Strategies for the Long Term Investor

Long Term Investors

Investing for the long term is extremely difficult for most people. There is an enormous tendency towards action on the part of most investors when most people should be sitting on their hands.

Many successful investors have followed an approach called the coffee can approach. This story emanates from the 1950’s and comes from an investment manager who had a client whose husband died suddenly. The wife had then transferred the husbands portfolio over for the investment manager to begin to manage. The manager was shocked! He found that the husband had basically stolen the managers ideas in the stock market but had never heeded the sell recommendations. The husband had put $5,000 into every recommendation the manager had suggested. This produced many losers with more than half of the $5,000 he put into numerous stocks being lost. But also the portfolio had many enormous winners with one in particular (an investment in Xerox corp) being worth more than 800k. The husband’s portfolio upon his death was worth substantially more than his wife’s. With the Xerox position being worth more than her entire portfolio.

This type of strategy lines up well with that of the investing style of Phil Fisher. His book Common Stock and Uncommon Profits is ranked in the top 5 of best investing books of all time. He was one of the most vocal supporters of long term investing and was an astoundingly successful investor in his own right.

Fisher’s Common Stock and Uncommon Profit set out as somewhat of a counterpoint to the work of Benjamin Graham (and his famous books Security Analysis and the Intelligent Investor). Fisher emphasized investing in a select few truly great companies with high profit margins, above average sales growth, excellent management with unquestionable integrity and a long term outlook. Whereas Graham would invest in predominantly extremely cheap securities with sometimes terminal businesses. Fisher eschewed selling stock ever unless he felt he had made a mistake of had better use of funds. Fisher would not sell stock even if the stock had gotten temporarily overvalued because of transactional costs/taxes and also because getting back in at significantly lower prices is often very difficult in most market environments. If a stock didn’t move after a certain period of time or it became fairly valued Ben Graham would sell it. Fisher stuck to very few meticulously research names that could be absolute bonanzas to the investor. He wrote that for every one stock he purchased he may have considered/investigated 250 companies and focused exclusively on common stock. Graham had an extremely diversified portfolio which included bonds and preferred stock. Graham would purchase control/activist situations, mergers/special situations as well as traditional value investments whereas Fisher was content to be a passive investor and eschewed shorter term strategies such as merger arbitrage. Graham purchased stock based on quantitative factors almost exclusively stating, for instance, that one shouldn’t double count management’s ability in a company. Fisher focused mostly on qualitative factors. Graham never met with management. Fisher would not only meet with management but would also call major customers, suppliers and lower level employees as apart of his so called, “scuttlebutt” research.

A Few Strategies and Observations From Successful Long Term Investors

  • Many long term investors will often state that they wish that they had totally ignored every macro-economic forecast that they had come across. The author of 100-1 in the stock market, Thomas Phelps, stated that fears of a recession that never came (or if it did it didn’t last long enough to buy back in at a lower price) as a recurring mistake that he made. His research indicated that if you bought one of several leading companies at its highest price right before the great recession you would have still made 100x your money in many names.
  • Although investing in popular companies such as Apple, Google and Facebook has been well rewarded in the past, the companies that will make the highest returns in the future are companies that are currently small that will become large. A question to ask yourself may be, “can this company’s earnings and revenue grow to be significantly larger than today?”
  • Although Phil Fisher invested mostly in technology companies it is not necessary to invest in these types of companies in order to make 100x your money. Mundane or neglected companies can also be great compounders of wealth.  http://secretsofcompoundinterest.com/compound-interest-100xers/
  • Companies such as banks, insurance companies and utilities can all be extraordinary investments despite being in industries that aren’t exactly growth industries.
  • Many of these companies have defensible positions often called a moat. A company with a moat but without great re-investment opportunities must buy back shares or issue large dividends.
  • Some investments in companies that look expensive on normal metrics may be permissible if the growth rates are high or if growth persists for an exceptionally long period of time.
  • Investing in a select few thoroughly researched companies is much better than investing in a widely diversified portfolio. Especially if you are purchasing securities regardless of their fundamentals and exclusively for diversification purposes.

Long Term of Short Term?

Should an investor invest long term in growth stocks like Phil Fisher or in the shorter term in special situation-type investments. It is my suggestion that the intelligent investor should be open-minded and invest in strategies and in securities as current market dictates. This mostly stems from the fact that in investing there are really no hard and fast rules that will work consistently year after year. Psychologically it may help an investor to stay invested in his/her longer term investments if they have special situations to invest in. Diversification of investment duration may work well for most investors. If the market is priced at the higher end, as it is today, it is understandable to invest more and more in special situations. The opposite is also true: if the market is priced extremely low it is usually a good idea to start looking for investments in high quality enterprises that promise meaningful earnings growth. One should simply distill an investment into its anticipated after-tax annualized returns and compare that to its risks regardless of strategy.

Compound Interest and 100xers

“Compound interest is the 8th wonder of the world.” – Einstein

Compound Interest

In school many of us are taught the story of an ancient king who tells everyone passing through his kingdom that he will grant them any reward they wish if they beat him in a game of chess. One traveler states that he will play the king only if the reward is such that there will be a grain of rice placed on the first square of the chessboard and doubled every square. The King scoffs thinking that the traveler is foolish for wanting a few grains of rice over the gold that the King possessed. The traveler eventually wins and to the King’s surprise the traveler is owed an extravagant sum worth more than the entire Kingdom.

Rice exponential growth

Eventually the grains totaled (2^64) 18,446,744,073,709,551,616. This is the power of compounding!

A cool video put together by Mohnish Pabrai that explains compounding: Einstein: Compounding is the 8th wonder of the world.

Real Life Compounders

That level of return mentioned in the story is almost non-existent in all but a few investments in some of the most successful companies. What most people think about when they think about compounders are the major tech companies. Many people are familiar with (at least the dramatized version of) early investors in Facebook. Investing in Facebook at that time looked a lot like the chessboard up to the 15th space. The annualized returns are literally 100% for the past 13 years. Seed investors/ angel investors in Facebook could have made 12,000x their investment if they held on to today. Early investors in Google, such as Amazon.com founder Jeff Bezos, have returned 75% per year for 18 years (if they held on for that long).

This is the type of investment that most people starting out in the world of investing usually try to focus on and it has undeniably been a good approach for the investors who picked up shares of Google or Amazon.com at the IPO price and stuffed the stock away. But many if not most venture capital backed startups are either priced too high (giving early investors the majority of the returns) or a crappy company or both. GoPro and quite a few others are in this category. In fact if a company IPOs it may be a sign that the company is expecting to face increased competition in the future or other similar threats.

Many of the highest gains for public market investors are often not in tech companies. Instead they can often be found in the mundane and in deeply neglected securities.

Mundane

Mastercard, not quite the hot tech IPO, has also been riding the wave of the internet. It’s returns since it’s would have left you better off than being an investor in Google’s IPO even though it was 2 years later. That’s right! If an investor literally held funds in cash for 2 years after the IPO of Google and then invested those funds into Mastercard you would have 71% more money. Not to mention getting a dividend of 20% on the original IPO investment price.

A $50 investment in a mundane railroad company called Kansas City Southern in 1949 would be worth at current prices about $1.6m. You’d also be receiving $23,680 in dividends on your $50 investment. The company was somewhat of a conglomerate but the company completed numerous spin-offs of companies including Janus Capital and DST systems.

The Kansas City Southern example is of course taken over quite a longer period of time. But the investment was available to the general public. Many of the most promising new companies are only available to a select few investors.

It is important to note that the current market capitalizations of Google, Apple and Amazon.com necessarily force the companies down to earth in terms of returns that can be expected going forward. Apple’s market cap is equal to 3-4% of total u.s. GDP. It’s certainly possible to get to a higher total market cap. But how much higher?

Neglected

Bankruptcies are taken as a terrible sign for all investors in every security involved with a company that has gone bankrupt. And for the most part that’s true. But in select situations an investment in the common stock of a bankrupt entity can lead to astronomical returns.

General Growth Properties

The most well-known investment in the common stock of a bankruptcy is probably Bill Ackman’s invesment General Growth Properties. The short story on General Growth (GGP) is that the company was never insolvent but simply could not refinance debt because credit all around the country had seized up. So they had to file for chapter 11. An orderly liquidation would have netted the company a large amount of proceeds over and above the stock price during the bankruptcy (somewhere north of $2 billion if the company took their time). But the company was worth more as a going concern. Shares could have been bought during bankruptcy for as low as $.33 and definitely for less than $1 for extended periods of time. During the bankruptcy process the economy improved and new shares were issued to help eliminate the liquidity crisis the company had experienced. GGP spun-off Howard Hughes Corp which is worth currently $11.5/ GGP share. Another Spin-off called Rouse Properties was recently acquired by Brookfield Asset Management for $.68/pre-spin-off share of GGP. So with just these two spin-offs alone you might have made 24x your money from a purchase price of $.5. General Growth Properties is now trading for $24.25. So the total return before diviends is around 72.86x in a little under 8 years. Compounded annually that is about 70% per year.

American Airlines AAMRQ

American Airlines was different than many bankruptcies in that they were bought out of bankruptcy as part of the bankruptcy process. They were bought out by U.S. Airways. It would have been possible to invest in the stock at a fair price before and after U.S. Airways stated their interest in buying American. U.S. Airways had previously bought an airline out of bankruptcy so that may have indicated a speculative position in the $.3 range. After the deal was announced shares could have been picked up for around $1. Right before shares of the old American airlines were exchange for .744 shares of American Airlines group (shares were handed out over a period of 1-2 years not all at once like a usual merger) the price was $10-11 dollars.

AAL is currently trading at ~$45 and so an investor in AAMRQ would have received $33.71 pre-merger in the buyout if they held until today. So obviously an investor at the lows would have made 100x their money in less than 4 years. But also an investor at the inception of the agreement between the two companies would have resulted in 33x return from the buyout. Finally an investor just before the merger would have a 3x return.

As apart of a student organization for stock picking a student brought up the investment idea for AAMRQ. A professor overseeing the organization immediately shot down the idea. “All bankruptcies wipe out the common stock,” the professor said.

The lessons of this story for me was that you shouldn’t dismiss ANYTHING out of hand and to keep an open mind. The most important thing is not to blindly follow anyone’s advice. Another key lesson from the larger post is the importance of holding onto a stock for long periods of time.   Very few stocks will make you vast sums of money in a very short period of time. But quite a few stocks will make you vast sums of money in a very long period of time.