In our view, being a long-term investor implies thinking in dynamic, not static, terms. It means seeing value as a movie rather than as a still picture
One of the most fundamental laws of investment is the law of compounding and this law directly applies to the rationale for long-term growth investing. The effect of compounding is to make the impact of growth duration on valuation not linear but exponential. This “exponentiality” in turn means that the weight of the later years in total valuation is disproportionate and the potential price-value differential so massive as to create a long-term “value reservoir” that understandably cannot be fully priced in by the market. To illustrate and understand the workings of this mechanism, we will refer to the exemplary investment case provided by the Coca-Cola Company through its historical evolution since its IPO in 1919.
WHITE PAPER - The long-term growth conundrum
Long-term investors are being rewarded above average
Comgest believes a very common limitation in the way market players approach valuation is that, in essence, they view it as a photograph instead of a film. They look at snapshots instead of a motion picture. They always seem to think that at each point in time, the value of a company is a fixed, determined object and fail to see that it is more of a living organism. There is a dynamic of both value appreciation and logical price evolution that is thereby missed. A few misconceptions or contradictions ensue.
As a case in point, many market players claim to be long-term investors, when they are in fact traders. This is because their investment strategy consists in buying assets at prices below their so-called “intrinsic value” with the expectation that later prices will converge towards this defined value. The corollary of that logic is that once the market perception of the asset as expressed by its price is back in sync with its value, there is no more justification for the investor to keep holding the asset (that is as long as (s)he is dedicated to outperforming the average market return). So the rationale of buying below intrinsic value and waiting for prices to catch up with value is really a buy-and-sell strategy, in other words a trading strategy. Of course, it may take a while for the gap to close. But the key point is that the objective interest of such a strategy is fast rotation because the excess return will be inversely related to the time taken by the market to align prices with value. If for example we suppose that an asset intrinsically worth 100 is bought at 50 and sold one year later at its appropriate updated value (108 assuming an 8% discount rate), the return will be 116%. Yet this return will drop to 26.5% if sold after the market takes 3 years to recognize the value (then at 126). So the strategy will be all the more successful that positions can be quickly liquidated and replaced by new ones, in line with a trading approach.
In contrast, the genuine long-term investor is one whose objective interest is to keep holding the asset. What kind of investor would benefit from a true buy-and-hold strategy? The quality-growth investor. Why? What is different in the case of growth investing? Why would this decreasing return phenomenon not apply to all growth stocks too?
Eric Voravong is an independent consultant who has been collaborating with Comgest on a regular basis since 2008. Previously, he was a senior analyst in a hedge fund. He started his career in 1989 at Banque Paribas, where he held various positions in Paris, Los Angeles and London, first in corporate banking before moving to equity research. He graduated from EM Lyon School of Management and is a CFA charterholder.