Understanding Long-Term Investing: The Reality of Price, Value, and Earnings Growth Beyond Short-Term Noise.

“The stock market is designed to transfer money from the active to the patient.”

Warren Buffett

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Welcome to 2024! At the beginning of each year, we publish a client note, choosing to share one key insight. This choice is always difficult. It’s difficult because there is always so much happening in the world. So much noise. Russia-Ukraine. Israel-Palestine. A widening conflict in the Middle East? How will this impact energy supply or shipping routes? China and Taiwan. The 2024 US Elections. A second term for Trump? Slowing economic growth from China and its potential property crisis. Uncertainty around monetary policy. Will rates go up or down? How could monetary policy impact property prices? What impact will artificial intelligence have on industry? On jobs? On humanity?

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Despite these events – their importance – and potential implications, do they really help us invest? In short, the answer is no.

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People too often confuse trading with investing. The two are completely different and the above quote from Warren Buffet, despite its simplicity, is a critical reminder of this. Yes, a new conflict, a new president, and interest rates can impact prices in the short term. But across 3-5 years, are they really the key driver of valuation or returns, or does the market move on?

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Below is a basic, but helpful reminder of how we invest, what we invest in, and how we expect to make a return for our clients.  Investing can be as simple or as complicated as you make it and these are fundamental concepts to remember.

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TRADING VS. INVESTING

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Trading

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Buying or selling shares, or other instruments based on actual or expected short-term news, such as quarterly earnings reports, events, or price action.

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Investing

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Buying and holding an asset, such as equity in a business, to share in its future (and hopefully growing) earnings over time, which causes its value to increase.

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What's the difference?

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Trading is short-term, speculative and event-driven. It attempts to buy assets before positive news is released and benefits from a near-term price appreciation. It is focused almost entirely on share price, news and sentiment. Investing is buying an asset to participate in the long-term value and earnings the asset produces. It is a longer-term decision. It isn't focused on price, but instead on the increasing rate of income that can produced for investors.

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When we, or a portfolio manager that we work with buy an asset - we generally do so with an intention to hold it for 5-7 years or more. This period allows for a typical, full business or economic cycle - allowing for negative years and volatility.

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Think about buying another asset, like a residence. If you buy a house and trade it in 6-months time how much will you make? Less transaction costs - probably nothing (or less). If you buy it and hold it for 5 years, the probably of a return is significantly greater. Replcement costs have likely gone up in that time (given labour and material costs increase with inflation). Or unlike the share market, if someone knocks on your door and offers you 15% less for your property, do you sell it in fear the market is falling? Of course not, you hold it, knowing or giving your property an inherent level of value until it no longer serves a purpose.

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What do we invest in?

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There are only two types of assets we advise on, and our clients invest in:

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Equity

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‘The value of a company, divided into equal parts owned by shareholders.’

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For example, you can buy a 1-share of Microsoft, which is currently the world's most valuable company. You are entitled to receive a share of any income or distributions paid out to all equity holders.

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Debt

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‘A financial obligation such as a bond, debenture etc. that shows money is owed and that the borrower promises to pay it back on a certain date at an agreed rate of interest.’

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For example, you can buy one bond issued by Commonwealth Bank, which must pay you the funds back within a stated period, plus a predefined rate of interest.

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How do you make money investing?

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To answer this question, first, we need to understand the concept of 'fair value.' The price you pay for an asset does absolutely matter. It matters because if you overpay for an asset, it is going to take you longer to make a meaningful return, or, you might guarantee a loss on a poor-quality asset. Fair value is simply a rational estimate of the market price respective to other asset classes, particularly cash. Any investment should provide you with a level of return capable of compensating you for the level of risk you are taking (likelihood of losing capital, and the level of uncertainty of achieving a result). The higher the cash rate, the higher every other asset class above cash needs to be to justify taking more risk to invest in it. And vice versa.

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Put simply, if you buy any asset (equity), you pay a multiple on the earnings or future earnings that it produces. For a 10% return, investors would need to buy an asset that trades at 10 times its earnings. For 5%, an asset would need to trade at 20 times its earnings. The exception to this rule is if earnings have consistently grown year-on-year. What trades at 15, or 20x now might soon fall to 10x or less if earnings growth continues to compound. Equally, a business that trades at 10x now, might be losing money, with declining earnings year over year - so the opposite would apply. So fair value ultimately reflects the price you pay for a company, given its current and future earnings. Also, any tangible assets or intangible assets that are owned by that company - for example, real estate, cash on balance sheet, intellectual property and the quality of management.

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Let’s look at these two scenarios, the first investing in equities or shares; and the second in debt.

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Scenario 1: Buying and holding Microsoft shares.

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In June 2019, I purchased 1,000 Microsoft shares for $105,000 ($105 per share).

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The Market Cap (total market value of all shares) of Microsoft in June 2019 was USD 1.06 Trillion.

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Microsoft had approximately 10,095,000,000 shares outstanding in 2019.

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In 2019, Microsoft delivered more than $125B in revenue, and $43b in operating income. So, investors had an operating income of ~$4.25 per share or ~4.05% of their equity.

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Since 2019, Microsoft has been buying back outstanding shares. Today, there are only ~ 7,000,000,000 shares outstanding. In 2023, revenue was approximately $211B, with an operating income of $90B, So, investors had an operating income of $12.86 per share.

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Given I purchased in 2019 and retained 1,000 shares, I earned $12,860 or 12.80% on my initial investment. What started off returning me 4%, is now threefold. The market value of my equity has also tripled, with Microsoft Shares trading at more than $315 ($315,000 on initial investment). The rise in share price reflects the rise in earnings or operating income received by shareholders…

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Despite Microsoft being an incredible business, its share price tumbled over 40% between 2021-2022. Why? Trading, the market narrative, the sell-off of big tech and rising interest rates resulted in it falling out of favour. Sentiment turned negative, so despite the leading position of the company, sound financials, the expertise of its management, and its team remaining unchanged - it declined.

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Irrespective of this, a shareholder who sees the improving operating performance of Microsoft, its earnings, and its innovations – who believes this success will continue, doesn’t need any daily, monthly, or yearly quote of its value. This can be intrinsically calculated. The only time the price becomes relevant is when you wish to sell it. When investors hear the sage advice of Warren Buffet, or the now-late Charlie Munger who talks to the power of compounding as the 8^th wonder of the world, many can be forgiven as believing capital needs to be returned for this to be achieved. But it doesn’t. If companies grow earnings at 10, 15, or 20% a year – as Microsoft has, then investors will see exponential returns on their original investment, which eventually get appropriately priced.

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Scenario 2: Buying and holding Commonwealth Bank Bonds.

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In March 2023, I purchased 1,000 Bonds issued by Commonwealth Bank for $100/bond note.

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These bonds have a ~15-year maturity, expiring in March 2038. They pay a fixed rate of 6.70% pa and promise to repay the $100 face value of each bond at the end of the term.

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CBA has a credit rating of AA; meaning it is of high credit quality and is a systemically important Australian Bank. It is very unlikely to fail its obligations, and if it does, it is critical for a well-functioning banking system in Australia. While it’s not guaranteed, it may imply a level of government support.

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Pricing of the fixed rate bond was the equivalent of the expected RBA cash rate (then 4.25%) plus a margin of 2.50%. Note that interest rate expectations are now that the RBA will reach 4.50%, which if it does would make my fixed-rate bond less attractive in the short term. The market price for these bonds in 2025 is currently 3.75%, which is lower than what I purchased them for (owing to this).

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To make a return on my investment, I can choose to hold it until maturity. In this case, I will have received the equivalent of $100,500 (6.70% pa x 15) in interest, plus my original investment of $100,000. This is irrespective of whether the bonds have a lower market than my purchased price.

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Or, if interest rate expectations begin to move lower, I might choose to sell my bond for a higher price than I paid for it. For example, if markets begin to price the Reserve Bank to lower the cash rate from the current 4.35% to 3.00% by 2025, I will now have a bond that is likely paying 1.20% more than where my CBA notes were priced. The market would be willing to pay me up to the extra amount my bonds are yielding relative to the market for the remaining term.

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For example, in 2025, in the above scenario, investors could be willing to pay up to 15.60% (1.20% x 13 remaining years = 15.60%) to buy the bonds from me. The calculations work a little differently in practice, but hopefully, this communicates the idea. Investors can choose to retain bonds, regardless of their market value moving higher or lower before it matures. Upon maturity, they will still receive all of their principal back, with interest along the way, provided the company remains solvent.

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If interest rate expectations drive the market value of your bond materially higher, then you may wish to sell it to take advantage of it – but this is simply an option available to you.

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Quality of assets & margin of safety

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While the above two examples are straightforward, they should emphasise why the quality of assets matters. If you buy equity in a high-quality, well-run business, which is growing and likely to continue that growth – you will participate in that growth over time. As an investor, you must distinguish between share price growth and earnings growth. If the business enjoys consistent earnings growth, share price growth will follow over the medium term (24-36 months), even if it doesn’t in the short term (6-18 months). Equally, if you are lending to a business, those that are well run, continue to grow and perform well, and are responsible with capital, will be best placed to repay your money.

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What happens when an asset carries high levels of uncertainty, higher risk, or the quality is questionable? Is it still investible and if so, what creates a margin of safety? The short answer is yes, but the purchase price needs to reflect it, and there needs to be a sufficient level of security underpinning your investment. By that, if the company is losing money - what does its balance sheet look like? What hard assets underpin the business? While the question around price is straightforward, the margin of safety can take several forms. If you are buying equity in a business that has been performing poorly, you might find comfort in the strength of its balance sheet or book value of assets which makes it attractive. For example (and this is not an endorsement of the company), Star Casino has encountered significant regulatory penalties, compliance obligations and costs after it failed to meet anti-money laundering procedures. There is a risk that it could lose its casino licence, or potentially face further penalties and fines.

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Star currently has a book value of ~0.50, meaning that, the market value of all its assets today, mostly landmark real estate assets and hotels, is double what the share price reflects (assuming it would receive market value if it sold said assets). Put another way, shareholders would receive double the cost of a share if it sold everything and closed its doors. That number could reduce if it received less than reported value for its property assets, or if shareholders had to absorb further penalties from the regulatory or pay other liabilities. But there is arguably a good ‘margin of safety.’ Share price and value often diverge. Almost every concern we receive is about price – but not the value or operating performance of a business and how that compares to the initial period when shares were acquired.

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When it comes to debt, investors can achieve better recourse if the loans they make are secured against real assets, such as an operating business or property. There are numerous opportunities available currently, where investors can receive a yield of 8-10% from senior secured, or first-mortgage loans over well-performing private businesses, or real estate with plenty of equity that ranks below them. In other words, equity investors would need to lose 40-50% of their investment before there is any potential impairment to senior debt holders in the business. Debt holders can potentially exercise a right to take control of the business, or property, bring in turnaround consultants for the company; or for real estate – simply sell the asset and recoup the capital and interest they are owed, or complete a development and on-sell it. So, quality should always be considered; and where quality is questionable, debt or equity can be structured in a way to reduce risk, rank higher than other investors, and take recourse over assets to provide a safety margin.

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Howard Marks, famed founder of Oaktree Capital and distressed debt investor embodies this well. His reputation would be on par with Warren Buffet but sits more on the debt side than equity. When the fundamentals of a business sour, many investors will rush to sell these assets. In the case of bonds or debt securities, investors will sell bonds below their face value. Distressed securities might sell for 20-30c in the dollar for example. If the work has been done the business has good assets behind it; would perform well aside from taking on too much debt and can be recapitalised, or there is other strategic value – buying these securities, receiving a very high coupon and recovering 100% of the face value of it can result in very significant returns. Howard Marks famously returned 31.50% in one of Oaktree’s largest distressed debt funds (OCM Fund VII) since inception.

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What about venture capital or early-stage investments? This is a more difficult or nuanced question. Venture or very early-stage investing is effectively backing an idea, and a founder executes that idea. There is generally little to no financial security or assets backing the business. There is generally little to no net operating income, given earnings are reinvested into growth – marketing, additional hires, and R&D etc, and hence why venture firms generally need capital to continue that growth. If the right idea or founder is backed, it can result in very significant, outsized returns, but even then, return on capital could take a decade or longer so the investment horizon needs to be appropriate. Generally, there is little need to take this level of risk. There is also the added risk that if the founder or one of the founders leaves – you have lost the largest determinant of success for that venture because as stated above, a venture is generally backing the idea and ability of a founder to execute on that idea.

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A more responsible way to invest in a venture may be through venture-debt arrangements. Lending to them – ranks above the equity of private equity firms and investors. Return expectations are still very high, but investors are protected by the seniority they have over venture equity investors. However, there is still much higher risk given the equity or valuation of these businesses is more uncertain. They might be determined as a multiple of revenue, but given they are typically growing, and unprofitable, write-downs in valuation that need to be realised will see equity erosion.

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Successful long-term investing is not just about choosing promising investments. It's equally about managing the associated risks and adjusting your strategies as per changing market conditions. Whether it be diversification, asset allocation, or regular portfolio reviews – all these aspects together form the bedrock of efficient risk management for long-term investing.

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Investors should always focus on investing, not trading. Buying assets because they have strong fundamentals, a reliable consumer, and will see continued earnings growth. Earnings ultimately drive long-term investors, and the price will ultimately reflect higher earnings. However, short-term noise and distortion, such as big narratives or news drive sentiment. Sentiment – how people feel about an asset, can cause price to trade above or below fair value. What’s important is that investors do the work to find high-quality companies or assets with sustainable earnings and a good margin of safety or security over real assets. This applies to both equity investors and debt investors. Additionally, further risk management mechanisms such as diversification, regular portfolio reviews and appropriate asset allocation that is dynamic enough to capture assets that are undervalued as short-term sentiment impacts price; and reallocate or reduce exposure to assets that trade expensive relative to long-run averages or trade on excessive optimism.

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