The Last Investment Edge

Includes: AMZN, MSFT, WMT
by: Long Hill Road Capital

There is very little informational edge left to exploit in the public markets. Markets are too competitive and information flows too quickly.

An analytical advantage can be possible, but that too is rare.

The last enduring investment edge is a long time horizon.

Financial markets are extremely competitive. There are thousands of sharp, highly-educated, and highly-motivated investors out there. Most of them work at large hedge funds and other institutions that have large research budgets. Every resource is at their disposal.

As a result, it is very difficult to obtain any kind of informational edge over other market participants these days, legally at least. There can be exceptions in pockets of the market that have less sophisticated competition, but overall my point is true.

It was once possible to get an analytical edge over other market participants, but that too is extremely difficult today.

Today, the last great investment edge one can have in the market is having a long time horizon. Why? Because the vast majority of professionally-managed money today invests with a short time horizon. Why? Often, the managers are wired that way, but even those who appreciate that long-term investing has less competition are still forced to invest for the short-term because their clients judge them on short-term performance.

And why do those clients do that? It's human nature. If your manager is lagging the index or other funds, clients get impatient and become itchy to switch horses. It doesn't always matter how impressive the manager's long-term track record might be. This is all too often a game of "What have you done for me lately?" It's unfortunate but it is reality.

I once worked for a company that recommended managers. I saw how managers were researched and recommended. I wish I could say those with the best long-term track records were always recommended the most, but that's not the case. It was not unusual for clients to fire managers that underperformed for brief periods, or at least put them on the hot seat.

So the last investment edge is a long time horizon because there is much less competition. Jeff Bezos summed this up perfectly back in 2011:

“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue."

I'd make one small tweak to adjust this to be relevant for public market investing. I'd substitute in "three-month time horizon" in the first sentence.

So what are the practical implications of this? And what sort of situations provide the best ponds to fish in?

I get very excited by a business that has a multi-decade growth runway ahead of it, and is reinvesting heavily in its business in order to capitalize on that opportunity. The great irony is that reinvestment spending depresses current reported earnings and cash flows, which causes the vast majority of the investment community to conclude that the particular stock trades at a "crazy high multiple," which of course, they use as a proxy for valuation. Why do they conclude that? Because, like I wrote earlier, they are short-term oriented and focus on current earnings and cash flow multiples. They don't bother to consider what assumptions might be baked into a stock's valuation and whether those could be achievable or even conservative.

The definition of value is the present value of all future cash flows from now to eternity. But if you need your stock to "work" in a 3-month or 6-month time frame, you really don't care about the present value of all future cash flows. You care about where these stocks will trade in 3 or 6 months. And what drives that? Sentiment. So the game these investors are playing is not based on long-term cash flows and valuing businesses, but guessing how other market participants are going to feel about certain stocks 3 or 6 months from now. Needless to say, that's hard.

So the beauty of these companies that reinvest in their own businesses is that 1) they have big opportunities to reinvest at high incremental returns, which drives long-term value creation, and 2) their stocks are often too cheap because so much of the investment community looks only at the near-term multiple and concludes they must be wildly overpriced.

Look at the multiple that Walmart (WMT) traded at through the 70s and 80s. Or Microsoft (MSFT). Or Amazon (AMZN) throughout its entire existence as a public company. Amazon has always been widely considered overvalued, but somehow its stock has appreciated by 1,131x since its IPO. That's a split-adjusted $1.50 per share IPO price versus the $1,696 per share price today.

There are countless examples of stocks that have traded at high multiples of current earnings because their management teams were never trying to maximize current earnings. And why would they when they saw decades of reinvestment opportunity ahead?

Far too many equate "high multiple" with "expensive" or "overvalued." A high multiple only means that current earnings or cash flows are not representative of future earnings or cash flows. That's true of plenty of growing companies. Likewise, far too many equate "low multiple" with "cheap" or "undervalued." The truth is whether a stock is overvalued or undervalued depends entirely on its price in relation to the present value of all future cash flows.

That's why I focus on thinking through several long-term scenarios for the businesses I study, so that I can then discount the cash flows, and determine 1) what expectations might be priced in, and 2) what set of expectations results in what sort of current appraisal of business value, and 3) whether there is an opportunity to exploit.

But none of this is easy, and it's certainly not fool-proof by any stretch. But I think it gives me the best odds of success relative to alternative valuation methods.

Disclosure: I am/we are long AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.