At Hyperion Asset Management (Hyperion), we believe the best way to achieve the financial benefits of long-term compounding returns is to invest in a portfolio of businesses that can achieve sustained earnings per share (EPS) growth. The search for companies that exhibit the potential for long-term compounding returns will become more important over the next decade and beyond as we confront a structurally challenged world of very low growth. Adopting a long-term investment mindset like that of a business owner rather than a share trader is an important factor in achieving attractive compounding returns. It requires the portfolio manager to focus solely on generating long-term alpha rather than trying to string together a series of unrelated short-term alpha generating trades.
Common short-term investment strategies such as predicting near-term earnings catalysts, mean reversion in earnings, buying average businesses on low price earnings (P/E) ratios or momentum will be less effective in a world where many average businesses are likely to suffer structural declines in both long-term earnings and intrinsic value. There are also numerous behavioural biases that further inhibit a successful long-term approach to generating compounding returns. These biases include recency bias, fear or embarrassment of losses, boredom, giving into client pressure regarding short-term underperformance, linear thinking and complacency.
In order to identify companies that can sustainably grow real EPS well above average levels over a long period of time (‘compounding machines’), investors need to be skilled at identifying mispriced companies with long-term sustainable sales growth profiles. Investing in a global context makes the task relatively easier, as the investable universe is larger and there are more high-quality companies available for consideration. It is the intent of Hyperion to direct its research efforts to finding these long-term ‘compounding machines’.
Emergence of a low growth world
From the end of World War II (WWII) up until the Global Financial Crisis (GFC) in 2008, the world enjoyed a period of robust economic growth. This was driven by solid population growth, a young and growing workforce, access to abundant low-cost energy and natural resources, a robust middle class (particularly up until the 1970s in developed economies), easy access to credit, strong productivity (particularly prior to the 1980s), mass market commercialisation of a wide range of technologies and growing consumer demand. Furthermore, over the past 36 years, equity market valuations have been supported by substantial declines in interest rates, lower discount rates and higher price earnings multiples. Low interest rates combined with strong fixed investment spending in China and substantial quantitative easing programs by key central banks in the U.S. and Europe, have supported global equity markets over the past decade.
Going forward, we believe most of these ‘growth’ drivers are likely to be absent. In this structurally challenged world, investors will be unlikely to achieve attractive compounding returns from index investing. This is because most broad-based indices are dominated by average businesses that are heavily reliant for their earnings growth on the overall expansion of the economy. If the overall economy is not growing or is only growing at a low rate, then it will be very difficult for these average businesses and the associated indices to produce attractive long-term EPS growth and returns. That is, broad-based equity index earnings and returns normally reflect broader economic growth over the long term (assuming stable interest rates). In a structurally low growth economic environment, investors will need a portfolio of superior businesses that can take volume-based market share and/or generate organic growth through strong pricing power rather than relying on ever rising consumption.
Challenges with short-termism
We believe short-termism is the enemy of both successful wealth protection and wealth creation. As we have discussed in previous articles, many investors try to achieve long-term net alpha (the difference between a portfolio’s return after fees and a relevant benchmark) by combining a series of short-term alpha trades. This involves searching for numerous short-term potential alpha events to exploit. Typically, multiple trades will be conducted in order to seek a small amount of alpha that can be sequenced together and potentially accumulated through numerous investment bets or speculation. This could involve searching for earnings catalysts to predict the reversion of a short-term P/E multiple to some historical average (including both long and short positions) or undertaking a short-term earnings revision or share price momentum strategy.
These short-term trading strategies are extremely difficult to execute successfully over long periods primarily because they are reliant on accurately predicting short-term share price movements and any successful factors are normally copied, resulting in a reduction in effectiveness. They are time intensive (if undertaken by humans) and are subject to a large degree of randomness, luck and imitation. Trying to predict and take advantage of short-term share price movements is very difficult because most market participants (including algorithms) are trying to do the same thing, using the same factors, at the same time. Most of these short-term trading strategies are quickly arbitraged away because many participants are trying to use the same or similar factors.
The market is directionally efficient in terms of news flow in the short-term. That is, if stock specific news is negative (positive) then the share price normally goes down (up) relative to the market. The problem is that the news flow tends to be unpredictable in most situations at the individual company level, the industry level and macro level. Financial markets and economies are inherently random and unpredictable in the short-term due to the influence of crowd-based behavioural factors and the general complexity of these systems. There are numerous variables to analyse and forecast when assessing short-term share price changes. Examples include market sentiment, tax driven trading, content of upcoming quarterlies, management guidance, analyst revisions, regulatory reviews, anticipated acquisition activity and changes in economic policy. Markets and economies are complex adaptive systems, heavily influenced by human sentiment and behavioural factors and thus, difficult to consistently predict in the short-term.
Effective short-term trading strategies require repeated success in the accurate prediction of both the direction and timing of short-term share price movements. It is very difficult to consistently time optimal entry and exit points in stocks as most investors are poor at selecting short-term share price highs and lows for individual stocks. However, when forecasting long-term share prices, the number of key indicators reduces significantly, as they are primarily driven by sustained long-term earnings growth and its predictability.
The mindset required to successfully exploit short-term alpha opportunities is the opposite of the mindset required to successfully exploit long-term alpha opportunities. Most market participants are obsessed with short-term alpha and share price-based returns because they don’t have the patience, business model, client backing or investment horizon necessary to implement a long-term alpha driven approach. This short-term mindset and approach effectively mean that the long-term fundamentals of the businesses underlying these stocks become less important and news flow and meeting or beating short-term consensus expectations become the dominant reason for going long or short a stock. In addition, if your mindset and investment process are centred around short-term investment performance, then it is much more unlikely that you will have conviction regarding each individual stock position. Conviction based on fundamentals is important because if market participants do not have a good understanding of the underlying economics and intrinsic value of the company, they are more likely to be forced out of the stock at an inopportune time.
Hyperion’s approach focuses purely on maximising long-term returns, long-term capital preservation and long-term alpha. We believe Hyperion is different from most market participants in that we do not attempt to generate short-term alpha through trading strategies such as momentum, near term news flow, feedback loops, shorting or short-term macro trends. Our focus is on long-term business fundamentals and long-term valuation. Even though our investment process incorporates short-term share price volatility, we do not attempt to predict the direction and/or quantum of future short-term share price movements to generate alpha. That is, our investment process is not predicated on accurately forecasting short-term share price movements. Predicting short-term share price direction and quantum is not key to our ability to generate long-term alpha. The investment process can add long-term alpha regardless of the direction and quantum of relevant short-term share price movements. Again, this is in stark contrast to how most market participants try to generate alpha by implementing investment processes that are reliant on correctly predicting the direction and duration of short-term share price movements.
Most investors are unlikely to have numerous exceptional investment ideas. However, most experienced investors have some ability to recognise a few good investment ideas over time. By investing in a relatively concentrated number of high-quality businesses, being patient and holding these businesses over the long term, investors can focus on their best investment ideas and benefit from the compounding growth in their value. This is an extremely powerful and effective approach to wealth creation.
At Hyperion, we believe that in a permanently low growth world, an effective way to achieve attractive returns in equities is to be selective and combine a smaller number of stocks that have the potential to compound returns at high rates over the long-term, into a concentrated portfolio. The historical tailwinds of high GDP growth, falling interest rates and stable industry structures that have aided short-term investors in the past are unlikely to persist in the future.
Short-term momentum investing
Over the past couple of decades, there has been a rise in short-term momentum investing, supported by quantitative funds. Momentum investing seeks to hold stocks that achieve above average or rising share price or short-term earnings revisions (price momentum and earnings momentum trading, respectively). However, in order to maximise compound returns, we believe investors need to hold structural growth stocks for very long time periods, generally many years to decades. Value creation within a business is rarely linear. This means that a business with long-term growth potential can have good years and bad years where the rate of growth fluctuates. Even when investing in the best ideas, investments can still go through long periods of flat or negative share price returns and negative news flows. Earnings growth is unlikely to be steady as businesses go through their own business cycles where execution varies and the need to reinvest fluctuates. This is when an investor needs conviction to act as a business owner. Unfortunately, when implementing a short-term momentum approach, if the price or short-term earnings momentum slows, the stock is typically sold even though the business can create further significant value over the longer term. In contrast, Hyperion tends to be contrarian due to our portfolio construction process. Typically, we tend to be selling a stock (decreasing our target weight within the portfolio) when its share price is outperforming relative to the rest of the portfolio holdings and we are buying a stock (increasing our target weight within the portfolio) when the share price is under-performing relative to the rest of the stock holdings in the portfolio.
Both value-based P/E arbitrage (based on current short-term earnings) and momentum-based strategies have significant disadvantages to a long-term fundamentally driven investment approach. Neither of these short-term based strategies attempts to rigorously estimate the long-term intrinsic value of a business (and compare it to the current share price).
Behavioural challenges to long-term investing – patience and conviction
Holding on to a position when share prices are flat or down for several years is difficult for most investors. The desire for trading activity is natural, particularly during periods of underperformance (relative or absolute), when perceived weaknesses in the investment thesis become hard to ignore and the level of uncertainty and pressure grows. There are many examples where stocks that have compounded 20% to 40% p.a. have gone through periods of up to 5 years, where the return has been flat or down in absolute terms or meaningfully less than its benchmark. This has been the case for Pfizer (PFE-US), REA Group (REA-AU) and Berkshire Hathaway (BRK-US).
“I don’t know which is harder, buying right or knowing enough to hold on.”
Reinvestment at both the company level and the investor level is important to maximise the compounding effect. Structural growth companies need to reinvest in their product set to ensure their value proposition continues to improve and that new products are developed for the future. Individual investors need to reinvest income from the portfolio back into the fund to enhance the long-term compounding effect. To achieve extraordinary long-term results, investors need to focus on investing in businesses that are potential compounding machines. Pursuing short-term alpha provides entertainment through increased trading activity but it is very difficult to find sufficient numbers of good trading-based ideas over time. Banking small, regular profits may (in some cases) achieve satisfactory returns, but it is less likely to lead to attractive returns on invested capital over the long term.
“All the rest of my life I have risked too little and sold to soon.”
To have a long-term position in a stock, investors need conviction in the business model. Maintaining this conviction is difficult for most investors as share price data is available virtually instantaneously, companies report financial results over short time intervals and even the best companies will be beset with perceived short-term problems. Additionally, there are self-interested parties who benefit from negative news stories (media and short-sellers) or short-term trading activity (brokers) and who are motivated to convince investors to sell their existing holdings. Stockbrokers are incentivised by commissions that are directly related to the stock turnover in their clients’ portfolios, while the media is incentivised to grow its viewership or readership by sensationalising news in order to entertain. The rise of short sellers and their ability to influence the financial media is an additional challenge for long-term investors. Investor sentiment can turn negative quickly and dramatically. Without conviction founded on fundamental analysis and patience, investors can be shaken out of their position (normally at the worst possible time).
“The stock market is a device for transferring money from the impatient to the patient.”
You cannot compound a short position beyond zero
The financialisation of society has been occurring over the past 70 years as financial institutions and their products have grown their relative importance and influence in the economy and society. The trend towards higher levels of debt can be seen in rising ratios of debt to GDP in most countries. At the same time there has been a trend towards other forms of financial leverage including derivatives and short selling.
We believe that short selling incorporates the worst aspects of the financialisation of society in that it encourages short-termism and uses financial leverage in order to facilitate speculation on future near term share price movements. Short selling involves borrowing shares from a third party and selling the shares with the hope that the stock price will fall so that you can buy them back at a lower price. The process involves taking on financial leverage so you can speculate on future declines in the share price. It is leverage because it creates an additional potential loss or gain on a financial position where the investor’s equity capital remains unchanged. Short selling magnifies potential profits or losses and, as with any form of leverage, it involves taking on additional fundamental risk.
Short selling has gained popularity over the past couple of decades as hedge funds have marketed equity products that offer high returns and low short-term volatility risk. At Hyperion we are very cautious regarding investment strategies that involve taking on leverage because this magnifies the potential losses for any given equity capital base. In addition, we do not believe that short-term market price volatility is risk. We believe that true risk relates to permanent loss of capital or destruction of capital.
Permanent loss of capital can occur on both short and long equity positions. However, short selling increases the potential quantum of losses whilst placing a cap on potential profits. That is, a short position has a return profile that is asymmetric with unlimited downside and finite upside. The most you can ever make on a trade is known at the time the short position is placed whereas the downside is unlimited because shorting a structural growth stock over the long-term can result in enormous compounding losses. There are no exponential positive returns on the short side. This unlimited and leveraged downside makes many short sellers desperate to ensure the companies they have shorted suffer significant price declines in the shortest period possible. This desperation leads to short-termism and gives patient long term holders a significant edge. The negative potential returns on a short position are not only infinite but there are also material holding costs from having to borrow stock. We would argue that short selling is primarily a marketing tool for hedge funds to charge clients higher fees by playing on their fear of short-term market price volatility. Our observation is short sellers very rarely uncover fundamental or structural flaws in a business model.
Characteristics of long-term compounders
“But now and then a business demonstrates that it has the power to live. It is a terror to competition, not a prey. It has mastered its market.”
Occasionally a business emerges with a value proposition that disrupts huge markets, such as Amazon (AMZN-US). Amazon has appreciated more than 100 times over the past twenty years. There are several characteristics that we have identified in companies that compound substantially over time. The rate of organic sales growth, its duration and its ability to internally fund that growth through positive free cash flows are essential for a company to produce sustainable long-term returns. Reported earnings can vary significantly to economic earnings and often require adjustments to value the earnings stream appropriately.
Companies need to have both high returns on capital and to becapital light in order to grow quickly whilst still producing positive free cash flows. Companies that require heavy funding will typically offer only modest growth as such businesses will continually need to raise equity or debt. This disrupts and dilutes the effect of compounding. The need for capital, whether debt or equity, is like a gravitational pull on growth. Sustained compounding requires growing free cash flows.
A sustainable business model is essential for earnings to compound over time. This means value needs to be shared between vendors, including staff and suppliers. Exploiting partners will eventually derail growth as ultimately consumers and other stakeholders will find better alternatives. This includes the community needing to accept the product or service. It is important that growth is not derailed by an unsustainable business model or culture. This is becoming more important as the world faces limited finite natural resources and environmental damage. We will return to this concept in part five of our five-part series on compounding.
Mean reversion is a real phenomenon as luck is temporary and high returns are competed away. This is the reality for most companies. However, a small number of elite companies have powerful competitive advantages that allows their superior growth rates and returns to be sustained for long periods of time. Warren Buffett refers to an “economic moat” while Thomas Phelps called this a “gate”. High economic returns need to be protected by a strong brand, cost advantage, network effect or continual innovation. Hyperion’s core competency is identifying companies with sustainable competitive advantages whose stock is still being mispriced over the long term by investors.
Investors should be aware of disruption; especially as disruptive forces continue accelerating and expanding their financial impact on traditional businesses across most key industries and sectors. Disruption is one circumstance in which investors should sell rather than hold long-term. Disruptive products and businesses tend to enjoy structural revenue growth at the expense of legacy businesses as they use their superior value propositions to attract customers. Buying a structurally challenged business and holding it long-term is the equivalent of financial suicide. A low P/E or a high dividend yield won’t prevent permanent capital destruction because a business that has no long-term sustainable earnings has very little long-term value. A lower growth world post the GFC has resulted in rising competitive intensity and more disruption as companies compete in, often, finite markets for market share.
Having quality management is also essential to drive long-term returns. This includes fanatical founders (‘intelligent fanatics’ according to Charlie Munger) whose life meaning is about growing their business long term, rather than managing short-term expectations and results. We will return to this topic in part four of our five-part series on compounding. The article is titled “The search for management teams that can compound returns in a low growth world – Part Four.”
The best companies have growing intrinsic values over time due to their inherent optionality value. Good things tend to happen to good companies. They have large embedded optionality value which becomes obvious with time. Thomas Phelps called this the “chance to profit by the unforeseeable and the incalculable”. A P/E re-rating from a low P/E to a higher P/E typically won’t generate significant wealth in the absence of sustained, strong earnings growth. In fact, a low P/E probably won’t even preserve capital in a severe economic and market correction as the lower multiple is often associated with above average gearing levels or lower quality earnings streams, which tend to be illusionary as conditions tighten.
Hyperion has benefited from many multi-baggers since 1996, including REA Group (REA-AU) which was initially purchased at less than $A0.85 in 2004 but now trades over $A75 per share. Companies that can grow earnings at high rates for a long period of time, with large addressable markets, will produce strong compounding returns. Typically, this means searching a universe of global stocks.
“No matter how high the rate of return, the company cannot grow by plowing back earnings if it already has enough capacity to supply all foreseeable markets.”
To grow earnings for decades, companies need large total addressable markets (TAMs). This makes it difficult for companies that only sell their products to local customers in countries such as Australia, as growth eventually matures at relatively low revenue levels. The business model of these domestic only companies then needs to be exported globally to maintain growth. This is usually difficult to do as companies are typically competing with entrenched incumbents who have spent their life spans building their footprint, infrastructure, brand and customer relationships in their geographical market. In order to more effectively exploit the benefits of investing in businesses with larger addressable markets, Hyperion has turned its attention to the global horizon in the form of the Hyperion Global Growth Companies Fund.
As time passes, and a well-chosen stock grows earnings and reinvests, its share price will increase. Such stocks will grow in value at multiples of the initial investment given enough time. As such, an investor’s focus should be applied to the long-term earnings outlook rather than the recent share price trajectory. The best businesses normally appear expensive on short-term earnings metrics. We believe long-term value investing is more appropriate than short-term value investing. The long-term investor looks for characteristics such as quality earnings, a sustainable business model and quality management. Investing in a global context makes the task relatively easier, as the investable universe is larger, and the quality of the companies is higher.
Hyperion has benefited from applying the principles of long-term investing. At times the market has held a negative view on some of the stocks within the portfolio resulting in periods of flat or negative growth despite long-term value propositions remaining solid. In addition, there are significant periods of short-term volatility in share prices driven by short-term news flow and swings in noise-based sentiment. At Hyperion, we have a disciplined and structured decision-making framework that is constructed on accessing long-term return opportunities as business owners. This long-term decision-making process is founded on substantial ongoing fundamental research. Hyperion’s investment style is characterised by research, conviction and patience. It is a long-term approach aimed at reaping the rewards of compounding returns. Since 1996, Hyperion has successfully identified and held numerous ‘compounding machines’ in its portfolios, and we believe we are well positioned to continue to take advantage of attractive investment opportunities over the next decade and beyond.