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