In order to be successful in any endeavor, it's a practical solution to identify a successful role model, study that person's "recipe", and then implement their approach diligently. That course of action works over a wide range of disciplines, whether it's athletics, professional occupation, or personal life. It simply makes sense that if you want to be good at anything, practice what you learn from studying a good role model. The same holds true for investors.
BUFFETTOLOGY - WARREN E. BUFFETT
In the world of Investing, few can match the success of Mr. Warren E. Buffett. As of 2015, Buffett had compounded an original investment of around $100,000 to more than US$352 billion. Shares in his company, Berkshire Hathaway Inc., have compounded at an average annual rate of 20.8% per year for the last 51 years versus 9.7% for the S&P 500.
Dubbed the "World's Greatest Investor," Buffett would insist that his success is easy enough to duplicate. Buffett's recipe is founded on a business owner-like focus. Buffett considers business owners to be the most capable investors because they are making capital allocation decisions on a daily basis. Although Buffett is very modest in estimating his own abilities, he suggests anyone can do what he does and his recipe is really quite simple - identify the best of the best businesses, buy at a discount, and hold for the long run. The study and application of Buffett's behavior and tenets of investing give rise to Buffettology and the principles are shared freely as follows.
BUFFETTOLOGY - INVESTMENT STRATEGY
Simple, but not easy, is how many describe what Buffett does. Buffett has said, "What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know." With the circle of competence defined and understood, we introduce our clients to investment managers based on the practical application of these and other tenets of investing which are common to a Buffett like approach.
To become an owner of a business we don't completely understand is tantamount to speculating because a successful outcome will depend on chance. We consider the business as though we are buying the entire operation. We look at the business independently of the share price. We want to allocate capital sparingly, as though we are only allowed a limited number of opportunities to choose from in our lifetime. It's okay to miss 100% of the shots we don't take because we are extremely risk adverse and prefer to take only the "fat pitch", the large and slow moving target. We like a business that requires modest amount of capital to operate and gushes earnings by the bucket full like Old Faithful, the geyser, time and time again. This allows us to sleep at night.
The previous earnings history, especially the dividend component, tells us how much money we could have disgorged from the business had we owned it in the past. It's the free cash flow of the business that we are purchasing when we buy the stock. We favor the certainty of reliable income streams over the uncertainty and speculation of short-term price movement. We derive a greater pleasure from owning a business with a history of steadily increasing the "free cash flow". Start-up operations have no track record and as a result, we would be uncomfortable as owners. We like a business that can retain and compound earnings into the indefinite future. Where appropriate, we like retained earnings to be used for retiring shares, adding value for the remaining shareholders.
In a rising tide even the leaky boats will come up together. Over time, the ebbs and flows of money in and out of our businesses, will float the share prices based on the expectation of future profits. Projections of long term earnings growth, (five years or more), are more credible when the business is part of a reliable trend indicating a rising tide.
A business is only as good as the people running it. We like the assurance that comes from having some of the greatest minds in the world of business running our companies. We don't expect to be telling the batter how to stand while he or she is in the batter's box, so we like to own a business a fool could run. In looking at the management of our businesses, we look for three qualities: integrity, intelligence, and energy. And if they don't have the first, the other two will kill you.
A commodity based business is easily recognized by its cycle of reinvention dependency. Since cost is the only determining factor in the purchase of a commodity, efforts are constantly underway to reduce the cost of production allowing prices to be discounted and market share to be won. This dependence on the cycle of reinvention is expensive. Typically the competition is undergoing the same transformations, playing leap frog with each other, always at the expense of profits.
As an alternative, we favor businesses with strong curb appeal or brand name recognition. The attraction is the added value allowing the franchise to charge a premium for its products or services. Premiums go right into profits, in direct contrast to the commodities based business where discount pricing and the cost of reinvention cut into profits.
Barriers to entry serve as a moat around the business and, through industry dominance, regulatory hurdles, or other impediments, our businesses are able to achieve pricing flexibility. When it comes to investing, we employ the strategy of the biblical David and the strength of Goliath.
This is likely the most important tenet of the Buffett investment strategy. Once we have identified an excellent business, as defined above, it is imperative that we fully understand the true economic worth, it's intrinsic value. Value is said to be a neighborhood and not an address.
"Intrinsic value is an elusive concept… it is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price.” -
Benjamin Graham is universally acknowledged as the father of modern security analysis. Graham pioneered the value investing discipline following his experience with the market crash of 1929. Seeking to prevent future financial disasters, Graham determined that a margin of safety against adverse price fluctuations is built in when we buy our businesses at a discount of 30-50% or more relative to their intrinsic value. Graham was a role model and mentor to Buffett, first as a teacher then as an employer. Buffett said that he was struck by the force of Graham's teachings "like Paul on the road to Damascus." Graham's recipe calls for value to be established based on the "here and now" and once full value is reflected in the price, Graham advocated selling it off and looking for another similar opportunity.
Buffett, under the influence of his long time friend and business partner Charlie Munger, further reasoned that since the future earnings were the object of desire, value is best determined on the basis of the discounted value of the future cash flow. This subtle distinction makes it necessary to own the quality of businesses that will be around for the very long term with a high degree of certainty and to be prepared to wait as value is recognized and compounded. Buffett has said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
The frictional cost of turnover runs contrary to the creation of wealth. In the mathematical sense, compounding is the essence of wealth creation. The longer we own our businesses without selling, the longer capital gains taxes are deferred. The longer taxes are deferred, the longer the compounding base remains intact.
We rarely like to sell, but in contrast to Buffett and more like Graham, our managers will take money off the table if the risk is magnified by a price that exceeds the intrinsic value and the opportunity can be replaced with a more promising alternative. The effects of taxation are minimized by the various sheltering strategies used by our clients.
Preservation of investment capital is also why so many successful business owners are multi-generational. It's quite common for business owners to remain focused on their business and never even think about selling. If we want the kind of wealth that is attributed to the ownership of an excellent business, we must conduct ourselves accordingly. Buffett's favorite holding period is infinity.
FOUNDATION OF TIME, TAX, AND TOTAL RETURN
Since the beginning of time, compounding has been an implicit mathematical principle that drives the process of wealth creation. The accumulation of wealth is absolutely dependent on this principle, and the component drivers of the compounding process are essentially what makes it work. It's worth taking a moment to test the capacity of this precedent. So, let's reverse assemble the "compounding engine" to confirm how the individual components work with each other.
Read more on the 3T's, Time + Tax + Total Rate of Return
Time is the primary driver and, as a result, it's also our main focus.
To begin with, let's put the component driver of time on our test bench to see how it functions independently of the other components. Using your home as our catalyst, let's say you purchased it 20 years ago for $100,000.
If you earned a compounding annual rate of return of 8% on the original $100,000 investment, 20 years later its value would have grown to $466,096. If instead the time component was reduced by 1/2 to only 10 years, then the result would be $215,892 which is less by more than 1/2.
Impact of a 25% Tax Rate
As you can see, increasing time by 10 years, would result in an acceleration of well over a double to an accumulated value of $1,006,266. So, we can then conclude that time decreases or increases the return exponentially in direct proportion to its duration.
Let's look at taxation which is a by-product of compounding.
Suppose you have to pay taxes each year on your investment gain at an average rate of 25%. An 8% investment, after tax leakage, would be reduced to 6%.
The chart below illustrates how during the same 20 year period, the original $100,000 investment would then leak taxes of nearly $150,000, reducing the compounding base to $320,714. Likewise, a 30 year investment would leak $413,917, leaving a residual value of $574,349. A little bit of taxation goes a long way to reducing wealth!
Impact of a 25% Tax Rate
So, we may also conclude that taxation and investment strategies that trigger taxation run contrary to the creation of wealth.
Finally, let's consider the catalyst and the Total Rate of Return.
Suppose certain investments serve as a better store of value than others. With other words, let's say you could earn an extra 2% by owning something representing better value. The same $100,000 investment compounding at 10%, with no tax leakage would be worth $672,750 after 20 years. Over 30 years it would grow to nearly $1,750,000, which is more than 17 times the original investment.
Total Rate of Return
FIVE WEALTH LAWS - COMMON PREMISE
If you look around your community, you may conclude that the wealthiest people you know are business owners. That's not a regional phenomenon; it's the same all over the world. Regular surveys by Forbes Magazine continue to prove many of the wealthiest people in the world are business owners. In the 2015 survey, 65% of the worlds billionaires are self made along with another 22% who are actively engaged in growing their wealth through entrepreneurial activity.
Owning shares in a business is substantially the same as owning the business, it just feels different. It feels different because you don't control the business and you're not involved in the day to day running of the operation. It's not the business owners' salaries that make them wealthy, it's the value of the underlying business assets. If you own 10% of the shares, then you would own 10% of the wealth that is attributed to that business. If you want the kind of wealth that business owners have, then it makes sense to conduct your affairs the way a successful business owner would.
Let's look at what they do.
Successful business owners set goals and develop plans for moving forward. They understand their business in minute detail. Understanding is developed by considering all aspects of their own business, their industry, and even looking at the business of their competitors. They plan their work and work their plan. As individual investors, we need to know where we are today, where we need or want to be, and what the options are to get us there.
Successful business owners surround themselves with other competent people. Often they will form a Board of Directors with specialized skills that complement those of the owners and managers. A board of directors may include specialists in the area of mergers and acquisitions, finance, or global trade. Your board of directors could be assisted by your investment and/or insurance advisor, an accountant, lawyer, or other trusted advisors. PEACE (Professional Executive Alliance for Client Excellence) was created to assist you with this.
Successful business owners often manage long term debt, an operating line of credit, or they may issue securities in the form of stock or bonds to raise operating capital. It would be unusual and not very tax efficient for a business to take its profit and loan it out to others, unless the business is operating as a bank! It makes sense for most people to use other people's money to finance a house and it can work even better to buy business shares through mutual fund investments.
Very few of us will get rich quick, so we must be disciplined and consistent in our approach to wealth creation. Pay yourself first! The story of the Richest Man in Babylon describes how to put aside 10% of everything you earn right off the top. It is an attitude as much as it is a discipline. Would you keep your same job if you were going to earn 10% less pay in the next year? Could you continue to cover your other expenses if you had 10% less? Business owners routinely deploy their pretax earnings to compound their business assets and reduce taxes so it makes sense for us to do the same.
Successful business owners often start from a basement or a garage and pledge personal assets as security for business loans. Once they have built a successful business enterprise they will often try to keep it in the family, sometimes for several generations. By ignoring the daily market noise they are able to defer capital gains taxes, allowing the compounding base of the business to be left intact.
These common characteristics of successful business owners also run symmetrically congruent with the 3T's.
FIVE LESSONS LEARNED
(with special thanks to Nick Murray for making it clear once and for all!)
Let's start with the following scenario. On October 9, 2007, the S&P 500 index made it's all time high reflecting the mood and sentiment of investors in American business. By March 9, 2009, the S&P 500 had dropped 57% which had never happened before during our lifetimes.
We didn't know when it peaked, we didn't know how long it would last and we didn't know when it ended. The banking system in the US failed and was propped up on the back of tax payers, the lenders of last resort. The credit function around the world ceased to exist and it happened quickly. The subsequent rally and recovery roared back 80%, the most significant rally in our lifetime.
I will never have any idea what the economy is going to do in the next 12-18 months.
I will never have any ability to anticipate what the market is going to do over the next 12-18 months.
(Buffett's best friend Charlie Munger commented on the same clairvoyant ability, "We don't think anyone else can either and we're just as good at not knowing as they are.")
The more traumatic the next series of economic or market events, the less likely I will be able to anticipate them or time them.
(a) There is no statistical evidence for the persistence of performance. Future performance is random as compared to past performance.
(b) At critical turning points in the investor’s lifetime, relative performance will not save you; it isn't going to matter.
The world did not end, because it does not end.
(Warren Buffett commented, "The system is incredible at unleashing the power of human potential. It isn't going away.")
INVESTOR POLICY STATEMENT (IPS)
Our IPS is based on customized individual planning which accounts for both short and long term investment objectives. The amount of allocation to income oriented investments versus equities and/or other forms of investment is driven by the short term, (less than 5 years), need for income. Individual preferences and current economic conditions will also determine how much is allocated to secure the required income stream. Our suggested target for fixed income is an amount that is suitable to sustain the income required for the next 3-5 years.
Investments that are not required for short term needs, we believe, are best managed with a long term planning horizon, say 5-10 years or more. Equity investments have historically outperformed other asset classes over the long term, but they are often accompanied by periods of negative returns. When equities outperform fixed income, it is prudent to “top up” the fixed income portion to maintain an adequate reserve.
The purpose of maintaining a suitable amount of income producing investments is to avoid selling equities when selling could result in the permanent loss of capital. Investment planning decisions are based around protecting capital and securing the required income stream. We apply a value based approach, where strong businesses are purchased at discounted prices relative to their intrinsic value. The discount to value provides a margin of safety against temporary price fluctuations and provides us with a high probability of above average returns, over the long term.
The study of the investment habits of Warren Buffett leads us to the formulation of a reliable framework for investment decisions. Investment concentration is one of several distinctions which differs from the approach of diversification and other concepts taught in many business schools. One of the expected results is “lumpy” returns from the equity component of our portfolios.
Another characteristic of our approach is a strong reluctance to sell investments which we believe to be in a period of temporary under-performance.