What would you rather have: $1 million in a month (31 days) or a penny that doubles every day for 31 days?
What about $2 million in a month versus the doubling penny? $5 million?
It’s a fun math puzzle that explains compounding. If you do the math, the penny takes a while to get rolling.
Ten days in, the doubling penny only sits at about $5. At 18 days, it finally passes $1,000. It clears $100,000 on day 25. Then the real impact kicks in. Over the last six days, it eclipses $1 million by a factor of 10. As investment analogies go, it’s a good one. Time is a fundamental ingredient for investing success.
I was reminded of the puzzle because Chuck Akre used it to kick off a presentation on his investment process. Compounding plays an important part of his process, just as it does in everyone’s.
Only Akre looks for companies that compound at a high rate of return over a long period of time. He uses the concept of a three-legged stool to explain how he does it:
I usually ask my friends this question: Which would you rather have, $750,000 today or the outcome of doubling a penny a day for 30 days. What do I hear? Penny. So that’s the question. Compounding our capital is what we’re after, that’s what makes it a great investment for us. What’s the value of compounding? Well the answer, in this case, is simply astounding. Doubling a penny a day for 30 days gets you, who knows, $10 million, $737,000 and change.
The reason why we use the notion of compounding our capital at above-average rates is that we can think of no better method of measuring the success of any business. Think for a moment about that, if you will. How else is someone able to judge the success of a business enterprise than through some measurement of the growth in real economic value. Granted, we all know about the importance of customers and employees and community, and obviously they’re important, but throughout my odyssey, I’ve been trying to identify and measure financial success in a manner other than whether the share price rises or falls. In fact, in a private business one is not afforded the luxury of share price discovery, so that some other method of measuring success must be present.
In our firm, we use this visual construct to represent the three things that we focus our attention on. This construct, in fact, is an early 20th century three-legged milking stool and before I go on to describe each leg to you I want you to see that the three legs are actually sturdier than four and that they present a steady surface on all kinds of uneven ground, which of course, is their purpose in the first place.
Leg number one stands for the business model of the company. And when I say business model, I’m thinking about all the issues that have come into play that contribute to the above-average returns on the owner’s capital. Earlier we called this the moat. You know the drill: Is it a patent, is a regulatory item, is it a proprietary business, is it scale, is it low-cost production, or is it lack of competition? There are certainly others but for us, it’s important to try to understand just what it is about the model that causes the good returns. And what’s the outlook? In our office we often say, “How wide and how long is the runway?”
The second leg of the stool is what we describe, is the Peevol model, and what we are trying to do is to make judgments about the focus around the business. We often ask ourselves, do they treat public shareholders as partners, even though they don’t know them? My good friend Tom Gaynor who you heard from yesterday describes it this way: He said do they have equal parts skill and integrity? What we’re trying to do is get at is this: What happens at the company level also happened at the per-share level. My life experience is, once someone puts his hand in your pocket, he will do so again. And presumably, we’re examining the company in the first place because we already determined that the managers are killers about operating the business. And because we run concentrated portfolios, we literally have no time to mess with those managers about who we have real questions about in our real experience.
We refer to the third leg of the stool, which quite obviously gives it its stability, as something…as the glue that holds the opportunity together. My next question, therefore, is does an opportunity exist to reinvest all the excess cash generated by a business, allowing it to continue to earn these attractive above-average returns? My experience tells me that the reinvestment issue is perhaps the single most important issue facing any CEO today. As in one place where value can be added or subtracted quickly and permanently. So this really relates to both the skill of the manager, as well as the nature of the business. One of my favorite questions to ask a CEO is, “How do you measure the ways in which you are successful in running a business?” And I can tell you that very few ever answer that they measure their success by the growth in economic value per share. Not surprisingly, we hear that the increase in the share price is the answer, others simply say chief incorporate goals established in conjunction with the board is the answer, and some say that accomplishments relating to customers and employees and the community and the shareholders are all the answer. Personally I’m deterred in my view that growth in real economic value per share is the holy grail. Just look at the opening pages of the Berkshire Hathaway annual report, and what do you see? You see a record of growth in book value per share, for 40 years. Forty years. Incidentally, in Berkshire that number, you know, is 20% a year for 40 years, and so it’s no wonder that Warren shows up here as the top of the Fortune 400 list.
After we’ve identified a business that seems to pass the test in all three legs we refer to it as our compounding machine. And as we describe it, our valuation discipline comes into play here and we describe it here as simply we are not willing to pay too much. Volatility is not part of our analysis of risk; rather we view it as an opportunity generator. What we say for our purposes is that risk involved the exposure of permanent loss of capital. Occasionally, we view it more narrowly. And we’re watching for a possible deterioration in the quality of the business, or any of the three legs of our stool. Is the economic moat getting smaller, are the managers behaving badly in some way, or is the reinvestment opportunity diminished or being abused?
Theoretically, if we have the three legs correctly identified then our only risk is the loss associated with the dying value of money. In practice, it never happens exactly this way. But we believe firmly that if we’ve identified the key ingredient for both preserving and enhancing our capital, we’ll be in good shape.
An Investor’s Odyssey: The Search for Outstanding Investments
- You Better Love This – M. Housel
- Confusing Effort, Preparation and Performance With the Outcome – S. Godin
- The Real Bubble Has Always Been in Active Management – The Reformed Broker
- Is Your Stock Portfolio A Museum or A Warehouse? – Safal Niveshak
- Hypothetical Value To Real Value – AVC
- When will Value Stocks Perform Again? – Klement on Investing
- 5 Reasons Why Value Investing May Never Regain Its Appeal – Globe & Mail
- Rob Arnott: Don’t Sleep on Value Investing (podcast) – The Long View
- Why the Smartest People Can Make the Dumbest Mistakes – Popular Science
- From Shareholder Wealth to Stakeholder Interests: CEO Capitulation or Empty Doublespeak? – Musings on Markets
- 100 Photos From a Century of Football – SI