Myopic Market: Why Investors Focus Too Much on the Short Term
Dear investors,
There was a time when access to information was a major competitive advantage for investors. In 1815, while England and France were fighting the Battle of Waterloo, banker Nathan Rotschild had his own network of spies to monitor the war's progress and learned before anyone else that England had won the battle.
Armed with this exclusive information, Nathan Rotschild began selling his assets on the London Stock Exchange. Since everyone knew about his network of informants, they deduced that the reason for the sales was that the war had been lost and began selling their shares as well, triggering a wave of panic and a rapid drop in prices. At the same time, the banker ordered several of his agents to buy various assets at discounted prices. When the news that the battle had been won reached everyone, prices quickly recovered, and Nathan's fortune suddenly increased.
Nowadays, this maneuver wouldn't be as viable. Major events are quickly reported on multiple media channels, and the time lag between professional investors receiving this type of news isn't enough to constitute a significant advantage. Furthermore, access to non-public information via espionage networks and similar platforms would likely fall under the category of privileged information, the use of which to operate in the market is illegal. Thus, today it seems to us that competitive advantage comes less from access to information and more from the ability to filter out what's relevant amidst the endless news and data, avoiding the rest of the daily noise. This filter involves having clarity about what matters for stock market investment theses, a topic we will address in this letter.
What impacts the value of a stock
What determines a company's intrinsic value is the expected cash flow it will generate over the years, discounted by the rate of return an investor believes is appropriate for the business's risk level. This is the discounted cash flow method, used as the basis for pricing virtually any asset.
A characteristic of the method's application is that cash flows generated in the distant future are worth less than cash flows generated in the immediate future. This is based on the logic that a dividend paid in the future must incorporate an adequate return over the entire holding period, while dividends paid immediately require no rate of return over time. In other words, R$ 100 paid now is naturally worth the same R$ 100, while R$ 100 paid 10 years from now is worth much less today. Considering a rate of return of 15% per year, R$ 25 invested today would become R$ 100 after 10 years.
However, even if cash flows generated in the short term are worth more than those generated in distant years, a company's total value still depends substantially on the results its business produces over a very long time horizon. For example, a company that grows its profits at a rate of 8% per year (about 3% above inflation in Brazil), when valued at a discount rate of 15% per year, has only ~6% of its total value in its first year of earnings. In the first 5 years, it would represent ~27% of the total business value, and in the first 10 years, 47% of the total value. The conclusion from this example is quite simple: next year's earnings matter little to a company's intrinsic value. Therefore, next quarter's earnings matter even less.
Despite this conclusion, it's common to see a stock's price move several percentage points due to a quarterly result above or below market expectations, or due to political or macroeconomic news. These price fluctuations are caused by the market adjusting its projections for future results in light of new information. In other words, a company's poor results in a given quarter, for example, can lead many investors to lower their earnings expectations for the company in the coming years. Making this adjustment makes sense, as it's necessary to incorporate new information into investment analyses, but its impact is often exaggerated, and we're interested in understanding why.
Why so much attention to the short term?
Behind market price volatility is an exaggerated focus on the short term, which, in turn, is the result of a coalition of factors pressuring investors and financial market agents to focus on upcoming events.
One of the main factors is the pressure from end clients (individual investors) on the agents responsible for managing their investments (wealth managers or fund managers) to produce quick returns and avoid volatility in the value of their portfolios. Although most professional managers understand that investing in the stock market is a long-term activity, the vast majority choose the latter between following their true beliefs and fulfilling their clients' wishes to ensure they remain their clients. Thus, predicting stock price movements in the coming months becomes the goal of most professionals working in the market.
As a consequence of this dynamic, forecasting the short term also becomes the objective that promises the greatest commercial success. For example, a research analyst who accurately predicts a company's results for the next quarter typically receives more praise from their peers and clients than one who accurately predicts a company's final state five years from now, as the time window is too broad for the forecast to remain fresh in observers' minds. Furthermore, five years have 20 quarters, which represent 20 opportunities for the short-term analyst to develop and promote new theses, while maintaining the same thesis for five years yields far fewer topics for interesting conversations with clients.
Finally, the fact that the long term is much more uncertain also contributes to this excessive focus on the short term, as the human mind dislikes uncertainty and seeks ways to escape the need to admit its ignorance (which also brings little commercial success). Thus, there is a strong bias toward spending most of one's time analyzing recent events, projecting the near future with greater caution, and assuming that the distant future will simply be an extrapolation of this brief past and short projection, with a line of continuity that is intellectually comfortable to accept.
The problem with focusing excessively on the short term and projecting the long term through extrapolations is that it overly amplifies the weight of recent events. If a company grew rapidly for a few quarters, for example, simply assuming that last year's revenue is the best starting point for applying an average growth rate going forward can overestimate the business's value. If the investor assumes that the pace of growth will continue to accelerate, the overvaluation can be even greater. The same dynamic applies to negative news, and as a consequence of over-adjusting based on recent events, prices become more volatile than they should be, given that projections for decades of results would not be expected to fluctuate so much from quarter to quarter.
Interestingly, a psychology study (McClure, Laibson, Loewenstein, and Cohen, 2004) found that the human brain tends to value immediate rewards (e.g., stocks rising in the very short term), perceived by the limbic system, more than larger, deferred rewards (e.g., expected returns on long-term investments), perceived by the frontoparietal system. This is because the limbic system has the ability to override the frontoparietal system, especially in stressful situations. In other words, the more stressed people are, the more value they place on the short term. This helps explain why investors focus so much on the short term during periods of economic crisis.
What is the proper focus
Having established the point that the short term has limited relevance for equity investment theses, the problem remains of how to deal with the unpredictability of the distant future. A first step is to understand that not everything can be projected with sufficient assertiveness to serve as the basis for an investment thesis with a good probability of success.
Among these difficult-to-predict factors, some are quite important to a business (for example, the price of oil for oil companies), but it's vital to keep in mind that the level of importance of something has no correlation with its predictability, and there are several factors in the world that remain unpredictable no matter how much effort is devoted to developing intellectually elegant projections. The trap is to believe that the complexity and elegance of predictions increase their chances of being correct.
For example, a few years ago, there was talk of a super drought cycle in Brazil, which would affect the electricity sector and agribusiness. At the time, rainfall had been below normal levels for years, power generation reservoirs were low, and agribusiness was suffering from a lack of rainfall. The projection was consistent with what had been happening and supported by extensive meteorological analyses. In the following years, a cycle of heavy rains began, filling reservoirs, generating bumper crops, and erasing the theories of prolonged droughts from memory. This is just one example of several elaborate predictions that we have seen proven diametrically wrong over time.
I accept that most of the future is irremediably unpredictable. A good investor's job is to find the few points that are both important to a business's success and predictable with reasonable reliability. To do this, we usually start by studying a long past period. It's not enough to simply look at a business's results over the last two or three years. We want to assess how the company has performed over the last 10 to 15 years and look for points in its past that have remained unchanged or that have evolved according to a logic comprehensible enough to estimate how they will continue to evolve.
In Warren Buffett's famous investment in Coca-Cola, a key factor was the understanding that people develop strong habits of consistently consuming the same beverages. Interestingly, we don't like to eat the same things every day, but we tend to drink the same things for years and years. Therefore, it's reasonable to assume that demand for Coca-Cola beverages is quite resilient, and consequently, so is its revenue level. This is an example of a factor stable enough to predict its future continuity.
No prediction is accurate
Note that, even in the Coca-Cola example, demand stability only persists over long time windows. In other words, Coca-Cola's revenue isn't completely stable quarter to quarter, or even year to year. Every business experiences fluctuations over time. Therefore, forecasting quarterly results is not only difficult but also unnecessary. That's not what really matters.
In fact, short-term stability isn't even a prerequisite for a good business. One example is our own investment in Whirlpool, the company that owns the Brastemp and Consul brands and in which we've been shareholders for over 10 years. Because appliances have a long lifespan, they aren't recurring consumption items. Thus, their demand is cyclical, varying with macroeconomic conditions and real estate development cycles (people buy appliances when they move). Despite the unstable demand, Whirlpool hasn't posted a loss in over 20 years. Its profit margin fluctuates between high and low levels, but the average profitability is quite attractive and stable over long periods, which has guaranteed us excellent returns over the last decade, even with the widespread macroeconomic instability that Brazil experienced during this period.
Each variable has a suitable timeframe for making estimates with reasonable reliability. This timeframe should be long enough to ensure the sample size necessary for the statistics used in the forecasts to be applicable, following the logic that it is easier to predict the outcome of 1,000 dice rolls than the outcome of 10 rolls. However, it should not be so long that qualitative aspects risk changing so much during this period that the logic behind the projections becomes inadequate. In our experience, the ideal timeframe for business results projections is usually a few years.
Why a long horizon is suitable
Because the very short term has little relevance to a business's value, and because the most accurate period for quantitative projections typically involves a few years, we believe that a suitable time horizon for developing explicit forecasts is five years. This period isn't applicable to all cases, as some businesses can be predicted for a longer period (such as highway concession companies), but it's a good benchmark for a timeframe that combines reasonable predictability and relevance to the intrinsic value of a company under analysis.
Consequently, when we invest in a new company, we're typically willing to hold its shares in our portfolio for several years. We may sell the position more quickly if the price rises to the point where it exceeds what we understand to be the intrinsic value of the business or if our investment thesis is undermined by an event contrary to our expectations. However, we believe it's important to have our expectations properly calibrated: most theses take time to deliver the returns initially predicted, and the exact timing is unpredictable.
In the meantime, between the initial investment and the decision to sell, it's important to remember that a stock's price and intrinsic value are distinct variables and don't always go hand in hand. We've discussed this at length elsewhere, and we're in good company in assigning little importance to stock prices when determining their true value. Benjamin Graham used the analogy of Mr. Market, a bipolar character who offered vastly different prices for the same assets over time, depending on his current mood, and Warren Buffett echoes the same concept, saying that the market is there to serve us, not to instruct us. Both advocate that investors should make decisions based on an independent assessment of each business's intrinsic value, not based on price fluctuations and its market performance.
This is a simple concept that almost everyone agrees on but very few actually practice, as daily price fluctuations affect most people's psychology. The best way to deal with this is to buy stocks with the genuine intention of holding them in your portfolio for the long term. When we buy a car, for example, we rarely intend to sell it a few months later at a profit. The purchase decision is based on the expected use over several years. Thus, if the market offers half the price you paid for the car the following month, you would hardly decide to sell it because the price dropped (the famous "stop loss") and simply continue using your car, regretting not having bought it a month later at half the price. Similarly, we buy stocks with the expectation of receiving a certain cash flow over time (this is the intended "use"). As long as the business continues to generate the expected cash flow, the rationale for the purchase remains.
The advantage of focusing on the long term
As obvious as the approach we've described may seem, it's an investment style that faces little competition. While most investors remain fixated on the short term and suffer the mood swings caricatured by Mr. Market, we prefer to focus on longer horizons and react less intensely to day-to-day news, which, for the most part, proves to be mere noise, with no significant long-term impact.
Despite our position, we prefer the market to continue behaving in the same way, with a predominant focus on the short term and causing exaggerated price fluctuations, as it is precisely these fluctuations that generate the investment opportunities we seek to capitalize on over time. Fortunately, the continuation of this behavior does not appear to be at risk.
However, we hope to identify, over time, individuals who share a similar investment philosophy to ours and can become investment partners for the coming decades. To date, we have the privilege of having an investor base that is highly aligned with our management style, having navigated turbulent times with us and having the patience necessary to reap good returns.
We remain optimistic about the coming years, given the quality of the businesses we currently have in our portfolio and the discount levels that our current share price represents compared to our intrinsic value estimates. Over our 10 years of investing, our portfolio price has rarely been as discounted as it is now.
