The Value of Long-Term Thinking
If there's one thing most investors agree on, it's the value of long-term thinking. But why? If the long-term is the sum of a series of short-terms, why is the long view so important?
Think about how casinos work. A casino's statistical edge in blackjack is about 2%. Casinos have no idea if they'll win any single hand of blackjack. But, they expect to win about 2% over time.
This is the Law of Large Numbers in action. The more hands the casino deals, the closer their profits will converge to 2%. Luck dominates any single hand. But, over thousands of hands, the good luck cancels out the bad and leaves the casino a predictable 2% profit.
Pharmaceutical companies rely on the Law of Large Numbers too. They test new drugs on thousands of patients, not one or two. A single result says little about a drug because anyone could have an idiosyncratic reaction. A couple thousand results is more telling.
Investing is no different. Idiosyncratic factors can dominate prices on any single trade or any one day. Remember last March when the price of oil went negative? That was due to a temporary lack of storage in Cushing, Oklahoma. It had nothing to do with oil’s long-term value to society.
Looking at a single day of trading is like looking at the results of a one-participant medical trial. It’s a mistake to place any weight on the result. Looking at a couple thousand trading days is more robust because the idiosyncrasies have had a chance to balance each other out. Over the long-term, prices converge with intrinsic value.
The chart below shows the change in the S&P 500’s price against the change in its intrinsic value. Here, the change in intrinsic value equals the change in earnings per share plus the average dividend yield. While this isn't a perfect measure, it's roughly right.
Source: Author, Data from Giverny Capital’s 2020 Letter
As you can see, price and intrinsic value follow the same trajectory. While they occasionally diverge for a year or two, they always reunite.
One of the tricks to investing is zooming out enough to keep this big picture in mind. This chart looks like a smooth ride higher, but the year-to-year was rough. Though the 25-year annualized difference was 2.6%, there was little correlation year to year. Only two years experienced a difference of less than five percentage points.
Source: Author, Data FrSource: Author, Data from Giverny Capital’s 2020 Letter
The short-term mis-match between price and intrinsic value is even more pronounced among individual securities. The table below shows the change in price and earnings of the ten largest companies in the S&P 500 last year. On average, their prices fluctuated by 185%, high to low.
Source: Author, Data From Value Line
These are the largest, most stable, and closely-followed businesses in the world. Did their intrinsic value really vary 85%? Probably not. Their earnings per share only changed by 11%.
Although their average value fluctuated by $456 billion, their average earnings only varied by $2.1 billion. This means that the noise was 200 times louder than the signal.
This isn’t unusual. Prices regularly fluctuate 50%+ in normal years, as we’ve pointed out in previous letters. Volatility is the rule, not the exception and holding through volatility is the price of patience. Investors who can “look to the other side of the valley” have a leg up on the competition.
Our approach is to ignore the day-to-day and year-to-year stock price fluctuations and focus on the businesses behind stocks. We can’t predict where the market will price a security on any given day or year. But, we are confident that prices track intrinsic value over time.
We focus on owning businesses we expect to increase their intrinsic value over time. We think that a business earning significantly more in five or ten years is likely to be worth significantly more in five or ten years.
We try to use the market’s volatility to our advantage by buying businesses when their prices dip more than intrinsic value. This gives us a margin of safety.
We put little credence in day-to-day or year-to-year profits and losses because they’re more noise than signal. In our experience, five years (about 1,800 days) is the minimum time necessary for idiosyncratic fluctuations to average out.
Good scientists require a few thousand data points before trying to draw conclusions from them. Investors should do the same.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.