Last time I talked about compound interest and how time and the rate of return were able to supercharge the effects of compounding. Time in the market is something that can’t really be controlled as there’s only so many years until retirement or some other goal. So long as you remain invested through the good and the bad and try to squirrel away some money each month you’re doing pretty much the best that you can on that count. So, that leaves us with trying to maximize the rate of return.
There are two things to remember here: 1.) It is hard to beat the market consistently and 2.) One bad bet can wipe out years worth of returns. We’ll actually start with #2. Capital preservation is both the first and second name of the game. Sure you may make 1000% return on those speculative biotechs for awhile, but all it takes is one 0 to wipe you out. A good rule of thumb: Can you figure out what the company is going to be doing in 10 years? No? Then don’t invest. Simple as that.
Getting back to maximizing our rate of return. The historical rate of return on equities is somewhere in the realm of 8% per year. Bonds somewhat less than that. So, if you compounding at 8% or less meets your long-term goals, your job is easy. Just buy the market, use dollar cost averaging, and stick with it through thick and thin. If you want to compound your returns at a higher rate, you’re looking at some sort of active investment management.
To make money in the market, you have to buy something and then sell it at a later time to someone else who is willing to pay a higher price for it. If you’re lucky, you will be able to sell for substantially more than you paid and you won’t have to wait long between buying and selling. Life doesn’t typically work out like that. The time between buying and getting a good offer to sell at can be years and in between the price may oscillate all over. Knowing this, how do we identify companies that are trading for less than their worth? Or put another way, how do we identify companies who should trade at higher levels either now or in the future?
The typical answer to this question is that you have to do a lot of research on your own. The lazy man’s route is to simply contract this job out to someone else. The problem is that it’s very hard to find money managers or funds that have long term rates of return in excess of the equity market. And by long-term we’re talking an investing lifetime. They’re out there, but they’re difficult to find, and you have to find them at the right time. Finding one at the end of their career certainly isn’t going to help you, and by then they may have too much capital to invest anyway which will hurt their returns going forward.
For example, Warren Buffett and Charlie Munger run Berkshire Hathaway like an investment firm. They reinvest the earnings and cash flow thrown off by the companies and stocks they own for you by buying other stocks or companies. So by buying Berkshire, what you are actually doing is betting that their managers (Buffett and Munger or whoever replaces them) are good enough at allocating capital that you will end up with a decent rate of return down the road. Now historically this was a good bet as they’ve compounded Berkshire book value at around 20% if you look back the entire history of the company. The thing is, they aren’t likely to have this degree of success going forward.
The problem comes with managing large sums of money. Eventually there’s nowhere that you can put it that will give you a rate of return that is much greater than the market. Sure there’s occasional opportunities (such as 2008/09), but that only takes you so far. I would tend to bet that Berkshire continues to ‘beat the market’ in the future, but its degree of outperformance will be less than in the past. If you read their annual shareholder letters, you’ll find that they agree. So if you’re looking for a 15% compounded rate of return by simply buying and holding Berkshire stock for 20 years, I think you’re likely to be disappointed in the future.
So what can we do then? Well, let’s say that Berkshire will compound book value at 10% year over year into the future. This is slightly higher than the long-term rate of return of the equity markets, but not overly so. Thus, I think it’s a fair target as it gives them credit for good asset allocation decisions, but recognizes that they manage such a large sum of money that their opportunities are limited. So, Berkshire’s going to compound their value at 10% year over year into the future. How do we make a 15% compounded return off of this? The answer is by buying Berkshire stock at less than book value. Right now Berkshire is trading around book. So I think it’s likely that you can make around 10% per year if you buy and hold it for a long time. But, if you managed to buy Berkshire at 66% of book value how would you do? Well, we take our 10% compounding of book value and divide by 0.66. This works out to 15%. So, for us as owners, if Berkshire compounds at 10% and we buy at 66% of book value, we actually compound the value of our investment at 15%. Pretty neat huh?
Now, I think it’s unlikely that Berkshire will ever trade at 66% of book value. As they recently announced a perpetual share buyback program that allows them to buy back their own shares if they trade below 110% of book value, there would have to be massive selling pressure to drive the price down much below book. So, this buyback is good for current Berkshire shareholders as it supports the price (and increases intrinsic value), but not so good for anyone looking to acquire shares at cheaper prices. So, we’re back to square one. Sort of. What if we could find another company like Berkshire that had a good long term track record at allocating capital? Well it turns out there are a number of other companies run like this. All of them operate on different principles, but they all have good long term results. One example is Fairfax Financial Holdings (FFH) which is a Canadian holding company. They’re somewhat similar to Berkshire in that they have a great investment team investing their insurance float, and they’ve recently started acquiring other companies. The difference is that they’re a lot smaller and have a lot more room to grow in the future. As FFH’s stated goal is to compound book value at 15% per year (a goal which they have met in the past), to compound your investing dollars at 15% all you have to do is buy them at book value, hold for the long term, and let them continue allocating capital as they see fit. Other companies in a similar vein are Loews, Leukadia, and Markel. All have good long term track records at creating shareholder value, and all are available at different prices in the market. In fact, if you look at Loews, it has a historical record of compounding book value at 10% and is trading at 66% of book value. So, if you’re looking to compound your money at 15% into the future, investing at Loews at these prices may help you to achieve that. Then again, it may not. Only time will tell.
Until next time,
Nathan @ EngineeringIncome.com
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question. The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past. This is generally not true. It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation. For more information, please see my disclaimer.
Full Disclosure: Long BRK.B, L as of the time of this writing.