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How Long Is Long Term?

Recent experiences demand a redefinition

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Jan 11, 2016
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If you ask 100 investors, at least 90 of them will likely say that they are long-term investors. In fact, we often hear claims such as “according to the IRS, capital gains and losses are classified as long term or short term. If you hold the asset for more than one year before you dispose of it, your capital gain or loss is long term. If you hold it one year or less, your capital gain or loss is short term. My average holding period is longer than 12 months so I’m a long-tem investor.” But is anything over 12 months long term? Or do you have to hold your stocks for three to five years before you can call yourself a long-term investor? What about five years? Ten years? Or forever?

I used to think that three to five years should definitely be considered long term, but my experiences in 2015 changed my thinking on this topic completely. Now I think it depends on how you think your return will be realized – business fundamental growth, multiple expansion, a combination of both, or special situations?

I’ve written a few articles on thinking about returns from a total return perspective in the past. Over any period of time, a stock’s return can be broken down into three categories – fundamental growth, multiple change and return of capital.

Of these three categories, the return of capital component is the easiest to figure out. Fundamental growth is a bit harder to figure out, but if a security analyst sticks to his circle of competency and works diligently, he can figure out a reasonable range of very long-term future fundamental growth of a business that he follows.

Once we, as security analysts, have figured out the return of capital and fundamental growth components, what’s left is the valuation change, which, in my opinion, is the hardest to project. Which multiple Mr. Market is willing to assign to a business depends on so many factors – interest rates, inflation rates, industry dynamics, business fundamentals, dividend yield, flow of capital, etc.

If you expect to get most of the returns from the growth of fundamentals of the businesses over time, there are two ways to achieve this – you can hold the stock forever so valuation change is almost completely smoothed out over time, or you can hold the business for say three to five years and hope that the valuation stays the same or improves.

If you expect to get most of the returns from valuation change – which both traders and a lot of deep-value Ben Graham followers do, then, by definition, you cannot be a super long-term investor because the valuation change on an annual basis will be closer to 0% the longer you hold. In this case, the sooner valuation changes, the better. Therefore, there may be some subconscious incentive for someone in this camp to seek out short-term speculative factors, which are less knowable and predictable.

Then there’s the third camp – these are investors who expect returns to come from both fundamental change and valuation change. Within this camp, we can define two groups – those who seek cyclical businesses with often fast and furious fundamental and valuation changes and those who seek predictable and stable businesses with steady fundamental changes and unpredictable valuation changes. Either way, investors in this camp are also prone to short- to medium-term thinking because again, with valuation change, the shorter the time period, the better the return.

The implication from the above is – before you make an investment, you better figure out where you expect most of your returns will come from before you can call yourself a long-term investor. There are some disguised value investors who call themselves long-term investors but seek most of the returns from valuation change only.

There’s nothing wrong about seeking returns from valuation changes mostly. It just seems to me that predicting valuation changes involves a lot of speculative factors that are not essential to value investing, especially in the equity world (in the distressed debt world this doesn’t apply). Some people can do it successfully and consistently, but few have achieved really impressive returns (again, except in the distressed debt area).

To me the true long-term investor is undoubtedly the first group exemplified by

Warren Buffett (Trades, Portfolio). They stick to their circle of competency and work hard to analyze businesses whose fundamentals can be reasonably predicted over the next 10 years. They don’t vastly overpay for them, and once they own them, they truly hold them forever. This is the type of investor I aspire to be ultimately.

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