Joys Of Compounding: The Passionate Pursuit of Lifelong Learning

by Gautam Baid

This leads to an important conclusion: when investing in short-term opportunities like commodities, cyclicals, and special situations, pay greater attention to price and mean reversion, but when investing in long-term compounders, pay maximum attention to the quality of business and management above all else.

Corporate profitability is sticky. Wonderful companies tend to remain wonderful, and poor companies tend to remain stuck in the mud. Our empirical evidence suggests that sustainable corporate turnarounds are difficult to execute. … Companies in defensive industries exhibit more stickiness in corporate profitability than firms in cyclical industries. However the persistence in performance remains highly significant and thus the reputation of the business tends to remain intact regardless of industry. … Firms with excellent profitability tend to outperform those with the worst return on capital. The outperformance improves if high-quality firms are purchased at a fair price

High quality always beats a bargain over time.

Competitive advantage is defined as a company’s ability to generate “excess returns,” that is, ROIC less cost of capital. A sustainable competitive advantage is defined as a company’s ability to generate excess returns over an extended period of time, which requires barriers to entry to prevent competitors from entering the market and eroding the excess returns. This, in turn, enables excess returns on invested capital for long periods of time (also known as the competitive advantage period, CAP).

Growing firms with excess returns and longer CAPs are more valuable in terms of net present value. The value of a company’s CAP is the sum of the estimated cash flows solely generated by these excess returns, discounted for the time value of money and the uncertainty of receiving those cash flows.

Great businesses are those with an ever-increasing stream of earnings with virtually no major capital requirements. They produce extraordinarily high returns on incremental invested capital. The truly great businesses are literally drowning in cash all the time. They tend to earn infinitely high return on capital as they require little tangible capital to grow and are driven by intangible assets such as a strong brand name with “share of mind,” intellectual property, or proprietary technology. Great businesses typically are characterized by negative working capital, low fixed asset intensity, and real pricing power.

The market places a heavy weight on certainty. Stocks with the promise of years of predictable earnings growth tend to go into a long period of overvaluation, until such time that they are no longer able to grow earnings in a steady manner. Predictability of long-term growth matters more to the market than the absolute rate of near-term growth, so a stock that promises to grow earnings at 50 percent for the next couple of years, with no clarity thereafter, is given a lower valuation multiple by the market than a stock that has slower but highly predictable growth for a much longer period. Consistent growth increases valuation; consistent disruption decreases valuation. The longevity of growth is always given a greater weight by the market than the absolute rate of growth, so you often will notice stocks with 12 percent to 15 percent predictable earnings growth for the next ten to fifteen years getting current year price-to-earnings (P/E) multiples of 40× to 50×.

Investors with a bias against high P/E stocks miss some of the greatest stock market winners of all time. Over ten years or more, a high P/E company that’s growing earnings per share at a much faster rate eventually will outperform a lower P/E company growing at a slower rate. This will be true even if some valuation derating occurs in the interim period for the former. If it comes to a choice between a 15 percent grower at 15× P/E and a 30 percent grower at 30× P/E, investors always should choose the latter, particularly when longevity of growth is highly probable.

If you want to participate in the high growth rate of an industry that is characterized by poor profitability, do so indirectly through an ancillary industry that has better economics and lower competition (the best-case scenario would be if it’s a monopoly business and the sole supplier to all the players in the primary industry). For example, the organized luggage industry in India (characterized by moderate competition) could be used as a proxy to profit from the high traffic growth of airlines (characterized by hypercompetition).

We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year. —Charlie Munger

I cannot emphasize this critical fact enough: although valuation is more important over shorter time periods, quality along with growth is much more important over long time periods (seven to ten years and longer). The longer you hold a stock, the more the quality of that company matters. Your long-term returns will almost always approximate the company’s internal compounding results over time. It is far more important to invest in the right business than it is to worry about whether to pay 10× or 20× or even 30× for current-year earnings.

Time is the friend of the wonderful company, the enemy of the mediocre. —Warren Buffett The bitterness of poor quality remains long after the sweetness of low price is forgotten. —Benjamin Franklin The best stocks will always seem overpriced to a majority of investors. —Gerald Loeb

I have a simple overarching belief that makes me joyfully average upward in the great businesses that I own. Over the coming decades, trillions of dollars are going to be added to India’s gross domestic product (GDP). The nation’s best-managed companies, with proven ability to scale up operations, will capture the bulk of this upcoming wealth creation boom in India’s stock market, assuming the market-cap-to-GDP ratio (also known as the “Buffett indicator”) approximates 100 percent over time.

In terms of percentages, the high-quality compounder category likely will have fewer errors—that is, fewer permanent capital losses—than the “statistically cheap” securities category. This doesn’t mean one will do better than the other, as a higher winning percentage doesn’t necessarily mean higher returns. But if you want to reduce “unforced errors,” or losing investments, it is more beneficial to focus on high-quality businesses. As an investor, life feels so pleasant when you are invested in high-quality compounders.

This led me to one of the biggest findings in my investing journey: great businesses created a lot of wealth even when measured from the top of the previous bull market to close to the end of the subsequent bear market. To achieve big wealth creation, an investor had only to hold on to them in a disciplined manner during the turbulent times in the stock market and stay the course. Liquidity and sentiment drive the market index in the short term, whereas individual company earnings drive stock prices in the long term.

Investing is about identifying great businesses with high-quality earnings growth and capital allocation and firmly holding on to them as long as they exhibit these characteristics. The stock markets do not really matter over the long run when you invest in such businesses and, most important, stay the course.

Don’t let exuberant markets get to your head. Don’t let pessimistic markets get to your heart. Volatility of the mind is far riskier than volatility of the stock price, and an objective mind is key to investing success.

Benjamin Graham had said, “Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

This advice is what Buffett was referring to when he shared the secret to becoming rich in the stock market: “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful [emphasis added].”3

Buying cheap and selling dear is always a good strategy, and Mr. Market keeps offering us plenty of opportunities to do so, even with durable, established, and widely followed businesses. Peter Lynch calls these companies “stalwarts.” They are the big companies without a lot of high growth potential. Occasionally, however, you can buy them at a discount and sell them after a 30 percent to 50 percent rise, which largely comes from the valuation multiple reverting back to the mean, as opposed to the business value increasing. Always remember: stock prices randomly fluctuate every day, sometimes wildly on either side, but business value changes very slowly. Therein lies the big opportunity.

Investors usually step up their efforts during a bear market, because of the tense environment, and they tend to become complacent during a bull market. Instead, dream big, manage risk, and intensify your efforts during a bull market to achieve financial independence early in life. When you are lucky to experience a bull market, ensure that it makes a big difference to your life. Make the most of a bull market to earn. Make the most of a bear market to learn.

This is how John Templeton has described bull markets: “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”

. FIGURE 23.1 What investors control. Source: “Dealing with Stock Market’s Moments of Terror,” Safal Niveshak (blog), February 5, 2018, https://www.safalniveshak.com/dealing-stock-markets-moments-terror/

During these times, investors should always heed Buffett’s advice: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” He continues, “During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy [emphasis added].”17

As Graham said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”20

because the benefits of diversification start diminishing beyond a certain point. Statistical analysis shows that security-specific risk is adequately diversified after fourteen names in different industries, and the incremental benefit of each additional holding is negligible. —Mason Hawkins Two things should be remembered, after purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small, and overall market risk will not be eliminated merely by adding more stocks to your portfolio. —Joel Greenblatt I decided to run a concentrated portfolio. As Joel Greenblatt pointed out, holding eight stocks eliminates 81 percent of the risk in owning just one stock, and holding thirty-two stocks eliminates 96 percent of the risk. This insight struck me as incredibly important. —David Einhorn

In the field of common stocks, a little bit of a great many can never be more than a poor substitute for a few of the outstanding. —Phil Fisher

According to the late management guru Peter Drucker, “Efficiency is doing things right; effectiveness is doing the right things.”

When you find a great idea, buy enough of it to make a meaningful difference to your life. Successful investing is not only about being right per se—far from it. Success in investing boils down to how the great ideas are executed, that is, initial allocation and subsequent pyramiding. It is not the frequency of winning that matters, but the frequency times the magnitude of the payoff. Michael Mauboussin calls this the “Babe Ruth effect.” It is what George Soros was referring to when he said, “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

The Kelly Criterion Formulated by John L. Kelly and popularized by the practical success of Ed Thorp, the Kelly criterion is a formula used to determine the optimal bet size for a given set of probabilities and payoffs. Although the formula can be stated in several ways, the following expanded version appeared in Thorp’s interview in the book Hedge Fund Market Wizards: F = PW − (PL/[$W / $L]), where: F = Kelly criterion fraction of capital to bet, PW = probability of winning the bet, PL = probability of losing the bet, $W = dollars won if bet is won, and $L = dollars lost if bet is lost.8 If an individual knows the odds and payouts of a given bet with precision, the Kelly criterion bet size will maximize capital over the long run.

I size individual allocations in my portfolio according to my evaluation of potential risk, with the largest holdings having the lowest likelihood of permanent capital loss coupled with above-average return potential. I initiate new positions with a minimum weighting of 3 percent and subsequently average upward if the management executes above my expectations.

Always have bigger weights in businesses with high longevity, solid growth prospects, and disciplined capital allocators. As Mae West said, “Too much of a good thing can be wonderful.”

We should not aim for the highest possible returns in the shortest period of time but rather we should seek above-average returns over a long period of time with the lowest possible risk. Risk management should take a higher precedence in the investment process, and risk-adjusted returns are a far superior indicator of performance than absolute returns. This is especially true during bull markets, when aggressive risk taking often is mistaken for intelligence.

To make money, we need luck. To create wealth, we need consistency. Any investment strategy, however sound, will have periodic phases of underperformance. The solution is not to keep changing the strategy but rather to stick to it, with the understanding that discipline is the price to be paid for long-term outperformance.

The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bring to bear on his task

The fundamental principle of auto racing is that to finish first, you must first finish.

Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.

Cash is a call option on opportunity. Having ample liquid cash puts a valuable optionality in the hands of investors, to make bargain purchases when opportunities arise, and it also makes them antifragile. Cash is a muchunderappreciated asset. It’s one of the only price-stable assets that is simultaneously highly value-elastic: cash increases in value as other asset prices drop. The more they drop, the more valuable cash becomes.

Risk and time are opposite sides of the same coin, for if there were no tomorrow there would be no risk. Time transforms risk, and the nature of risk is shaped by the time horizon [emphasis added]: the future is the playing field. —Peter Bernstein

In 2007, Buffett gave a talk to a group of MBA students at the University of Florida, wherein he shared his thoughts on the collapse of the hedge fund Long-Term Capital Management (LTCM): To make money they didn’t have and didn’t need, they risked what they did have and did need, and that’s foolish. That is just plain foolish. Doesn’t make any difference what your IQ is. If you risk something that is important to you for something that is unimportant to you, it just does not make any sense. I don’t care whether the odds are 100 to one that you succeed or 1,000 to one that you succeed. If you hand me a gun with a thousand chambers—a million chambers in it—and there’s a bullet in one chamber, and you said, “Put it up to your temple, how much do you want to be paid to pull it once?” I’m not going to pull it. You can name any sum you want but it doesn’t do anything for me on the upside and I think the downside is fairly clear. [Laughter.] So I’m not interested in that kind of a game. And yet people do it financially without thinking about it very much

Charlie and I believe in operating with many redundant layers of liquidity, and we avoid any sort of obligation that could drain our cash in a material way. That reduces our returns in 99 years out of 100. But we will survive in the 100th while many others fail [emphasis added]. And we will sleep well in all 100. —Warren Buffett

As an investor, how can you be best prepared to survive the inevitable periodic, severe corrections and bear markets during your lifetime? Ensure that you have tennis balls (high-quality businesses) in your portfolio and not eggs (bad quality junk stocks) that will splatter after hitting the floor. In a market crash, both quality and junk fall. Quality eventually rises again and junk never recovers.

I limit second-line stocks to less than 20 percent of my portfolio. Having been around in the markets for more than a decade, I have seen plenty of rising stars vanish without a trace. The returns from tried-and-tested frontline stocks may not be spectacular, but over longer periods of time, they tend to be more consistent and reliable. The key to a lifetime of investment success is not to make brilliant or complex decisions but to avoid doing foolish things.

Risk is what’s left over after you’ve thought of everything possible, plausible, and probable.

Failure often comes from a failure to imagine failure.

Maybe ‘worst case’ means ‘the worst we’ve seen in the past.’ But that doesn’t mean things can’t be worse in the future.”12 This story has a valuable lesson for investors. Never bet the farm on a single investment, no matter how certain you are of the outcome. You never know when luck will hand you the equivalent of a crazy horse.

The most valuable part of history is studying how people behaved when something unprecedented happened. It’s the most consistent thing over time [emphasis added]. —Morgan Housel

I have experienced in this business is that the unexpected and seemingly impossible continue to happen. This is why reading history and studying human behavior during past episodes of panic is valuable for an investor.

Progress happens too slowly to notice; setbacks happen too quickly to ignore. —Morgan Housel

Remember, the pessimist sounds smart, but it is the optimist who makes money.