Finding the balance

“In the short run, the market is a voting machine, but in the long run it is a weighing machine.”

—Benjamin Graham

Investors seeking to determine a security’s “true” long-term value and to invest in those priced below that value can employ various methods. Some may build dividend discounting models or apply multiples to earnings forecasts. Others may come from the top down, estimating total addressable markets, market shares and profit margins. One commonality these investors share is that there will inevitably be periods when their methods appear to malfunction.

As a result, one classical way to interpret Graham’s words above (and presumably the one intended by Graham, widely considered the father of value investing) is essentially: Have confidence, ye value investors! The short-term beauty contest that is the stock market will often overlook those rugged-looking, less universally loved stocks in your portfolio. Still, over the long run, the market’s weighing machine can come around to recognize the value in those stocks’ fundamentals. And there is a reason this advice has stood the test of time. Generally, the worst time to abandon a well-reasoned investment process is when the voting machine seems to have gone haywire and is voting for all the “wrong” kinds of stocks.

What if, rather than looking at the voting machine as just a source of noise in the markets, we read Graham’s words as prescriptive, as a reminder not to ignore the short run while waiting for the long run to arrive. Perhaps a portfolio could have better outcomes by harnessing the voting machine when it favored some of the stocks and the weighing machine when it favored others.

A decade ago, many investment managers were confounded by certain fast-growing but expensive tech stocks whose businesses, in retrospect, were on a collision course with incumbent firms across a variety of industries, such as retail, media, and advertising. The companies being disrupted seemed to offer substantial value based on various metrics. And many of these stocks seemed to represent even better value as their stock prices retreated, while the growth companies became even more overvalued. The dominance of a few tech companies became such a prominent feature of the stock market in 2015 that the media coined a nickname for those exciting growth stocks — FANG (Facebook, Amazon, Netflix, Google).

The FANG companies and others like them have continued their performance into this decade as the acronym evolved. Our ongoing research efforts, driven by the desire to determine whether investing in companies with qualities like the FANGs could improve portfolio results over the long run, led us to explore different avenues of investing. This research led us to consider the efficacy of purely price-based, or technical, factors. 

We considered price trends over a wide range of intervals, from as short as a few months to as long as half a decade. Some detected momentum-type effects, where companies that have done well over a particular horizon continue to perform well (and vice-versa). Others detected reversal effects, where the largest losers may become the biggest winners (and vice-versa). What they all have in common, of course, is that they are pure expressions of market sentiment — results tabulated by the voting machine.

A benefit of managing a portfolio of investments is that diversification may help to improve risk-adjusted outcomes. Adding price-based factors to our investment process led us to some new and interesting types of stocks to invest in, but perhaps even more importantly, from a portfolio construction point of view, some of those new opportunities are significantly differentiated from what we were previously able to find—because the voting machine loved them and they were extremely out of favor on our price-based metrics. We still find plenty to like about value and quality characteristics. An investment strategy with only voting-machine factors may likewise be enhanced by adding the weighing machine.

Like active and passive investment strategies, there is no reason short-term technical and long-term fundamental factors cannot co-exist. There can be complementary benefits. We see no contradiction and no reason to choose exclusively between the short and long run. In our opinion, the best response to Graham’s observation on the behavior of markets is this: “Why not both?”