration.
Hohn won’t invest in banks, commodity producers, retail, airlines, insurance, utilities or media. He doesn’t think those industries have true sustainable competitive advantages.
There are reportedly only 200 companies globally that Hohn would even bother to research. He holds 10 to 15 of these companies in his portfolio with an average holding period of 8 years.
The world is full of smart investors trying to figure out what emerging trends will drive markets in the next few years. Competing with them is hard.
Hohn focuses on competitive advantages that he doesn’t think will change. Combine that with long holding periods and you have a formula for success.
Final thoughts
The game sell-side analysts and short-term investors are playing is really hard to win. I like playing games with higher chances of success which is why I focus on the long-term.
As investors it is so easy to fall into the trap of forgetting what matters. The media is filled with the best performing investments and sensationalist coverage of each twist and turn.
Your fear of missing out will drag down your returns as you take the same haphazard approach as most investors.
To follow the example of investors like Christopher Hohn takes more will power than most people have. That is exactly why it is such a successful strategy.
Please share your thoughtsby emailing me at mark.lamonica1@morningstar.com.
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What I’ve been eating
I had very strong expectations for Ven-cenzo’s in Darlinghurst. Unlike Microsoft’s results my expectations were exceeded. The agnolotti con pollo e mortadella was the standout course.
Agnolotti is a tiny stuffed pasta from Piedmont in Italy. In this case the agnolotti was stuffed with roast chicken, mortadella and parmesan. I don’t know what they did to make the broth taste so good but it worked. A perfect dish for a rainy day in Sydney.
