Compounded

Many of the investment greats – Charlie Munger among them – claim to have no sense of market timing.

Now that is anathema to many active money managers. After all, if you call the timing on the two or three big turning points in a year, and you put your money where your mouth is, you can likely clear 20% – more than enough to stay in business.

So what are the big guys doing, if they’re not market timing.

The one thing they’re not doing is buying stuff that Graham & Dodd would buy. Two relatively little known facts reveal a lot about the Graham & Dodd legacy. The first is that Ben Graham destroyed most of his funds under management after the 1929 crash. Second, a large chunk of his strong performance thereafter is attributable to GEICO, which didn’t comply with his own stringent valuation requirements.

Warren Buffet himself had a lot of trouble in the textile business, even though he bought in at what looked to be staggeringly cheap valuations. Berkshire Hathaway might not exist if Buffet had no more ‘game’ than a Graham & Dodd valuation screen.

The turning point at Berkshire Hathaway may well come down to a single insight – and it was Charlie Munger’s insight; A great business at a fair price is superior to a fair business at a great price.

That doesn’t sound like the talk of a partner in the most successful value investing team in history. But as soon as Munger explains the power of compounding returns, that simple statement turns out to be one of the great investment insights.

Here’s a simplified example, and to make it really simple, let’s assume no depreciation, and an expectation that all free cash is reinvested in the business at the same rate of return. So here are two companies – one that makes 20% a year free cash, and is trading at two times par (two times price to book), the other that is making 10% a year free cash, and is trading at par. The first company is a great company at a fair price, the second a fair company at a great price.

The question Munger asks; if I buy both, and I’m sitting here in ten years’ time, what will each be worth? The fair business we assume rises from par to 2x par and reinvests its spare cash. What’s that worth in a decade? 2x1.1^10 = 5.2 times your initial stake.

With the great business – we assume it still trades at 2x par in ten years – and reinvests its 20% free cash – that’s 1.2^10 – or 6.2 times your money.

So even with something as extreme as a par price on the fair business, and even assuming that the fair business rerates, but the great business does not, even then, it’s still better to buy the great business. And if you reduce the discount of the fair business to say 1.5x par, or alternatively let the great business get re-rated some– the great business is worth about double the fair business in ten years time.

Most of Buffet & Munger’s time is spent working out whether a company can sustain high returns, and whether it can grow sufficiently to be able to reinvest at those same high rates of return. In other words, they spend their time working out whether businesses are great.

And you have to admit that the maths is pretty startling. No wonder Einstein called compound interest; ‘The eighth wonder of the world’. No wonder, also, that there are no trillion dollar commodity funds, but there is a Capital in equities. A friend told me about one of Capital’s greatest investors. He started in the 1960s. By the time he retired, the annual dividends on several of his stocks were greater than his total investments in those companies.

Now, I tend to invest thematically – I tend to believe that long running global themes can lead to a sustained change in returns in specific sectors or companies.

I think that the global infrastructure theme, and possibly the global resources theme, has several years to run. And when I say several years to run, all I mean is this; the fundamental forces in play will tend to keep returns high in infrastructure and resource businesses. As I described yesterday, it will take a long time to get capital and labour back into line.

Now, of course, I’m going to try like heck to get my timing right. But when I’m thinking about value, rather than just price, well, I bought the stocks I now own because I think the value will compound at 20% over the next five years. And if that is right, I’m happy to take a chance on their price.

I can’t say the same for banks. Can you?