Time Arbitrage: A Powerful Edge for Investors
March 02, 2009
Some years ago while attending an investment conference in New York, I was struggling to stay awake during an afternoon session when the words “Time Arbitrage” jolted me back to full consciousness. Joel Greenblatt (author, professor at Columbia University, and successful investor) was discussing his “edge.” As happens to me occasionally, it was at that moment that many concepts, ideas, and cherished beliefs coalesced into one elegant thought: Time Arbitrage. The supreme advantage of all the giants, from Warren Buffett to Peter Lynch to people you’ve never heard of who have quietly made billions through their investing prowess. Never has this tool been more valuable, and possibly never in shorter supply.
All professional investors seek an edge — a research method, a trading tactic, an information source — that creates a higher probability of successfully making a return on investment. An easy example is insider information. If you had non-public knowledge that Company X was developing a new technology that would revolutionize its industry, you could make a killing by buying the stock and potentially selling the stocks of Company X’s competitors. Called “insider trading,” this edge became illegal back in the 1930s. Legal methods of collecting proprietary information have long been the foundational advantage for many investors and institutions. However, increasing regulation and the speed and volume of information flow has dramatically changed the value of pure data. Today, investors around the world have almost perfect access to the same data and react (or overreact) in concert. Ironically, it is still believed by many that “having the data” leads to successful investing. In a world of free-flowing and instantaneous information, time arbitrage is a tremendous edge when so many investors are measuring success in days, weeks, and months. Like the CEO of a privately held company who can make decisions for the future without worrying about next quarter’s earnings, the savvy investor uses time arbitrage. He or she is able to benefit from historically-valid investment tactics without the anxiety, and often financial ruin, that comes from frenetically chasing the next short term trend.
Keeping Time on Your Side
Time arbitrage essentially takes advantage of having an investment strategy, a personal discipline, and a tactical structure that allows time to be on your side. At the strategy level, consider the implications of a philosophy that compares the major stock market indices to cash and other fixed income investments. If you don’t need the cash in the next few years, your strategy could dictate investing a substantial portion in the S&P 500 or other stock investments versus fixed income. Simply because you have the time to weather through ups and downs in stocks in order to achieve what have been historically superior returns point to point.
Consider an example using the string of performance numbers in the S&P 500 during the period 1972-1976. Up 19%, down 15%, down 26%, up 37%, up 24%. If you invested $1,000,000 near the peak at the beginning of 1972, you caught the last of the good times and then ’73 and ’74 took your investment down almost 40%. See Figure 1. However, since you didn’t need the cash, you used time arbitrage to your advantage and held tight. Two years later your portfolio is up 70% from the bottom, and importantly, your annualized return from the initial investment through the bottom and back is 5% per year. Six years later, your portfolio has recovered 164% from the bottom, bringing your annualized return to 8% per year for the nine years of your investment. Through the ups and downs of the 1970s, including one of our country’s worst bear markets, your portfolio grew through time arbitrage properly applied in an investment strategy. Then you were properly positioned for the bull markets of the ’80s and ’90s. And this “blunt instrument” time arbitrage does not even consider the potential for superior investment talent, tactical allocation shifts, or even diversification across geographical boundaries.
Pricing Dynamics are the Key
Markets are short-term pricing mechanisms. The numbers flashing across the screen on CNN reflect the current price at which buyers and sellers come together. They do not necessarily reflect intrinsic values of the underlying assets for four important reasons: 1. gaps in information flow, 2. Imperfect knowledge of the future, 3. Structural buying and selling, and 4. Emotional swings of investors. Each of these factors moves prices back and forth daily without regard to underlying value that could eventually be realized by a patient investor. Structural selling in 2008 due to the forced deleveraging of major financial institutions and hedge funds created a break between pricing and fundamentals that we believe is unprecedented. Litman Gregory wrote of this in their recent commentary: “Empirical Research estimates that hedge funds have eliminated almost all their leverage. In total, Empirical estimates that hedge funds, and to a lesser extent mutual funds, have resulted in $1 trillion of selling, about 7% of the entire equity market and almost 10 times the effect of mutual funds alone in their worst years.” Whether you are a real estate investor, small business owner, or stock market investor, it is not difficult to understand the dynamic created by forced sellers. Tremendous opportunity for those with time arbitrage on their side.
Time Arbitrage Eliminates the Need For Short-Term Guessing
Time arbitrage can be applied at multiple levels of your financial strategy, including asset classes, market subsectors, and individual stock and bond selections. Say you are considering an investment in Acme Shipping Company (a fictitious example). Acme has global operations and dominant market share. Based on earnings of $4.00 per share using a normalized average of the past five years, the current price at $32 reflects an 8x multiple. Your analysis estimates an intrinsic value closer to $45. The company pays $1.50 per share dividend each year. After careful analysis of all facets of the company, management, industry, and economic climate, you determine that normalized earnings in 2013 (5 years out) should be at least $7 per share even on conservative assumptions. You expect the multiple paid on earnings for Acme will return to its historical trend of 10x which, using a very simplistic valuation measure, puts the future value estimate at $70. Including dividends, at today’s price, your five year pre-tax return would be roughly 20% per year assuming your conservative case works out for the company and you sell the shares at the end of year five. Importantly, price fluctuations along the way do not change this result, either up or down, unless you sell or invest more cash along the way. See Figure 2. The potential returns for investing in Acme appear compelling when compared to government bonds yielding 4% annually so you decide to buy shares.
If your investment approach depends on forecasting market prices (whether day-trading, technical or trend analysis, reading tea leaves, what have you) you must now determine whether Acme is going to trade higher or lower in the next few weeks or months based on all the factors that drive short term market pricing discussed above. You are concerned that buying at $32 may create a paper loss if the price drops to $28 in the next few months. You are concerned that if you don’t buy today, the price may go up to $40 next week. Faced with the Herculean task of predicting market movements, your emotions will ride the roller coaster while you analyze mounds of data (including the latest feeds from MSNBC) in a desperate attempt to stay ahead of daily price movements. And, you are not comforted by the dismal results of such attempts at fortune telling. Nor do the investing greats offer much hope of success. As William Ackham of Pershing Square wrote in his latest investor letter, “If we believed that it was possible to accurately predict short-term market or individual stock price movements and we had the capability to do so ourselves, we might have a different approach.”
Not Easy, But Effective
Investing in a world of uncertainty requires making educated decisions that create the highest probability of success. Time arbitrage is not easy. Every month of a bear market can feel like years. The impulse to “do something” can be overwhelming. Unfortunately, that impulse, more often than not, hurts the investor’s long-term returns. Time arbitrage, on the other hand, yields tremendous financial and psychological benefits for those with the discipline to hold fast against the noise. This is an edge worth cultivating. It costs nothing but time and can be applied by everyone from novice to expert.
