Novel Investor

Compounding investing wisdom...

Wise Words from Peter Lynch

by Jon

Anyone who got the investing itch in the ’80s or ’90s followed Peter Lynch at some point. He was the last star mutual fund manager — who left the game early and for the right reasons. Lynch was playing at another level than everyone else.

One of the best examples of this, that I’ve come across, was in the 1988 Baron’s Roundtable discussion. All these fund managers are in the same room. They’re a little jittery after the ’87 crash. They’re arguing about what’s next for the economy, interest rates, trade deficits, and “what if there’s a recession or another crash?” Basically, all the crap you hear on CNBC every day.

And then there’s Lynch — I picture him sitting quietly, smirking. Finally, he interrupts:

There’s always something to worry about. But it’s garbage to worry about these things… You have to look at corporate profits, and see what’s going on in the companies. It’s total garbage to worry about the things that’s going to drive us to a 300 Dow. It’ll be something you couldn’t imagine if you picked the brightest or dumbest people in the world and assembled them for hours.

Lynch made his point and none of it stuck because everyone went to back arguing about the economy. It’s his sarcastic, witty, cut through the noise style that really stands out and makes for some classic lines.

Here’s Lynch: Continue Reading…

Philip Carret on Forecasting Market Swings

by Jon

There’s a long history of market timing methods that work some of the time. Yet, the search for the holy grail strategy to get in and out of the market before every turn has been a failed endeavor. That hasn’t stopped people from searching or trying the latest and greatest method that worked twice in a row.

I’ve been reading a series of articles written by Philip Carret in 1926-27. Buffett was a big fan of his (so I did some digging). Carret would base a book on the series — The Art of Speculation — titled with the same name.

Despite the title, Carret was a value investor. He would go on to found one of the first mutual funds in 1928, ran it for the next 55 years while beating the market in the process. He also had a solid understanding of market history, market cycles, and the tendencies of its participants.

In one article, he points out why market timing methods fail eventually and how difficult forecasting can be. Continue Reading…

Galbraith: ’29 Financial Innovation Run Amok

by Jon

John Kenneth Galbraith kicked off 1987 with a warning of excessive speculation in the stock market. Black Monday came nine months later. A 22% loss for the Dow. The worst single-day drop in market history.

Was it prescience or luck? Who cares. Galbraith, as usual, offered a history lesson worth learning.

He specifically covers four parallels between 1929 and 1987.

  1. Speculation, euphoria, and greed take hold
  2. Financial innovation run amok, fueled by debt
  3. Inevitable punishment of those previously viewed as financial “geniuses”
  4. Policy changes meant to “stimulate the economy” just flowed into the market

The second is worth highlighting because of the long history of financial innovation run amok.

By the late ’20s, companies were creating companies out of thin air, issuing bonds and a minority of the stock to the public. The newly created companies had no other purpose but to own stock.

But it didn’t end there. The new company would create a company, issue a minority of stock to the public, and the process would repeat all the way down. Investment trusts would do the same. The entire process drove the market. And easy access to leverage magnified it.

The “innovation” was seen as ingenious at the time, yet looking back it all seems ridiculous. As Galbraith concludes — we prematurely ascribe genius to anyone associated with large amounts of money. It’s a repeated trend that gets investors into trouble. Continue Reading…

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…

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