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Benefits of long time horizons in stock market investing

25 November 2012 06:30 pm - 0     - {{hitsCtrl.values.hits}}

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“Always invest in the long term” is the mantra employed by Warren Buffett, the most famous long-term equity investor, who is a living testament to the potential benefits of thinking long term.

A survey of the trading activities of the investors at the Colombo bourse reveals the behaviour consistent with both value and growth investing strategies (discussed below).

The vast majority of empirical findings based on the observation on historical stock returns reveal that trading anomalies such as value and growth investing, which offer superior returns tend to persist regardless of one’s beliefs on market efficiency.
However, a failure to fully comprehend the tenets and limitations of the above strategies leads investors to take on risk over and above their risk tolerances.
A particularly worrying concern is the myopic behaviour shown by most retail investors which is in contrast to the long time horizons which characterize the successful implementation of the above strategies.

While successful investing also requires an understanding of one’s risk tolerance, reacting to developing trends in the short term (Tactical Vs. Strategic investments), planning entry and exit strategies, etc.; this analysis will constrain itself to demonstrate via empirical findings the importance and benefits of having a long-term time horizon in the context of the above trading strategies.

Equity premium puzzle
Empirical evidence confirms the fact that equities over a long time horizon outperform fixed income instruments such as Treasury bills and bonds on a risk and inflation adjusted basis.
Highlighting just one such study done by Mehra and Prescott which studied 90 years’ worth equities data in the U.S., concluded that the real annual yield on the S&P 500 was 7%, while average yield on a short-term Treasury bill was less than 1% (Mehra, Prescott 1985).
A similar observation could be made with respect to the Sri Lankan market, where data from 2002-2011 on 12-month Treasury yields and annual ASI data reveal that an investor in the ASI would have realized a compounded annual growth rate (CAGR) of 26% in comparison to a CAGR of 11.3% for 12-month T-bills over the same period.

In fact, the aspect of the findings that Mehra and Prescott found most puzzling was the reason as to why investors have consistently underinvested in equities over time compared with the actual returns made (the so called ‘equity premium puzzle’).
One of the key reasons identified by subsequent academics (Bernatzi, Thaler 1995) for this phenomenon is the inherent myopic behaviour of average investors.  

As a result, investors tend to overreact to the arrival of new information and close out their positions prematurely. This is an acute problem amongst retail investors who in the event of a loss experienced in their position due to short-term market volatility tend to close out their positions quickly and realize a loss without evaluating whether fundamentals justify such an action.
Empirical studies clearly demonstrate the mean-reverting nature of financial markets, i.e. stock prices correct for short-term mispricings and volatility over time and hence, the importance of having a long time horizon.

While these myopic biases are ingrained in the human psyche and hence are difficult to correct, trading styles such as value and growth investing is an attempt to bring about self-control particularly with regard to the time dimension of investments in order to earn superior returns.
Further, both these trading strategies which are deemed as market anomalies in the context of a well-functioning equities market require a market correction to be brought about. That is, the market must identify and act on this anomaly in order for the strategy to pay off and which may not take place in the short run.
These strategies also incorporate some element of fundamental analysis and thus investments made on this basis would generally require a long time horizon.
In this regard an investment time horizon of at least five years as recommended by Damodaran would constitute as being ‘long term’.

A value investor
A value investor can in the broadest sense be classified as an individual who invests in stocks which are trading at a discount, based on some predetermined criteria.

Most investors’ approach to value investing is based on some predetermined ‘screening criteria’ such as those popularized by Ben Graham.
Some of the most popular screening criteria employed by value investors include: 1). A Price-to-earnings (P/E) ratio below a sector or market average, 2). A Price-to-book (P/BV) ratio below a sector or market average, 3) A relatively high dividend yield.  
The set of investable stocks that fall into these criteria include both large cap firms in mature sectors, as well as small cap, illiquid and cyclical firms.
Despite the simplistic nature of the above screens, value investors point to a plethora of empirical studies that concede that the P/E ratio is a reliable indicator of undervaluation of stocks, while low P/BV stocks tend to outperform high P/BV stocks.

This directly leads to the first fallacy of value investing, which is a blind faith in screening criteria which ignores rational explanations based on fundamental analysis (such as future growth potential, profitability, etc.).
Further, what many value investors tend to conveniently forget is the fact that the findings of the empirical evidence cited above hold for investments made over a long time horizon.

Of particular interest to investors following a value strategy of small cap stocks is the relatively high transaction costs as a percentage of the stock price.
Empirical evidence by Fama and French based on 70 years of data found clear evidence that small cap firms outperform large cap firms of equivalent risks.
However, this holds only for passive investments made over a long time horizon as the proportionately higher transaction costs on small cap stocks would erode returns with every transaction.

This is confirmed by the evidence found by Chan and Lakonishok, which indicates that an increase in the frequency of transactions over a short time period can wipe out any perceived excess returns to be made on small cap stocks (Chan, Lakonishok 1991).
How this takes place is that given the relatively large percentage price appreciation required for an investor to break even in such investments, an investor could develop a loss aversion mentality which would lead to the booking of profits prematurely and subsequent buying in to the stock at a higher price.
The impact of this can be clearly witnessed in figure iii which indicates a positive relationship between returns and the investing time horizon.
Hence, financial discipline and self-control in having a long-term time horizon is of even greater importance to investors of small cap stocks in order to earn superior returns.    

IPO pop
Turning to growth strategies, growth investors are “those who invest in companies based on how the market is valuing their growth potential” (Damodaran 2012).

Growth investors in general seek to identify investable firms with high growth potential which has not been fully reflected in market prices.
The observable characteristic of most growth investments is that they tend to possess high P/E or high P/BV multiples relative to a sector or market.
A particular area of interest for retail investors in Sri Lanka is the Initial Public Offerings (IPOs).
The vast majority of Initial Public Offerings (IPOs) are attempts by firms to raise capital to fund future operations and hence, subscribing for such IPOs is inherently a growth strategy.
Investors attempt to profit from the spurt in prices of the new IPO over and above the issue price (known as the ‘IPO pop’) experienced during the first few days of trading.

Hence, although the investment in an IPO should be made on the basis of the future growth potential of the firm, the objective of the majority of the retail subscribers is to earn excess returns in a short period of time.  This strategy has in the past led to superior returns being made as evident in the findings made by Lee, Lockhead and Zitter who observed a high probability of the ‘IPO pop’ taking place with the average IPO issue price being underpriced by an average of about 10% to 15%.
However, this does not necessarily mean that IPOs are necessarily good investments. Retail investors in IPOs that do not experience a spurt in prices in the first few days (the ones that are least underpriced) tend to remain at a price below the issue price for an extended period of time, exposing the investor to high risk.

Although investors claim that excess returns may be earned by investing indiscriminately in all IPOs, on the belief that majority of IPO issues are underpriced; this thinking is inherently flawed for the following reason.
IPOs which are truly undervalued with respect to the issue price and which are most likely to experience the ‘IPO pop’ are likely to be oversubscribed several times over as opposed to fairly priced or overpriced IPOs which may not experience the ‘IPO pop’.
As a result, an individual investor is most likely to receive only a fraction of his share allotment to underpriced IPOs and the full share allotment to overpriced IPOs.

Hence, the investor’s portfolio is underweight with respect to underpriced IPOs and overweight with respect to overpriced IPOs (Damodaran 2012).
Hence, in order to attain a more favourable portfolio mix, having a long term view with a particular attention to assessing the long-term prospects of the new issue in the context of the sector and the economy it operates in is a necessary condition.
In conclusion, it is clear that regardless of the investing strategy, a long-term view of investing and a long-term time horizon is unambiguously imperative for any stock market investor.
Investors should take to heart the words of Warren Buffett, “The stock market is designed to transfer money from the active to the patient.”      

(Source: This article was written by Travis Gomez of Asia Wealth Management Co. (Pvt.) Ltd., with auspices of the Research Committee of the Colombo Stock Brokers Association.

(References: CFA Programme curriculum, Level III, Volume 02/Rajinish, Mehra, Prescott, Edward “The Equity premium: A puzzle”, 1985/George, Thomas, Hwang, chung-Yang “The 52-week high and momentum investing”, Oct 2004/Damodaran, Aswath “Growth Investing: betting on the future”, July 2012/Damodaran, Aswath “Where is the “value” in value investing”/Warren Buffett quotes:  http://www.minterest.com/warren-buffet-quotes-quotations-on-investing/)
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