“Human nature desires quick results, there is peculiar zest in making money quickly….compared with predecessors, modern investors concentrate too much on annual, quarterly and even monthly valuations”, Keynes

Humans tend to focus on short-term outcomes. We prefer to see results sooner rather than later. This focus makes it easier to enjoy a reality we understand than to make sacrifices for a future we don’t know. Self control is challenging for us all, at any age.

The simplest example is the happy feeling people get when they go shopping. The gratification of buying something is immediate and spurred on by the release of a happy drug called serotonin (encouraging repeat behavior). Contrast this to the alternative of delaying the purchase to save the money and put it towards your retirement. It is our emotions at play that influence the way we behave.

We have spent a lot of time, and much has been written, on better understanding how human behavior influences the decisions people make when it comes to finance and investing. In particular, we are most interested in identifying companies to invest in where the share price is well below the value of the cash flow stream. There are two key sources of mispricing that arise when asset prices become disconnected from their estimated values.

Firstly, behavioral biases such as greed and fear impact on the daily decisions people make. In markets where uncertainty increases, it is our fear of losing money that drives our behavior. We are often faced with the fight or flight dilemma. Instinctively we should prefer flight (for example when a zebra is being chased by a lion) but it may result in undesirable outcomes in other situations like investing. For example, if you liked a company at R100 and the share price fell to R50 you should like it a whole lot more (unless the facts have changed, you should be buying more not selling).

Right now, the Zebra is not thinking about his long term future

Both these reactions (flight or fright) are controlled by our emotions, which are processed in the oldest part of our brain (the limbic system). It requires no conscious thought and can frequently come up with the incorrect conclusions.

The second opportunity arises when there are differing time horizons. Making a decision always involves a trade off. In the example above, it involves sacrificing the perceived short-term happiness of being a shopaholic versus being able to live out a comfortable retirement at some stage in the future. In the world of investing, it may involve having to endure short-term relative underperformance in the likelihood of experiencing longer term value creation. The root cause of the problem is we don’t consider our total wealth, but instead tend to judge a decision by evaluating changes measured in terms of short term gains and losses.

Human nature normally serves us well in dealing with day-to-day life (in fact, it’s been core to our survival). It does, however, get in the way of achieving success in long-term activities like saving and investing. Unfortunately there is no cure other than trying to understand the types of behaviours that may arise and attempting to avoid or overcome them. This will go a long way towards improving the outcome of decisions relating to investment choices.

What drives this short-term behaviour?

The proliferation of investment products that incorporate a greater element of speculation versus investing, for example hedge funds and high frequency trading. This has most likely been the key driver of the big decline in average holding periods over the decades (see chart 6). However, trying to exploit short-term price value gaps is unlikely to produce consistent outperformance over time.

Increased focus on quarterly performance by pension funds and consultants, particularly short-term relative performance. Human beings like to track progress in the smallest elements possible, however meaningless this may be. We prefer to think in relative, rather than absolute, terms.

Behavioural factors such as “recency” bias i.e. overweighting most recent events when making future predictions about a company, rather than focussing on longer term value drivers. For example, investors are more likely to be fearful of a stock market crash when one has occurred in the recent past, prompting them to withdraw their money at the wrong time.

Short-term news flow. We operate in a world where information flow far exceeds our needs (and does not add to knowledge). More information does not necessarily translate into better decision making, especially if information is unlikely to have an impact on the long-term prospects of a business. Information cascading typically leads to a herd mentality.

Stock market cycles. Investment time horizons shorten when uncertainty increases. This may further compound the quality of the investment decision.

Short-term oriented behaviour is particularly evident at the corporate level and within the active fund management industry (including pension fund trustees, consultants and fund managers themselves). We discuss each of these separately.

At the corporate level

We have often come across examples where the actions of management of companies are misaligned with the goals shareholders are trying to achieve. Some recent examples include:

The board of Anglo American engaging in share buybacks when the Anglo American share price was pushing new highs in 2008. Management are generally incentivised on short-term performance linked to the growth in earnings per share (EPS) (doing buy backs is often a good example of enhancing EPS in the short term). However, if the buy backs are done at prices well above fair value, they destroy value for shareholders over the longer term.

Many incentive schemes we come across are linked to short-term earnings growth. This encourages companies to grow by acquisition, often paying top dollar to boost short-term earnings growth, but destroying value for shareholders (this only becomes evident some years later). A great example is Group Five’s acquisition of Quarry Cats in 2006 (miner of stone aggregate), only to subsequently write off a large portion of shareholders’ capital because it overpaid for the asset.

The market often presses management teams to provide short-term earnings guidance. Again this misplaced emphasis encourages the wrong behaviour and in extreme cases leads to misrepresentation of financial statements (E.g. CS Holdings, Corp Capital, Super Group)

The best management teams we have come across are those management teams that think and act for the long-term benefit of all shareholders, rather than those motivated by meeting analysts’ short-term earnings expectations.

Active fund management

“In the short run the market is a voting machine, in the long run it is a weighing machine”, Benjamin Graham

Vayanos and Woolley (from the London School of Economics) contend that the best long-term views are not necessarily made by the sum of the best short-term returns. This is because the time frame becomes a reference point that influences the decision.

If the stock market were only open one day a year, would the way in which you make decisions differ from having the ability to trade every day or even intraday.

We conducted our own three-year experiment amongst four portfolio managers with whom I work. The objective was to choose an equally-weighted five-stock portfolio with a fixed three-year view. Three of the four fund managers handsomely beat the market (with in excess of 60% average cumulative outperformance for all the managers). While these returns are extraordinary (not one other manager in the country achieved this outperformance) and many clients would be very happy with these returns, they probably would not have been able to withstand:

-the extreme levels of short-term volatility
-the short periods of underperformance

So you can see how our behavioural shortcomings can prevent us from achieving our longer-term wealth creation objectives. The probability of outperforming when decisions are made according to longer term time horizons is higher.

Why we follow an unconstrained approach to managing our client’s money

In an environment where investment performance is measured over shorter periods of time relative to a predetermined benchmark, managers often take decisions to reduce the risk of short-term underperformance. This is where short-terminism can act to reduce the long-term value add achieved by active fund managers.

Often fund managers who outperform in the short-term are hired and others are eliminated prematurely after they have experienced a period of short term underperformance. This happens despite all the evidence that points to the contrary. 4When picking managers, reality dictates it’s a zero-sum game so you need to have proper tools to gauge who the potential winners are likely to be – and it’s certainly not going to be short term performance5.

Why we don’t place much emphasis on short-term earnings forecasts?

“Returns in the stock market are volatile and uncertain, the returns earned by businesses are in aggregate far less volatile and predictable”, Keynes

As part of our investment philosophy we do not place much emphasis on short-term earnings forecasts. Firstly, the accuracy of short-term earnings forecasts is very poor. Even if you could accurately predict a company’s earnings one or two years ahead, it is unlikely you would be able to translate this into an accurate prediction of the share price. This is because it’s the change in the price-to-earnings (PE) multiple that has a greater influence over short-term returns than changes in EPS6.

In the long term, the profitable growth in earnings has a much higher correlation with returns than the PE multiple. Hence predicting short-term returns becomes dependent on your ability to predict changes in the PE ratio and this measure is extremely volatile in the short term and is a function of investor’s view of risk and uncertainty at any point in time. It is unrelated to the actual underlying value of a company.

In conclusion, stock prices in the short term move in largely random fashion; however in the long term they tend to follow the actual fortunes of the company.

Summary

A short-term focus is hard to reconcile with a fundamental view of investing. On a one-year time horizon, return arises out of random price fluctuations, while on a five-year horizon, return is generated by price you pay and the growth in underlying cash flow.
 
There is considerable evidence of how short-term oriented behaviour in financial markets potentially negatively impacts on the objective of long-term wealth creation. While there is no pill we can take to cure the problem, there are some behaviour patterns that, if recognised, can be managed and even avoided.

Most active equity-based managers who survive over the long term have philosophies focussed on exploiting mispricing events; instances when long-term intrinsic value and price have moved apart.

At SIM Unconstrained Capital Partners, we further ensure proper alignment with our clients longer term objective of wealth creation by not paying annual bonuses based on short-term performance. We are all invested in the products we manage, including our discretionary savings.