Share investors require the patience to let companies implement long-term plans, says Bob Van Munster
In the wealth management industry we constantly advocate the need for investors to take a long-term view – we have even written about this many times ourselves in this column. Sadly though, many continue to focus on the short term - and it’s not just investors or day traders either. This behaviour is widespread from professional investors, to analysts, corporations and even fund managers – either by their own doing or just the sheer pressure of others.
Working in the funds management industry I see this behaviour every day; and like the other investor behaviours we have explored in previous articles, it’s not necessarily a rational or healthy approach.
In this article we look at how “short-termism” can not only impact investor returns, but can ultimately be detrimental to long-term economic growth. Investors chasing the next big stock phenomenon, hoping to make a quick capital gain; companies facing constant pressure to meet analysts’ profit expectations; and fund managers being increasingly scrutinised for their short-term performance, are all damaging behaviours. Indeed, they run counter to the underlying premise of investing in shares in the first place, with the majority of Australian share funds having an investment time horizon of three to five-plus years.
Short-termism – the evidence
As a participant in the investment industry for more than 35 years, I have been observing the increasing focus on the short term from a variety of aspects – from a shareholder investing on behalf of our clients, and as a fund manager being constantly scrutinised for performance by the industry.
I have observed a marked increase in the level of short-termism in the market in recent years, as evidenced by higher turnover in the sharemarket, shorter tenures for CEOs, and remuneration packages for senior management that have a heavy bent towards short-term performance.
I see this behaviour at its strongest during company reporting season. The last reporting season in February was a particularly enlightening one, where we saw a high level of “fast money” looking for a turnaround in company performance and profitability, which exited quickly if reality fell short of expectations. This included companies that reported a lift in profit, but which still disappointed.
Qantas was a case in point. It returned a good result for the first half of the year (it delivered a profit while most airlines languished in the red), has worked at rationalising the business, and is well positioned to take advantage of the expected increase in travel as the global economy gains momentum. But the market was expecting more of that positive outlook to be delivered now. When the company didn’t increase its guidance for its full-year profit, the stock fell 12 per cent in a week. Nothing had changed, except that the analysts had forecast a linear recovery and were disappointed. The company’s advice that price increases take some time to flow through to higher revenues should have been heeded. With no change to the longer term fundamentals the stock slowly recovered its losses over the next month or so.
This “fast money” trend, where investors are looking to make quick gains, is not new and we expect it to continue for some time yet. Similarly, we expect the average holding period for stocks to continue the decline that has now been in place for several years.
During the last reporting season there was an unusually high level of turnover in the sharemarket across all sectors, which is an indicator of the average holding period of stocks. Indicative numbers show that the Australian sharemarket, which has a market capitalisation of around $1.3 trillion and an annual turnover of around $1.430 trillion, effectively turns itself over every nine months. This compares with every 15 months just four years ago; and roughly every two years, 12 years ago. Those companies that have high turnover in their shares make it very difficult for management to have confidence in implementing long-term investment plans.
This trend for a lower average holding period is also evident overseas. In the US, the average holding period for stocks on the New York Stock Exchange has progressively fallen over the past 70 years. In the 1940s the average stock holding period was around 10 years. By the 1970s this had fallen to six years; but by the late 2000s this had fallen to just six months. There are a number of reasons for this decline; however, there is clearly a trend for investors to turnover their stocks much more frequently.
This trend was further evidenced by a fall in the holding period for US mutual funds. In a paper written by John C Bogle, founder and former chairman of The Vanguard Group, in the Financial Analysts Journal in 2005, he commented that the average holding period for mutual funds in the 1950s was 10 years, but by 2004 it had fallen to around four years. Gone are the days when investors bought funds for the long haul. Bogle cited the plethora of managed funds in all shapes, sizes and sectors now available to investors as one of the reasons for the higher turnover.
Similarly in Australia, investors have an incredible array of managed funds to choose from. Each time an investor switches from one fund to the next, they are more than likely paying the price in one form or another – namely transaction costs – which perhaps unbeknown to them could be having an impact on their net returns.
Corporates feeling the pressure
Companies are feeling the pressure of this short-term focus on their profits, especially by analysts. Each reporting period there are high expectations for companies to deliver on their profit forecasts – not for the next financial year, but the next six months.
Analysts are increasingly expecting companies to not just meet, but exceed their expectations. If they don’t, then the share price suffers. This constant pressure for companies to exceed short-term profit expectations means that often long-term investment can be sacrificed. Cost cutting to the muscle is a reflection of companies making short-term gains for long-term pain.
The danger here is that companies are less willing to invest for the long term, as the pay-off period is too lengthy for a market obsessed with short-term earnings results. This is not beneficial for a company’s growth or indeed the economy.
One way management are getting around this dilemma is to participate in private equity deals, rather than staying listed (or listing) on the stock exchange. One example of this was Myer. In June 2006 retailing giant Myer was sold to a private equity (PE) group led by Texas Pacific Group and which also included the Myer family and company management. The PE group implemented significant changes, including updating the look of the stores, new IT systems, changing the store-card and loyalty program and the management reward system. By going private, company management were able to make changes and turn the company around. While the company may have been able to make these changes if they had remained a public company, the market would have punished them severely.
According to Myer CEO Bernie Brookes, “Because you are no longer a public company, the focus of your communication on the changes can be internal; ie, your own staff – you don’t have to explain yourself again and again to a stream of financial analysts or shareholders.” He also stated, “We don’t need to ‘sugar-coat things’, we can make smart financial decisions that have long-term benefits, and the owners are sophisticated enough to understand and endorse that approach.”
The PE group paid $1.4 billion for Myer and it was subsequently floated on the Australian Stock Exchange in September 2009 for a value of $2.3 billion – delivering them a very handsome return of 64 per cent.
Fund managers under scrutiny
Fund managers too are feeling the pinch, with an increasing focus on their short-term performance. The release of the performance tables by various research houses, and accompanying media reports about which fund manager was ranked number one over the previous month, are testimony to this behaviour.
The constant focus on short-term performance runs counter to the investment philosophy for many fund managers and is also contradictory to the investment objective of share funds, which tend to have investment horizons of three to five-plus years.
At Tyndall Investments, we adopt a threeyear view and look beyond the market “noise” to find intrinsic value in stocks. This can mean our share portfolios may underperform in the short term as we buy certain stocks as they continue to fall, remaining steadfast in stocks we believe will outperform over the long term.
However, our disciplined approach is generally rewarded with strong long-term outperformance when the market re-bounds and re-focuses on a company’s fundamentals and long-term growth prospects. A good example of this occurred during the recent global financial crisis when many cyclical stocks were sold down heavily and represented exceptional value, providing good buying opportunities for value managers.
Unlike the tech boom, where optimism fuelled demand for growth stocks, this time pessimism fuelled demand for defensive and “safe” stocks. Investors were prepared to pay a premium for stocks in sectors such as healthcare and consumer staples. As an intrinsic value manager, we recognised that cyclical stocks represented excellent value compared to defensives, with the price-to-earnings spread between the two widening to extreme levels (see chart 2). Accordingly, taking a three-year view, we positioned the portfolio to benefit from an expected market upturn.
While we did experience short-term underperformance on some of these stocks, as fear remained supreme, our strategy did pay off with cyclical stocks subsequently bouncing back in March and April 2009 (as evidenced by the narrowing in the P/E spread in chart 2) as investor confidence returned.
This pressure to outperform in the short term can mean some fund managers may be reluctant to make investments in stocks that don’t pay off for a few years. This of course can lead to some active managers being accused of being index huggers – which is not what investors are paying for.
The short-term focus can also mean fund managers can be terminated too early in the cycle. Research by Goyal and Wahal (2004) on the hiring and firing of fund managers by US pension funds between 1994 and 2003, showed that fund managers are fired at the wrong point in the cycle, with excess returns of the fired fund managers usually turning positive after being fired. They concluded that if the pension plans had stayed with the fired investment managers, their excess returns would have been similar to those from the newly hired managers.
David Gonski, chairman of the Australian Securities Exchange and chancellor of the University of New South Wales, believes the way fund managers are continually monitored and graded is one of the biggest reasons for the market’s short-term focus, summing up the situation succinctly stating: “We judge investment managers on their ability to perform well in the short term, which is crazy since many of these managers are funding whole-of-life situations.” Gonski went as far to say that short-termism actually contributed to the global financial crisis, with the ready supply of cheap credit and the constant pressure to produce quick profits substantially weakening company balance sheets.
The focus on the short term is indeed an issue for investors, companies and fund managers alike, either of their own making or because of pressure from gatekeepers and influencers. This behaviour is not beneficial for any party and directly contradicts the purpose of investing. It represents a complete mismatch with each party’s goals - whether it is an individual’s investment objective, a company’s long-term business plan or a fund manager’s performance objective.
Shares are a long-term investment, not only because of their volatile nature, but primarily because their intrinsic value (as opposed to their market value) is a function of their future longterm earnings and cash flows.
In order to grow and reward their shareholders with dividends and capital growth, companies need to invest in their business, which can involve projects that run for many years. Companies need to have confidence that they can implement these long-term strategies; and investors and analysts need to have patience to let these projects run and deliver long-term benefits to shareholders.
Bob Van Munster is head of equities for Tyndall Investment Management
