Sunday, April 30, 2006

Long term investing

So often you would read my messages about investing for long term.
Today when I was watching CNBC I got an interesting interpretation of
long term. A small investor said he invests only for long term. in
further questions he said that he invests with 1 year time frame in
mind. This interpretation of long term surprised me and I thoughts
let's clarify what I mean by long term so that the members of this
group are not confused about it.

Long term as I take it, is a time period which is required to take
business from the present state to a very different state in term of
progress of business. In case of new businesses its the gestation
period for the business where the reaches its normal level of
profitability on the initial investment.

In the corporate world the period may differ based on the
characteristics of the industry but the lowest time frame that can be
characterized as long term is 5 years.

For a typical business you can say 4 or more years as long term, 2-3
years as medium term and anything less than 2 years as short term. I
don't think that capital invested for less than an year timeframe in
mind falls under investment category and back that tax department for
taxing it.

I have delved upon the advantages of long term approach in countless
messages in last 3 years. Out portfolio LWB Special is an example of
what long term investing means. Hence in this message I would focus
on the cases where long term investing can go wrong.

When you invest for long term, the future of your invested capital
and retuns is tied up with the success of business. In short term you
can play around with undervalued stocks which revert to their mean
valuations and make money. However in long term the only determining
factor is the cash flows generated by the business during this period
and the potential at the fag end of your investing time frame.
Please note the second part clearly. Even though your business is
successful during the 5 years when you are holding the stocks but
when you need money the business in a temporary down phase, the
markets may not give you true price of the business. This is because
the investment communities, including high profile analysts are so
fascinated with quarterly numbers, the immediate past counts heavily
on stock prices. That leads us to the first implication.

Implication 1: When you invest for long term you have to manage your
investment and liquidity needs in such a way that you are never
forced to exit at unattractive prices under any circumstances.

Let's move on to the other aspect implied in the fact that the
success of your investment depends on success of your business. All
the businesses operate under inevitable economic laws. Among these
laws the one that can cause you greatest harm is law of diminishing
returns. Let's assume that you invest in a business that is generated
very high returns on capital. You pay a premium price to get a stake
in the business (the price of the stock). In the long run such high
returns attract competitors both the domestic and multinationals.
When the total capital invested in the business grows the returns
come down to more average levels. As an analogy you can see how your
speed diminishes the number of cars on the road grow. Another
important consequence is that your risk of accident increases.
Your business may still be generating sufficient returns above the
cost of capital, but the premium paid on such a business evaporates.
In such a case the price paid by you may turn out to be too high to
enable decent gains even when the business as such grows. There are
other changes and associated laws which can affect the profitability
of business including but not limited to, changes in interest rates,
regulation, taxation, technology, consumer preferences, currency
fluctuation, economic recession etc. This leads us to the second
implication of long term investing.

Implication 2: When you invest for long term you have to be aware
that the superior business returns can degrade to more average
levels. Hence before paying premium for such superior returns you
have to ensure that these are sustainable over the investment
timeframe. Conversely you can not reject the business yielding
average returns without proper analysis.

Let's move on to prices that you pay for the stake. As Buffett says
the investors drive using rear view mirror. When they analyze the
valuation of the stock they pay high importance to the immediate past
last 4 quarters. They use the past opportunistically to find a growth
rate for last 5 years and project it to next 10 years. The growth in
long term is at mercy of another empirical law. The law of reversion
to means. Most economic variables in a stable economic system revert
to their mean values. It is not possible for a company to grow at
rates higher than industry average for a long period. The same goes
for growth of a specific industry relative to the country's growth.
The investors and analysts try to sum up the situation in over
simplified parameters like P/E, RONW without analyzing properly the
quality and sustainability of the same. The newer terms like PEG are
what I term as mathematically flawed because PEG assumes linear
relationship between a growth rate and P/E attributable to that
growth. This leads us to the next implication.

Implication 3: The earnings and other profitability parameters of the
businesses are mean reverting. Over a long term a company with high
returns can return to average returns. A company with high growth can
return to a low growth or negative growth. Hence the valuations for
long term investments can not be based on variable of immediate past.
Averages of last 5 years may be better indicator then the current
earnings. The analytical ratios derived without proper context can do
you more harm then anything else.

Though the list of implication can go on and on, I would summarize
the message with the last but important point. As Graham said the
promoters and managements are closer to the assets than the
investors. There is a huge variety of ways, including some perfectly
legal ways, in which promoters and managements can serve their own
interest rather than the interest of small investors. If you invest
for long term with a company managed by crooks and promoted by
unethical promoters, your assets would be siphoned off. Its like
keeping a valuable locker room unlocked for too long. The
preferential allotments when the prices are low, stocks options, huge
salaries for directors, acquisitions of other companies owned by
promoters at high prices are some of the legal ways which can lead to
wiping out the networth accumulated over a long time period. This
leads us to the next implication of this message.

Implication 4: A typical business returns only a part of earnings as
dividends. The rest of the profits are reinvested in the business. If
the promoters or management follows unethical practices the investors
can not count upon the reinvested earnings as a return on their
investment. This implies that dividends are very important aspect
contrary to the currently popular belief that growing businesses
should not pay high dividends. It also means that the risk of assets
being siphoned off is not only high but incalculable and even
astronomically high returns can not compensate for this risk. Hence
the long term investments should be made only in those companies
which demonstrate high degree of accountability to general investors
and have high standards of corporate governance.

I would like to summarize the message with saying that the long term
investment by itself does not guarantee high returns, even though
it's the best investment strategy available to investors. If you are
investing for long term you should make a very careful selection of
your investments and pay a price only after completing an all
encompassing analysis of the characteristics of business.

Posted: Dec 2, 2004

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