Measuring long-horizon investing

Institutional investors are, in general, very long term in nature because the obligations they are aiming to meet are due many years or decades hence. Such institutions are natural investors in equities, expecting to benefit from relatively high returns driven by long-term corporate profit and dividend growth.

An approach focused on capturing this profit and growth by making investments with low turnover — in relatively stable portfolios of underlying companies held over long periods of time — could be described as long-horizon investing.

In practice, equity manager turnover shows that portfolios aren’t very stable and underlying companies are generally held for short periods (often less than two years).

Of course, such averages can be misleading. In this case, the averages likely disguise what can be thought of as two styles of equity investing — managers who identify share prices they think will go up (by more than the market), and managers who identify companies they believe will grow (by more than the market expects) over the long term.

For many institutional investors, the second type of manager approach (which might crudely be considered as investing rather than speculation) is more naturally aligned with their own long-term investment horizon. Critically, it is also consistent with their underlying raison d’etre – to ‘grow’ the savings pool sustainably by investing in equities. But do such long-horizon managers really exist and can they be readily identified?

The answer is undoubtedly yes. Managers which focus on buying companies for the long term do exist, though they are rarer than one might expect. Warren Buffet’s approach of buying wonderful businesses at fair prices and holding them forever is relevant here. But this brings up additional questions:

1. Do such great businesses exist? Answer: probably yes.
2. Are they sufficiently stable and enduring that ‘holding them forever’ (say for 10 years or more) is a viable strategy? Again, the answer is probably yes, although with less certainty than the answer to question 1. Through changing external or internal circumstances, great companies may not persist for an extended period of time (because the product they sell becomes obsolete, for example).
3. Is holding them forever regardless of price a realistic strategy? Even the greatest company can become overvalued relative to its realistic future growth prospects. Should the manager ignore this overpricing and continue to hold the company even though it’s likely to underperform over an extended period as the overpricing corrects? Or would it be more prudent and pragmatic to take some profits and invest in other great companies that aren’t as overvalued?

The true long-horizon investor will probably agree that a) the company is held for its long-term growth not its shorter-term share price performance, and b) great companies are so thin on the ground that one would need to think very carefully about disposing of one in favour of other opportunities if the risk is that it proves impossible to buy the company back at a reasonable price (because it remains overvalued or becomes even more so).

Two categories of long-horizon investor

There are arguably two distinctive styles of long-horizon equity investor.

A majority of the managers would focus on those companies that are high quality with strong brands, large market shares, high barriers to entry, low operational gearing, and robust balance sheets.

Such companies should have the ability to earn higher rates of return on capital employed ad infinitum (or at least over many years). This has tended to be a successful investment strategy because the majority of other investors assume that the returns earned by these companies will eventually return to the average rate, whereas the long-term investor has confidence that these businesses will ‘beat the fade’.

The second type of long-horizon investor is almost completely different.

This type of manager buys companies that he or she expects to grow to a much greater extent than the market currently believes. These companies will already have been identified as high growth companies by the market but this type of manager believes that the market lacks the imagination or time horizon to understand how fast and for how long these businesses can actually grow.

What the two approaches have in common is a much longer time horizon than the market generally. The success of these approaches is not going to be appropriately assessed by considering the movement of share prices over short or even medium time periods, whether in absolute or benchmark-relative terms. What happens to share prices along the way is arguably just noise.

Knowing what success looks like

Measuring performance by comparing share price performance with the market average over short periods of time is likely to be fruitless at best, or misleading at worst. But we do need to find a way of measuring how the portfolio of shares is progressing – is it ‘on track’ or has it ‘gone off the rails’?

For the first ‘compounding’ group this is probably not too difficult. It should be possible to look at the whole of the portfolio and measure it as if it were a single company, looking at whether, for example, dividends had increased, return on capital employed had grown, and if the balance sheet had remained strong, with the deliberate use of a combination of measures that are naturally in tension and therefore cannot be easily manipulated either by the asset manager or the managers of the companies in the portfolio.

For the second type of manager, which invests in what might be called ‘transformational growth’ companies, the same type of measurement approach is not going to work.

Companies growing at very rapid rates are unlikely to see dividends at all or neatly corresponding returns on capital employed.

For these companies, more of a private equity approach is likely to be required. When the manager acquires shares in the company, what are his/her expectations for growth, and how do these compare with the company’s business plan?

The manager should then be prepared to report on whether the companies in the portfolio are in line with, ahead of, or behind expectations, and why.

The establishment of a monitoring process that works for both investor and manager should enrich the debate at the outset of the mandate, align investors and managers more closely, and make for a much better informed discussion about portfolio performance, ultimately leading to good long-term relationships and superior long-term performance.

Nick Sykes is director, manager research at Mercer