Compounding Through Long-Term Business Ownership

Long-term means long-term. Long-term is measured over five to ten years or more. In the short run, a coin flipper has a 50 / 50 chance of correctly calling heads or tails. Many investment professionals employ this coin-flipping approach and pass it off as skill or insight. Wisdom is borne out over time, not this quarter or next. Slow and steady wins the race.

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

Own a fractional interest in a business, not a little piece of paper that wiggles around every day. Investment performance is underpinned by the performance of the underlying business over time. Let the operating results of the business inform your decisions, not the stock price. An investor is not right because the stock market immediately agrees, nor wrong because the stock market immediately disagrees. Positive investment results are due to a reasonable, rational, and long-term assessment of the business. Long-term market price and underlying business value are highly correlated and should converge over time.

“Over the long term, it’s hard for a stock to earn a much better return than the business that underlies it. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

Compounding takes time. A penny ($0.01) that doubles every day for thirty days becomes over $10.7 million, but it takes twenty-seven days for that penny to grow into $1 million (exponential returns coming in the last three days). Investing is a long-term endeavor and requires patience. Often, investors are impatient and do not give businesses time to compound. The business does the work, and a stock cannot earn a higher return than the underlying business over an extended period. High-quality businesses that grow economic value per share at high rates of return are rare, and, when owned, can be the gift that keeps on giving.

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

“Time is your friend, impulse is your enemy. Take advantage of compound interest and don’t be captivated by the siren song of the market.”

“The first rule of compounding is never to interrupt it unnecessarily.”

The stock market is comprised of many participants who show up each day to play different games. The various games may include:

• — Computer trading based on algorithms
• — Trading based on charts (technical analysis)
• — "Educated" guessing which companies will do the best in the next month or quarter
• — "Playing" popular investing themes or industries (e.g., artificial intelligence, railroads, or consumer discretionary)
• — Selling stock because it goes down ("sell discipline")
• — Taking profits (selling winners)
• — Selling stock to send a child to college
• — My neighbor told me about this stock
• — CNBC recommended the stock

All of these "action items" have nothing to do with the value of the underlying business or its fundamentals. Buying stocks when the value of the underlying business exceeds its stock price is the only rational game to play.

“But investing isn’t about beating others at their game. It’s about controlling yourself at your own game.”

"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities, that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future, will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands."

Financial markets have overdosed on Modern Portfolio Theory, such that volatility management is risk management, and diversification is the way to reduce volatility. This CYA approach to "investment" allows the allocator to know nothing about the various investments chosen and to own the Noah portfolio - two of everything. This definitely guards against volatility, but is a recipe for average results. Risk is defined as a permanent loss of capital. The risk that you actually lose money in a particular investment. More specifically, risk is the risk that the underlying business's intrinsic value is destroyed by its management or its competition. Temporary quotational prices or even losses do not capture risk and may not even be informative in the long run. Volatility is the price of admission to earn above-average returns. Use volatility as a tool, not as a guide.

“In fact, the true investor welcomes volatility... a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.”

“Academics, however, like to define investment 'risk' differently, averring that it is the relative volatility of a stock or portfolio of stocks - that is, their volatility as compared to that of a large universe of stocks. Employing databases and statistical skills, these academics compute with precision the "beta" of a stock - its relative volatility in the past - and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.”

Humans are wired for action. Most employers pay people to "do" things at work each day. Doing something is productive; not doing something is lazy. Stock prices rarely stay the same day after day. 24/7 news, social media, and CNBC are a constant feed shouting, "Do something!" Even in investment management, the management fee is justified when there is investment activity. After all, what am I paying you for? Michael Mauboussin called it the rub between the investment business and the investment profession. The professional may say "no" to an investment, but the business may push the professional to invest anyway. Further, firms with teams of investment analysts, presenting investment ideas hoping they will be implemented, may find that the analysts are discouraged by the "Abominable No-Man" as portfolio manager. In investing, however, when there is nothing to do, the investor should do nothing. Doing nothing goes against human nature, cultural norms, employment expectations, and the investment "business." It is a simple idea, but not easy.

“If there's nothing to do, do nothing.”

“For most—almost all—of the lifetime of an investment, you should be doing nothing about it. The bulk of the activity of investing is waiting.”

“'You make your money by the waiting.' Now that doesn't mean sitting around for the next depression; you can't do that, but a fair amount of patience is required in some of these good investment records. Patience followed by pretty aggressive conduct when the time comes. Imagine sitting there, we're [Daily Journal] having all of this money rolling in with the foreclosure boom, and then deploying it in like one day...It wasn't luck that we had the money on hand when other people didn't, and were willing to deploy it when other people were running for cover.”

“There are huge mathematical advantages to doing nothing.”

“Make a few great investments and sit on your assets.”

“We continue to make more money when snoring than when active. Inactivity strikes us as intelligent behavior.”

Independent thinking is the hallmark of a successful investor. The crowd is often driven by emotion—greed in up markets and fear in down markets—which leads to irrational pricing. To achieve superior results, one must have the emotional discipline to stand apart from popular opinion and rely on sound reasoning and objective data. Profit is rarely found in doing what everyone else is doing; it is found in the discipline to remain rational when the world is not.

“Even the intelligent investor is likely to need considerable will power to keep from following the crowd.”

“An intelligent investor gets satisfaction from the thought that his operations are exactly opposite to those of the crowd.”

“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

“You may take it as an axiom that you cannot profit in Wall Street by continuously doing the obvious or the popular thing.”