It is easy to get caught up in the blizzard of data on stock returns and investment performance and lose sight of the fact that investing is ultimately about owning part of a business. In the long run, the fundamental source of superior investment performance is, and must be, the subsequent performance of the business in question relative to the market’s expectations for the business at the time of the investment. The second half of the preceding sentence is critical. Even the best business can be overpriced due to unrealistic expectations. If so, long-run investment performance will lag even if the company performs admirably but fails to live up to expectations. In the past, we have offered Tesla as an example of this phenomenon. It is an exciting, innovative company, but one for what market expectations have typically exceeded performance. Specific examples aside, the key thing to remember is that superior investing requires not only an understanding of the outlook for the company in question, but also knowledge of the market’s perception of that outlook.
More specifically, whether or not owning part of a business produces superior investment performance depends on four interrelated factors which I will discuss in turn: 1) mispricing of the business at the time of investment; 2) the quality of the business and its management relative to market expectations; 3) financial engineering and 4) serendipity.
The first factor is obvious and is the one most often stressed by active investment managers. For a host of reasons, including those proposed in hundreds of papers on behavioral finance, the market may fail to accurately access the ability of a company to produce future free cash flow for investors. In fact, theoretical work by Sanford Grossman and Joseph Stiglitz proves that mispricing must always exist in market equilibrium to provide the proper incentives for investment research. Unfortunately, the theory offers no suggestions for actually finding mispriced securities.
The second factor, the quality of the business and its management, is really a subset of the first. What matters for investment performance is the not the quality of the business per se, but the difference between the quality of the business and the market’s perception of that quality. Nonetheless, assessment of the quality of a business and its management is so important, it makes sense to break it out as an additional factor.
The main impact of the third factor, financial engineering, primarily is the result of leverage. Borrowing can create value directly because interest is deductible at the corporate level while payments to shareholders are not. Consequently, it is possible to increase value by issuing debt and buying back shares – at least to the point where the risks of financial distress become binding. Apple, for instance, has been doing this. It is also a mainstay of the private equity business. However, these direct benefits have been muted by the reduction in corporate tax rates. What has not been muted is the return magnifying impact of leverage. By adding a wedge of fixed costs, borrowing increases the return on equity in good times and the reverse in bad times. For investors, like private equity firms, who think they have found mispriced companies, or companies whose valuation can be improved by new management, leverage is a godsend allowing them to multiple their profits. Of course, if they are wrong leverage working in reverse can be a fast train to bankruptcy.
The final, and in the short-run likely to be the most significant, factor is serendipity. An investor who bought Amazon stock because she liked the idea of an online bookstore did just as well as an investor who bought it based on a long-term study of the company’s strategy. Given the immense volatility of stock prices, short-term performance is dominated by random variation. This unpredictability is another reason for using leverage with caution.
When considering investment alternatives, we find the four factors to be a useful tool. They force investors to ask the question, if I think this is a long-run superior investment exactly what is the source of that superiority?