Novel Investor

Compounding investing wisdom...

How the South Sea Bubble Burst

by Jon

The South Sea Bubble got its name from the South Sea Company that generated so much enthusiasm in the early 1700s. But the company is only part of the story. The bubble really inflated because of hundreds of smaller issues being created around the same time.

The reason is fairly simple. The high price of the South Sea Company stock made it difficult for the masses to participate. The smaller issues became the gateway for almost everyone to buy South Sea stock. Those smaller issues were just as wild and unsuccessful as most Dotcom stocks. But that didn’t stop people from buying.

The pop came about because of the directors of the South Sea Company. They needed to prop up the stock price and saw the smaller issues as competition. They wanted a monopoly on all investor capital.

So the directors pushed for the Bubble Act, which only allowed for joint-stock companies approved by royal charter. With the Act in place, only three companies had royal approval and the rest ceased trading almost immediately.

The entire episode was recorded in “Anderson’s History of Commerce,” originally published in the late 1700s. The entry for 1720 — the peak of the South Sea Bubble — paints an interesting picture of the experience (edited for easier reading): Continue Reading…

Chuck Akre’s Three-Legged Stool

by Jon

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: Continue Reading…

Keynes Reviews “Common Stocks as Long Term Investments”

by Jon

Once upon a time, bonds were considered the best investments in all the land. Stocks were speculative and risky. Bonds were “safe.”

As luck would have it, Edgar Lawrence set out to test a theory and happened upon an interesting result. Lawrence originally thought that stocks did better during periods of inflation, bonds during periods of deflation.

It turned out stocks did better under both periods because retained earnings, reinvested back into a business, would grow more earnings and the business would appreciate in value. It naturally created a compounding effect that showed up in the stock price over time.

Of course, this is common knowledge today but it was a new idea at the time. Lawrence published his results in a book titled Common Stocks as Long Term Investments, with little fanfare, at first.

But John Maynard Keynes helped popularize it with a review written in May of 1925. The book would go on to be, at least partially, blamed for the stock bubble and burst of 1929 (what started as a sound premise devolved to chasing price action). Here are the highlights of Keynes’s review: Continue Reading…

Bogle’s Biggest Mistake

by Jon

John Bogle talked about his biggest mistake during a 2006 interview.

A unique set of circumstances — starting with the “Go-Go” Sixties and ending with the brutal 1973 – 1974 bear market — led him to put his cost matters hypothesis to the test and change the investing landscape forever.

It’s an interesting story with a happy ending and a few lessons strung throughout.

Here’s Bogle: Continue Reading…

Write It Down

by Jon

Journaling your investments is a tip that pops up a lot because it’s common sense. Aside from being cathartic, writing gives you an idea of how well you understand an investment.

And once written, you have a handy reference — a reminder of why you’re doing what you’re doing — for whenever an investment deviates from your expectations. It becomes a short term aid to help avoid typical emotional mistakes.

Writing it down also works in tracking your emotions. How did you feel about the market correction or spike in volatility or other latest market event? What action did you want to take? Did you follow through? Why or why not?

Because large gaps can happen between these events, and investors tend to forget, you now have a reminder of how you felt the last time it happened. You might even notice patterns of stupidity (or brilliance?) — your unique cycle of emotions — to help stop any repeated mistakes.

Gerald Loeb covers writing about investment in his book The Battle for Investment Survival. He refers to stocks but it works for any investments, asset allocations, or strategies too. Here’s what he had to say: Continue Reading…

Carol Loomis on Buyback Yield

by Jon

Carol Loomis wrote about the benefit of buybacks in 1985:

Working with the 1,660 stocks covered by the Value Line Investment Survey, we identified companies that bought significant amounts of their own common stock in the ten years from 1974 through 1983. Next we reduced this list to voluntary repurchasers — cutting out, for example, companies that had bought the shares by paying “greenmail” to get rid of a threatening shareholder. Then we measured the total returns (stock appreciation plus dividends) earned by shareholders from the approximate dates of each repurchase “episode” to the end of 1984…

The outcome is spectacularly decisive. The shareholders in the buyback companies earned superb returns, far exceeding those accruing to investors as a whole. For all episodes measured, the buyback companies showed a median total return, expressed as an annual average, compounded, of 22.6%. The equivalent return for the S&P 500 was only 14.1%. That difference of 8.5 percentage points is enormously significant to an investor.

This information has been floating around ever since and the research shows the strategy still works.

The reason comes down to basic math. Buffett calls it smart allocation: Continue Reading…

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