01Don’t Confuse Growth Rate with the Rate of Your Compounding
It’s possible to compound your money at 15% from a business that is only growing at 3% per annum. How? First, you’d have to pay a price that is less than its intrinsic value; that is, the net present value of all future cash flows discounted at an appropriate rate – usually the long-term U.S. Treasury bond plus an inflation kicker. Second, management would have to pay out large dividends or undertake substantial share repurchases. For a stock trading at 10x earnings, this would increase earnings per share (EPS) by 10% plus the organic growth of 3%, leaving the investor compounding at roughly 13%. Of course, the ride is going to bumpy and it won’t at all look like a gradual upward slope. But if your analysis is correct, your results are likely to be good.
The inverse is also true; were you to buy a company growing at 25% per annum for 100x earnings, it’s highly unlikely that you would do as well. Not only is there an enormous risk of a single glitch in execution destroying much of the stock’s value, but also you are relying on a hope and a prayer for things to work out satisfactorily. True investing is about banking on things that are likely to work out in your favor, even if everything doesn’t go according to plan – which it rarely will.
02Keep Turnover as Low as Possible
Tweedy, Browne & Company, one of the oldest and most respected value investing shops in the world, illustrated the destructive influence high turnover can wrought on a portfolio in its November 22, 1999, letter to shareholders. The chart they produced assumed a $1 million initial investment compounded at 20% per year (after all – most money managers who are hyperactive in their trading espouse their desire to perform at least 70% to 80% better than the long-term average of the index.) They further estimated a 27% tax rate on all realized gains and a twenty-year holding period.
At an annual turnover rate of 0%, the value of the portfolio would have grown to an astounding $38,337,600; at 3% turnover, $34,211,200, at 10%, $27,808,500, at 30%, $20,250,200, at 85%, $15,695,500, and at 100% turnover, $15,264,800. In other words, you’d end up with 150% more money as a result of a 0% turnover portfolio than you would be investing in the 100% turnover portfolio, which lowered the compound annual growth rate (CAGR) to 14.6%. Hence the attractiveness of the buy-and-hold method of investing – because of frictional expenses, you can actually come out ahead with more money in your pocket by holding investments that compounded at slightly lower rates.
It is the demonstrable superiority of this approach that led Charlie Munger, Vice Chairman of Berkshire Hathaway, business partner of Warren Buffett, and an extraordinarily respected and accomplished money manager, to coin the rather colorful phrase of “sit on your a** investing” to describe the secret of growing really wealthy over long periods of time. It allows you to do the things that really matter to you such as going to your kids’ little league games, school plays, reading, having coffee with friends, vacations with your spouse, or whatever else it is that you value highly.
03Know the Power of Reinvested Dividends
04Do Your Portfolio an Enormous Favor: Take a College Course in Basic Accounting
You spend years working your way up the corporate ladder. You wake up each morning, pour caffeine into your system, deal with rush hour commutes, business trips, being away from your kids, mean bosses, hateful coworkers, irate customers, and a myriad of other issues that are bound to come up, at least occasionally, throughout your career. Yet, when it comes to actually taking care of the money for which you work so incredibly hard, many people just throw in the towel. This is tragic, especially in light of the fact that with proper, basic management, those funds can generate far more profit for you than your labor ever could.
This was exasperated recently when I was discussing the case of how most investors misunderstand how it can actually be good over the long-run to change a company’s capitalization structure to replace equity with debt by borrowing funds on a long-term, low-cost, fixed-rate basis to repurchase stock, lowering the total count of outstanding shares. This is happening as we speak in one my personal favorite holdings, AutoZone. For more information on it, see The Limitations of the Debt to Equity Ratio - Looking Beyond the Numbers
05Stay Within Your Circle of Competence
When you look over your stocks, bonds, mutual funds, and other assets, you should get a warm feeling of familiarity. If it is an apartment building, you might remember what you paid, why you bought it, going and checking out the property for the first time, and signing the papers. If you own shares of McDonald’s, Johnson & Johnson, an S&P 500 index fund, or any other countless security, when you glance over your reports, you should know exactly why you own them – how much you expect earnings per share to rise over the next decade, management’s capital allocation policies (dividends vs. share repurchases vs. debt reduction vs. acquisitions, vs. growing organically), as well a legal and economic trends that might affect your position.
That’s why Warren Buffett’s assertion that investors stay within their circle of competence is so incredibly important. You might not be able to value an oil services firm; leave that to someone with competence in that field. Instead, focus on what you do know and how to make money from it. Graham, in one of his many investing books, pointed out the case of an average man who became so intimately familiar with the American Water Works Company, he was able to make his fortune buying and selling only that one security over his lifetime. In investing, breadth of knowledge is worthless; what you want is depth of knowledge.
06Ask the Peter Lynch Question
Peter Lynch used to say that at the end of every year, the investor should look over his or her holdings and ask themselves, “Knowing what I know now, and the price at which these stocks current trade, would I be willing to invest new money into the company under these circumstances if I didn’t already own a position?” If the answer is no, you need to examine long and hard your reasons for holding the equity.
There are a few situations where it may be okay to maintain the status quo, even if your answer is “no.” Perhaps your deferred taxes have grown so large as a result of a very small cost basis that selling and switching into an investment you expect to earn even three percentage points or more over the next decade will actually cost you money as a result of the principle value lost to the IRS. Maybe, even, it’s a simple matter of familiarity and comfort. It was Philip Fisher, author of the groundbreaking Common Stocks and Uncommon Profits, who often exhorted his readers to be cautious about trading in the stock of a company they have known for many years and come to understand well for one with which they are not as familiar as it introduces different types of risk.
07How You Hold Your Investments Can Be a Multi-Million Dollar Decision
Different accounts have different tax characteristics under the law. In a Traditional IRA, for example, you can deduct the contributions you make from your income taxes, the money will grow tax-free until you withdraw it, when you will be taxed on the gains as they are distributed. A Roth IRA, on the other hand, does not permit you to deduct the contributions from your income taxes, but the money that grows in the account will never be taxed according to current law. That means if you have $10,000 in your account and find the next Wal-Mart, growing it to over $10,000,000 in a few decades, Uncle Sam isn’t going to share in the bounty; it’s all yours.
Remember you should always consult with your own well regarded and recognized tax advisor so you can get informed advice based on your individual situation. Most tax-advantaged accounts are subject to maximum contribution rules each year so you are often forced to decide which assets to hold where. A few general rules are:
- Tax-efficient investments such as index-based mutual funds should be held directly with the fund company or through a brokerage account. Since they are not likely to buy and sell investments often, gains can build up in the form of underlying appreciation. More on that later.
- Cash generating assets such as REITs, dividend-rich stocks, and corporate bonds should be held in tax-advantaged accounts. Shares of companies that retain all of their profits and you plan on holding for long periods of time might be best held in brokerage accounts. A business such as Berkshire Hathaway, which has not paid a dividend since the mid-1960’s, is a good candidate because as long as you bought your shares and are still holding them, you haven’t paid a dime in taxes. Instead, your money has been compounding just as if it were in a Traditional IRA with a tax due only upon sale.
08Only Look at Market Quotations on a Quarterly Basis
Finally, this is one piece of advice that is likely to do you well if you’ve chosen to build a long-term, conservative investment portfolio based upon dollar cost averaging, low-cost ownership methods such as a dividend reinvestment program (also known as a DRIP account), and do not expect to retire or need the funds for ten years or more, the best course of action based upon historical experience may be to go on autopilot. That is, set up your investments for direct withdrawal from your checking or savings account, reinvest dividends, and focus on only buying the lowest risk, highest quality, most attractively valued stocks or index funds such as one based upon the S&P 500.
After this is done, don’t bother even pulling up the quoted market value on the Internet when you’re sitting in front of your monitor screen, bored. Your intention, in this situation, is to acquire equity in America, Inc. that you hope and expect to be worth far more in the ensuing decades. Gyrations, even on a two to three years basis, become meaningless in this scenario. Why, then, exert emotional energy of fluctuations of asset prices? Instead, every six months or year, meet with a qualified investment advisor that is well respected, has a good track record based upon conservative portfolio allocations designed to meet your individual needs and risk profile, and review your holdings. If the companies still appear sound, reasonably valued, and your outlook for cash requirements hasn’t changed, you may not need to do anything. If historical precedent over the past one hundred years remains true, you’ll end up with far more wealth than you would have by trading on your own or squirreling away assets into cash or commodities such as gold.
Eight Secrets to Improving Your Portfolio Returns
In the step-by-step guide Building a Complete Portfolio, we gave you practical insight into what your balance sheet might look like if you were focusing on creating a total solution to your current and future monetary needs. In this follow up, Eight Secrets to Improving Your Portfolio Returns, you’ll discover how a few small, intelligent moves can mean a world of difference in the amount of money you find in your pocket as you sail toward retirement.