Publisher’s Note:
This is the fifth in an ongoing series that analyzes investing from an entrepreneur’s point of view. At the end of the series, the collected columns will be available as a consolidated white paper at www.sbnonline.com
Investing isn’t easy, but when you take the time to look at those who do it well, you start to realize it isn’t magic. Many of Warren Buffet’s ideas are what investor Ben Graham taught him (see last month’s article), but Buffet takes these ideas to a whole other level.
Two professors did a study of Buffet’s Berkshire Hathaway Corp. over 30 years. They asked what investment return would be generated if a person purchased what Buffet bought after the purchases were publically known.
If an investor simply followed Buffet, he or she would beat the Standard & Poor’s 500 by more than 11 percentage points per year. The S&P 500 has done about 10 percent or so over a long time. This would have done 20 percent over that period.
By comparison, if a 30-year-old person started off with $100,000 to invest and realized what the S&P 500 had returned historically in the last 30 years, by his or her early 70s, he or she would have accumulated (not including taxes or the time value of money) approximately $1.75 million. If this person invested the $100,000 in Berkshire Hathaway 30 years earlier, the value of the investment would be in excess of $200 million.
The compounding effect of investing in the overall stock market long term is certainly powerful, but investing in Berkshire Hathaway three decades ago proved to be phenomenal. This is the power of compounding. There are some investors who refer to the compounding of money as one of the great wonders of the world.
Never forget the miracle of compounding. Strive to produce at least a 15 percent compounded annual rate of return over a five-year period. If you can do that over 30 years, your money will grow 66-fold.
My interpretation of what Buffet, his partner Charlie Munger, vice chairman of Berkshire Hathaway, and some of the other great investors recommend is to buy great companies. These are companies that have tremendous products, services, a brand and track record that has a durable, sustainable, competitive advantage going into the future.
Good investment is good business, and good business is good investment. Even great management cannot overcome bad businesses. Great companies will typically have the following:
- A high return on capital (a real crucial number for quality and how efficiently they are using their company’s resources).
- A high return on equity.
- Consistent growth.
- Value with growth.
Investor Greg Speicher notes additional attributes of a good business, including high barriers to entry, brand name, high return on invested capital, high free cash flow, loyal customers, growth opportunities, pricing power, low capital expenditures requirements, high-return reinvestment opportunities and commodity inputs (suppliers have low power).
People tend to overpay for future earnings and sometimes don’t pay enough attention to what Graham calls a “margin of safety.” We can’t always look at the upside, and we can’t risk what we need for what we want and do not need.
What Buffet does many times is take bad news, a bad economy or an off quarter that is short term and creates a buying opportunity of a great business that will be good long term, even though it is temporarily out of favor. He takes advantage of that and leaves it alone. Why mess with momentum? Buffet says Wall Street makes money on activity; investors make their money on inactivity. That is the immense power of compounding.
Next month: Part 6 – 10 rules for investing success
