Monday, February 15, 2016

Asking more valuable questions...

From Capital Returns (the excerpt below was from a Marathon letter in March 2003):
While the case for long-term investment has tended to centre around simple mathematical advantages such as reduced (frictional) costs and fewer decisions leading (hopefully) to fewer mistakes, the real advantage to this approach, in our opinion, comes from asking more valuable questions. 
The short-term investor asks questions in the hope of gleaning clues to near-term outcomes: relating typically to operating margins, earnings per share and revenue trends over the next quarter, for example. Such information is relevant for the briefest period and only has value if it is correct, incremental, and overwhelms other pieces of information. Even when accurate, the value of the information is likely to be modest, say, a few percentage points in performance. In order to build a viable, economically important track record, the short-term investor may need to perform this trick many thousands of times in a career and/or employ large amounts of financial leverage to exploit marginal opportunities. 
And let’s face it, the competition for such investment snippets is ferocious. This competition is fed by the investment banks. Wall Street relies heavily on promoting client myopia to earn its crust. Why else would Salomon Smith Barney produce a research report which begins “We are focusing on the three month sales momentum model this month”; or Deutsche Bank publish a “Weekly Autos” review? Can there really be much of value to say about industry developments over such limited time frames? Of course not. Even so, we would hate to discourage such research as, from time to time, what the short-term guys are selling can turn out to be wonderful long-term investments. 
The operative word here is “quick.” The longer one owns the shares, however, the more important the firm’s underlying economics will be to performance results. Long-term investors therefore seek answers with shelf life. What is relevant today may need to be relevant in ten years’ time if the investor is to continue owning the shares. Information with a long shelf life is far more valuable than advance knowledge of next quarter’s earnings. We seek insights consistent with our holding period. These principally relate to capital allocation, which can be gleaned from examining the company’s advertising, marketing, research and development spending, capital expenditures, debt levels, share repurchase/issuance, mergers and acquisitions and so forth. 
Take marketing, for instance, which can be vital to long-term value creation, yet is often ignored. An understanding of the economics of line extensions and an advertising strategy would have proved useful to investors in consumer products companies. Colgate Palmolive introduced its first line extension – a blue minty gel – in the early 1980s, and supported this new product with a hefty advertising spend. This was Colgate’s first new toothpaste in a generation, and line extensions, which had been used successfully in other household goods, were novel to the toothpaste market. By advertising heavily, the firm hoped to change the buying habits of a generation of shoppers who would subconsciously think of Colgate as they approached the toothpaste section of a supermarket, and when they got there, would find a product which was new, superior and, because of advertising spend, trusted. 
We did not attend any Colgate meetings in the early 1980s, but if they were anything like their equivalents today the questions might have been along the lines of: what does the rise in advertising spend mean for margins next quarter (an almost worthless piece of information)? Or, how will the increase in depreciation from the new product line for minty gel affect earnings (yawn)? Brokerage reports following the meeting may have been like one which crossed our desks this morning, entitled “Thinking Outside the Box, but near term outlook remains dreary,” recommendation: under-perform. Few investors would have understood, and even fewer would have cared, about the transformation that was taking place. 
Even today, Colgate presentations do not mention the company’s advertising spend, which remains in excess of market share in all countries except Mexico, where market share is around 90 per cent. And this is despite 20 years of the firm demonstrating that line extensions and advertising support are powerful competitive weapons. “Most people don’t think it is important,” confessed the firm’s investor relations spokeswoman. Even though we don’t own the shares, Marathon is the only fund manager to have sought and gained a meeting with Colgate’s director of advertising and marketing. 
In the two decades since its first line extension, Colgate’s share price has risen 25 fold, handsomely beating the market. This shows how important it is for long-term investors to understand a firm’s marketing strategy. Yet, given the annual 100 per cent turnover in Colgate shares, very few of the firm’s shareholders have benefited fully from its success. And since Colgate’s investment returns didn’t outperform the S&P 500 in any meaningful way for a full ten years after the introduction of its first line extension, investors with short time horizons wouldn’t have cared about such matters. 
Why did so few Colgate investors stay the course? There are a range of psychological forces stacked up against the long-term investor. In particular, there is strong social pressure from peers, colleagues and clients to boost near-term performance. Even if one has developed the analytical skills to spot the winner, the psychological disposition necessary to own shares for prolonged periods is not easily come by. J.K. Galbraith observed that: “nothing is so admirable in politics as a short-term memory.” Why should politics have a monopoly on sloppy thinking? Which makes us think that long-term investing works not because it is more difficult, but because there is less competition out there for the really valuable bits of information.