Inactive Investing

Keep trading to a minimum to achieve above average long-term results.

Instead, get those above average returns buying shares of businesses with high and durable returns on capital (ROC). The heavy lifting, as measured by total return, gets done by the high ROC of the businesses themselves, instead of relying on some special talent for trading.

Of course, it's not as if future returns on capital can be perfectly measured or predicted. To find high and sustainable ROC look to those businesses with the widest "economic moats". AXP, PG, PM, KO, JNJ and DEO among others all are sustainable high ROC, wide moat businesses that happen to be selling at reasonable valuations these days. Here's a good example of how high ROC combined with a stock consistently priced reasonably low impacts long-term returns:

$ 10,000 invested in Philip Morris (now Altria: MO) in 1957 was worth over $ 80,000,000 fifty years later (with dividends reinvested).

So the stock generated average annual returns of nearly 20% during that time frame.

The magic of compounding.

In contrast, $ 10,000 invested in General Motors in 1957 was well on its way to being worth nothing fifty years later. (Also with dividends reinvested. In this case, the investor would do better to not reinvest the dividends or, better yet, not invest at all.)

That means more than a 6x increase in value has been an average decade for MO. That also happens to be pretty much what Altria produced this past decade. Odds are good that both Altria and the recently spun off Philip Morris International (PM) will continue to do just fine.

A big part of the returns produced by Philip Morris/Altria came from dividends that were reinvested in a stock that was consistently inexpensive (this works the same way as share buybacks). The threat of legal liabilities and the fact that some investors won't touch a tobacco stock kept shares of Philip Morris/Altria mostly cheap for many years. So the stock will actually do better if prices remain relatively low. 

Consider that the next time you're inclined to cheer when a stock price goes up in the short run yet your investing horizon is long-term.

Choosing between GM and Altria was quite a flip of the coin back in the late 1950's. I'm guessing most investors back then thought of GM as a juggernaut while Altria was a company heading into uncertain legal liabilities.

A more recent example is Procter & Gamble. It is interesting to note how well the stock has performed in every 20 year period since 1971 (i.e. 1971-91, 1972-92, 1973-93, etc...). My guess is also that you will find few of the great franchises (those that sell small-ticket consumer items with leading brands) did not do very well. Once again, the reason is durable high returns on capital.

Sustainable advantages.

If a company can sustain a relatively high ROC the investment returns in the long run will converge on that rate of return if you hold it long enough.

The hard part is knowing which businesses can sustain it.

So here is a model I've come up with that may be useful. Think of good businesses as a kind of strange certificate of deposit (CD).

For example, if a business has a sustainable ROC of approximately 15% it effectively becomes a kind of bizarre CD:

In a high ROC business: As you increase the time frame the range of possible annual returns gets narrower and converges on the higher ROC rate.

In a low ROC business: As you increase the time frame the range of possible annual returns gets narrower and converges on the lower ROC rate.

Take KO as an example of a high ROC business. The free cash flow that KO will generate this year can be used to pay dividends with the rest going into growth opportunities such as new brands...expanding distribution etc. The returns on these new investments tend to be very high and eventually get reflected in the company's intrinsic value. In the first 2-3 years those investments would not typically be reflected in the stock price because they appear small relative to KO's other assets. The trick occurs when you compound the new investments made by KO each year over a 20 year horizon. Result? A tidal wave of intrinsic value is created.

Better to pay a fair price for the wonderful businesses.

Low ROC businesses can be okay for shorter time horizons but in the long run a 6% ROC business will generate approximately 6% annual returns. Buffett in the early days used to buy these so called "cigar butts" (Ben Graham style) and hold them for relatively short time frames. He'd look for a $ 1 bill selling temporarily for 50 cents and sell it when the market began to price it more appropriately. He moved away from the Ben Graham approach in the 1970's beginning with See's Candy.

This low activity style of investing is what Charlie Munger has been recommending that individuals and institutions emulate for years. His point has been, I believe, that while it is unlikely anyone will be able to achieve the 20%/year returns of Berkshire Hathaway, doing the above will outperform most professional active managers while taking less risk. I emphasized the word active because it is the activity itself that adds frictional costs (taxes, commissions) and increases the likelihood of making mistakes that ultimately causes the subpar returns.

Newton's 4th Law.

Interestingly, at the most recent Berkshire meeting both Munger and Buffett pointed out that they would NOT be interested in a money manager that timed the market effectively during the most recent crash. In other words, any manager who was "smart" enough to sell right before the crash would not be considered a good investor in their book. This is counter-intuitive but their view seems to be this. You cannot consistently time the market. Attempting to do it eventually will lead to making the mistake of being out at the wrong time which can kill your long term returns a whole lot more when it happens**. In other words, why worry about a temporary paper loss of 30-40% if you buy a businesses with favorable economics that should be going up roughly 500% to 1000% in the next twenty years? An asymmetrical dislike of losses compared to the satisfaction from gains probably explains some of this. Most focus on the risk of loss but few put enough emphasis on the risk of missing gains. This bias is costly in investing. If you own quality businesses, the long-term impact of compounding will trump what happens in the market even if a crash occurs.

Some of Buffett's biggest long-term gains came on investments that initially lost 50% on paper.

So instead of actively trading, use the spare time you have to do important things like evaluating whether the businesses you own are about to have their "economic moat" reduced or eliminated. (The newspaper business being the most recent example.)

This is a simple (but not easy) approach that helps eliminate the casino-oriented thinking that is so prevalent when it comes to investing.


* As always, I am talking about growth in the intrinsic value of the business not the stock price. In the short run stock prices can be all over the map but in the long run stock prices will track intrinsic value growth.
** Buffett and Munger have sold or not owned stocks at times when valuations were not attractive to them. These were not decisions based upon market timing...they were decisions based upon price versus value.
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Inactive Investing
Inactive Investing
Reviewed by jembe
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