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Warren Buffett and Time-Horizon Arbitrage

Samuel Lee

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." --Warren Buffett

Buffett must have had those words in mind when he and private-equity firm 3G Capital offered to buy out H.J. Heinz Company for a hefty 20% premium to market value. At the time (not too long ago), consumer staples stocks were widely thought to be expensive. Eyebrows were raised, and some went as far as to say he and 3G overpaid. A few months later, he confounded expectations again by agreeing to buy out NV Energy (NVE) at a 23% premium, again when the consensus was that utilities were expensive.

Buffett learned from Benjamin Graham that all assets have an intrinsic value, and the goal of the intelligent investor is to buy assets at a substantial discount to it, a margin of safety. It's clear Buffett's estimates of Heinz's and NV Energy's intrinsic values were substantially higher than the market's.

I think many observers were surprised because they associate Buffett with value investing, commonly defined as buying statistically cheap stocks. Rather, Buffett tries to buy assets at substantial discounts to intrinsic value, regardless of whether that value is crystallized in current assets or yet-to-be-realized future earnings. In my opinion, this is a better definition of value investing as practiced by Buffett and his acolytes--call it intrinsic value investing.

For the past few decades Buffett has favored the future earnings side of the intrinsic value calculus thanks to the influence of his partner, Charlie Munger. If you have to lump the duo into one of the commonly accepted styles of investing, Buffett and Munger are best described as "quality" or "growth-at-a-reasonable-price" investors.

Both Buffett and Munger declare their favorite holding period is forever. This seems to contradict the fact that at a high enough price, even the most wonderful business in the world will produce less-than-wonderful returns. No doubt part of their hesitance to sell wonderful businesses at any price reflects a philosophical aversion to "gin rummy" investing. I think, though, the main reason they hold on is because they truly believe wonderful businesses are persistently undervalued by the market, even when common valuation metrics suggest otherwise.

This suggests to me that much of Buffett and Munger's edge rests in the ability to engage in time-horizon arbitrage: buying assets with long-term value underappreciated by the market.

Of course, many managers claim they take the long view, shunning Wall Street's quarterly earnings game. It sounds great in theory, but the nature of the investment-management industry makes time-horizon arbitrage nearly impossible. Few managers can live through more than a few years of massive underperformance, but beyond 10 years? Forget it. You've long since been fired.

This is a critical flaw of the investment-management industry, because the real value of most firms is not in their next 10 years of earnings, but the 20 years after that. The real time arbitrage is beyond what most investors can stomach.

Time and Value
If we had a crystal ball that could reveal true intrinsic value, it's virtually certain we would see that many stocks are either substantially overvalued or undervalued relative to current market prices. It would be a lucky coincidence if a stock traded right at its fair value. The goal of the long-term investor is to come up with better estimates of intrinsic value than the market and buy stocks trading for below intrinsic value and sell stocks trading above it.

However, if you plug in reasonable-seeming numbers, you quickly discover that the majority of an investment's present value is often embodied in the cash flows many years out. After inflation, the U.S. stock market has returned about 7% and grown per-share earnings by 2% over the past century. Apply a 7% discount rate to an earnings stream growing by 2% per annum in perpetuity, and you'll find that the earnings beyond the first five years account for almost 80% of intrinsic value. Earnings beyond 10 years account for more than 60%.

Even if you increase the discount rate to 10%, lessening the value of future dollars, about half of the asset's intrinsic value is determined by earnings generated more than 10 years into the future.

Imagine a professional investor coming up with intelligent predictions as to what a stock will be earning 10 and 20 years from now. Not only is this difficult to do, it's nearly impossible to act on when you do it correctly, because a few years of underperforming your peers (no matter how stupidly they're behaving) is a good way to lose all your clients. As a result, many analysts use higher discount rates to make the next few years of earnings matter more. By doing this, they're largely betting on how earnings surprises will evolve over the next few years. The discounted-cash-flow framework becomes more a tool for longer-term speculation.

The Value of Moats
Buffett inverts the solution, making far-flung future earnings the most important thing. He looks for firms with economic moats: sustainable competitive advantages that allow them to endure and thrive in spite of capitalism's tendency to creative destruction. The moat enables Buffett to do something that, on its face, seems insane: He uses the long-term U.S. Treasury rate to discount future cash flows (though I doubt he's actually plugging today's ultralow rates into his intrinsic value calculations). The only way to justify using such a low discount rate is to be absolutely certain that a firm will still be around decades from now and thriving.

It turns out that a company with a genuine moat is so valuable that if you can identify one with certainty, you should be willing to pay seemingly silly prices to own it. For a brief spell, Americans did just that. In the early 1970s, they were taken with the idea of high-quality, stable companies that could be bought and held forever, regardless of price. The "Nifty Fifty" had long histories of uninterrupted dividend growth and hefty market capitalizations. According to Jeremy Siegel, they had an average price/earnings ratio of 41.9 in 1972, more than double the S&P 500's 18.9.

Then they crashed, and their valuations fell to more pedestrian levels. For decades, the Nifty Fifty became just another cautionary tale of the madness of crowds. In 1998, Siegel revisited the Nifty Fifty.(1) It turns out that buying and holding an equally weighted portfolio from the mania's peak would have returned 12.5% annualized from 1972 to 1998--only a hair under the S&P 500's return. In hindsight, the lofty valuations didn't turn out to be so mad.

Siegel computed the warranted P/Es of the Nifty Fifty stocks if investors had perfect foresight. Philip Morris (now Altria (MO)) deserved a 68.5 P/E but traded at only 24. Coca-Cola (KO) deserved 82.3 but traded at "only" 46.4, and so on. The biggest disappointments were technology firms. Xerox (XRX), Polaroid, Eastman Kodak, Texas Instruments (TXN), and Digital Equipment Corporation were all big losers. Without them, the Nifty Fifty would have handily beaten the market.

Ironically, the Nifty Fifty phenomenon can be seen as a bout of temporary rationality brought on by mania. Yes, some stocks are so good that they deserve to be bought at what look like rich prices--provided you're willing to own them forever. The real task is identifying those stocks in the first place and then ignoring all the noise. The former is nowhere near as hard as the latter. Taking the long view can be excruciatingly hard at times, and for that reason wide moats will almost always be undervalued.

Munger's genius was figuring this out before nearly everyone else. Buffett's genius was listening to him and following through, enduring the long, lonely periods when the market was telling him he was a fool.

(1) Siegel, J. "Valuing Growth Stocks: Revisiting the Nifty Fifty." AAII Journal, 1998.

Samuel Lee does not own shares in any of the securities mentioned above.

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