"Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years." - Warren Buffett
Value investing is not only about investing in companies with low Price to Earnings ratios and/or companies with low Price to Book ratios. After all, these ratios moved up and down a lot, which meant that stocks that looked like "value stocks" one year do not fit the description the next year. By contrast, a growth investor would pay more close attention to price to earnings.
Without knowing what these ratios would be 10 years from now, Buffett's recommendation would seem misguided.
That is unless you look at value investing a different way.
In this article, we'll explain why Buffett makes the recommendation to only buy stocks you are willing to hold on to for at least 10 years.
Components of Intrinsic Value
Let's begin by reiterating what value investing is really about.
Value investing consists of estimating a stock's intrinsic value (i.e. an objective, rational value), and choosing to buy stocks that are priced more cheaply than the intrinsic value. For example, value investors would buy a stock trading at $5 if they estimate that its intrinsic value is $10.
While measuring intrinsic value can be complex, we can boil it down to two basic components:
1. Liquidation value - the amount cash shareholders would receive if the company sold everything today and distributed the proceeds.
2. The sum of discounted future earnings - the sum of a company's future earnings after having given future earnings less weight (giving less weight to money received farther into the future, because (A) there is risk involved as profits are not guaranteed, and (B) for having to wait for money to arrive).
A company's intrinsic value is the sum of its liquidation value plus the sum of its discounted future earnings. For example, if we believe that a company's liquidation value is $10 per share and we estimate that it will earn $20 per share in discounted earnings over its entire life, then the intrinsic value of this company would be $30 per share.
For the average North American corporation today, the latter component - discounted future earnings - matters much more than liquidation value. For example, Moody's (Ticker: MCO) has somewhere between negative 1 and 2 billion in liquidation value.
In other words, Moody's wouldn't be able to repay its lenders if it ceased operations today, let alone pay out shareholders. But most analysts would estimate a positive intrinsic value for Moody's because they believe it will almost certainly earn a lot of money for years to come.
Importance of Long Term Earnings
Since discounted future earnings matter so much to a company's value, let's examine it in more detail. In particular, let's talk about the importance of near term earnings vs. that of long term earnings. On this subject, one famous value investor named Michael Burry had this to say:
"What should strike the intelligent investor is that 76.8% of the true intrinsic value of the company today is in the company's earnings after 10 years from now".
To see Michael Burrys point, lets take an example.
Let's say that Company A earns $10 this year, and grows its earnings by 5% every year unto eternity. That means after year 1, earnings will be:
$10 x 1.05 = $10.5
After year 2, earnings will be:
$10.5 x 1.05 = $11.03
After year 3, earnings will be:
$11.03 x 1.05 = 11.58, etc.
Then, let's discount the earnings such that for each earnings a year farther out in the future, we give 8% less weight to them (i.e. the discount rate is 8%). For example, for earnings in year 1, we weight them such that they're worth:
$10.5/1.08 = $9.71 when discounted.
For earnings in year 2, we weight them such that they're worth:
$11.03/(1.08 x 1.08) = $9.43 when discounted.
In year 3, we weight them such that they're worth:
$11.58/(1.08 x 1.08 x 1.08) = $9.19 and so on.
If we do this for all earnings unto eternity and sum the discounted earnings, Company A's earnings will be worth $350. Since we used 8% as our discount rate, this also means that if we buy Company As stock for $350, we can expect to earn 8% per year on our investment.
On the other hand, let's say that Company B earns nothing for the first 10 years, and earns the same amount that Company A earns forever afterwards.
In this case, the sum of discounted earnings for Company B will be $264 (i.e. if we bought Company B's stock, we can expect to earn 8% per year on it). Since $264 is about 75% of $350, Company B is worth about 75% of Company A.
Since the only difference between Companies A and B is the first 10 years worth of earnings, this means the first 10 years worth of earnings only contributed 25% of the value of Company A.
Conversely, earnings after the first 10 years contributed 75% of the value of Company A, which comes close to the 76.8% quoted by Michael Burry.
Where Long Term Mentality Leads You
Unfortunately, this is not how most analysts and investors think.
Most analysts and investors are obsessed with how a company will do in the next year or even just the next 3 months, not the next 10 years and beyond. You can see how prevalent this short-term mentality is when you read research reports from investment banks or online articles. Most analysts and article writers will focus on events in the next couple of years at most.
As a result of this short term mentality, the stock market routinely overreacts to short-term news. Companies that miss quarterly (i.e. 3-month) earnings estimates by even a fraction often see their stocks plunge, while companies that beat earnings often see their stocks soar. Stock prices behave this way, despite the fact that such earnings misses or beats hardly matter in the grand scheme of things. Its just one example of how irrational the stock market can be.
On the other hand, a true practitioner of value investing looks at a company's prospects beyond even the first 10 years, because that's where the bulk of a company's value lies.
Value Investing Is Long-Term Investing
This is why Buffett recommends only purchasing stocks that you're willing to hold for 10 years. Taking on that attitude forces us to stop caring so much about the short term, and refocuses our efforts on predicting what will come after.
Indeed, when we focus on the next 10+ years, we will naturally ask very different questions than the ones well ask if we focus on the short term. This is why Buffett emphasizes looking for businesses that possess strong economic moats (i.e. defences against new competitors). Because questions like this will reveal to us businesses that can survive new competition many years down the road - and deliver real value.