Several weeks ago, I began a new series of articles. In that first piece I discussed that fair value is one of the most misunderstood investing concepts. This edition discusses time horizon and the ways in which it is misunderstood.
Time Horizon Is Usually Subterranean
I have said for years that almost every debate in investing and between investors can be resolved by first having everyone stop and disclose their assumption for time horizon. The next time you find yourself in a discussion about investing where there is disagreement let this point be at the forefront of your mind, I think you will find that the debate mostly is a failure to discuss the time horizon underneath the argument. Once that assumption is revealed the rest is just a conversation about the logic of the argument, and not an actual substantive difference of opinion.One such example of a differing time horizon and its importance to understand is the supposed difference between value and growth investing. Growth investors also care about value, because they do not want to overpay for the price appreciation they believe is embedded in a security. Nor do value investors want to purchase a security without growth, because otherwise this is just a bond where there is no hope of a credit rating upgrade. No, one of the biggest differences between growth and value investors, is a different approach to time horizon. Growth investors want to double their money, not in 100 years, but in 2 years.Yet another example is that two analysts having a different opinion about a security, usually a stock, have used different assumptions about time horizon in their valuation models. If an analyst has used a 7-year time horizon, and another a 5-year horizon this leads to very different answers in terms of value. Importantly, a 7-year time horizon does not always mean that the presumed value is lower. After all, if modeling two extra years of revenue growth at a faster than GDP growth rate has taken place, then the terminal value is off of a higher base.Want more sane, more informed investment debates? Then get agreement on the time horizon first.
Time Horizon Is Divorced from Anything Meaningful
It is also my experience that most investors’ time horizons are divorced from anything meaningful and are entirely arbitrary. If your valuation model always explicitly models five years, and not 2-years or 12-years, why? Here are some ideas about what you could anchor your modeled time horizon to, and that would honor the power of time in your thinking and modeling:
- The period of excess, or unusual growth of the business (e.g. a new product’s release)
- A full economic cycle (e.g. include an up and down, or a down and up GDP period)
- A major product’s life cycle; this could be until there is market saturation (e.g. iPhone)
- Tied to the natural lag between beginning an investment in R&D and a product from R&D
- Something, anything, other than just arbitrariness
If you cannot tie anything in your model to a time horizon, then for God’s sake run your model over different time horizons so that you can at least see and get an estimate for theta, θ, the change in value with respect to time.
There is No Such Thing as a Future Fact
Another misunderstood aspect of time horizon in investing is that there is no such thing as a future fact (discussed at length in The Intuitive Investor). All of the results of investing take place in the future, not the past. But most investors spend all of their time on factual analysis. This is the equivalent of conducting an autopsy, when what is needed is a physical.Value investors, for example, engage in this kind of behavior all too frequently, and therefore miss state changes. The miss usually happens because they look for businesses with “moats” around their business models, great leadership, and so on. Said another way, they hope the past repeats itself with high probability. Rare, though, is the business whose past facts can so easily be extrapolated into the future where there are excess returns to be had. Value investors compensate for this by purchasing with a margin of safety. But, the unintended consequence of this is that they frequently are buying companies that have an identifiable problem – a failed acquisition, a management transition, a flattening top line – and they are actually buying companies where there is business model risk, if not valuation risk.Yes, there is some value to understanding the facts that lead to an understanding of a business or of securities. To me what this argues for is to build the unexpected into your investment process because history does not repeat itself, but sometimes it rhymes. Here are some ways of how to do this:
- Conduct scenario analysis and construct radically different narratives about the future and examine how your holdings will do in these different futures.
- Identify the key driver of business value, such as gross margins, revenue growth, returns to innovative products, and so on, and then break that assumption. Does the company still look attractive?
- Ask management about the risks for which they are prepared. Can you imagine anything that they cannot? By definition, the greatest risk is the one for which you have no preparation. Therefore, if you can imagine a risk and they cannot, then you are purchasing an interest in their uncovered losses. Model that, too.
- I could go on, but my point is that time, the fourth dimension, the æther through which we are all moving MUST BE MADE EXPLICIT in EVERY INVESTMENT THOUGHT AND CONVERSATION.
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