Terry Smith wrote the investing classic "Accounting for Growth" in 1992. His relatively new fund, Fundsmith, has increased (mark to market) by 19,7% per year compared to 12,7% for his equity benchmark. The following excerpt is similar to the way we think at ValueMachines Fund and the reason we chose to invest in "compounders":
"There is also the fact that the alternative of investing in cyclicals, financials and so-called ‘value’ stocks involves investing in companies, which over time do not create shareholder value by generating returns on capital above their cost of capital and growing by deploying more capital at such favourable returns. We seek to invest in companies which accomplish this. Quoting Warren Buffett, the ‘Sage of Omaha’ and arguably the best investor over the past fifty or so years has in my view become somewhat passé. It is frequently done by acolytes or imitators many of whom seem to have done only the most cursory study of what he actually does, if anything at all. So instead I am going to quote his business partner and Berkshire Hathaway’s Vice Chairman, Charlie Munger:
‘Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return— even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result’ (emphasis added).
I have no idea why Mr. Munger chose those particular rates of return but what I do know is that he is not voicing an opinion. What he is describing is a mathematical certainty. If you invest for the long term in companies which can deliver high returns on capital, and which invest at least a significant portion of the cash flows they generate to earn similarly high returns, over time that has far more impact on the performance of the shares than the price you pay for them. Yet I have been asked far more frequently whether a share, a strategy or a fund is cheap or expensive than I am asked about what returns the companies involved deliver and whether they are good companies which create value or not. Even though Mr. Munger is right it requires a long-term investment perspective to capture that compounding by high return companies, and finding those companies is not easy especially as you need to assess their ability to grow and ward off competition. But the most difficult part of applying the investment strategy suggested by Mr. Munger’s quote, and which we seek to apply, is us. Our inability to take a really long-term view, particularly through the periods when our chosen strategy and companies are not performing as well as less good companies, which are enjoying their period in the sun, is our greatest enemy. I will leave this subject with a sporting analogy. We are often told that life is a marathon not a sprint. So is investing. Most of us will be investors for the majority of our lives. If we start investing in our 30’s with current average life expectancy most of us will be investing for over half a century. It makes Mr. Munger’s 40 year example seem a bit short. So why we should think about what happens over shorter time periods, like quarters or even years is a bit of a puzzle."
Source: https://www.fundsmith.co.uk/docs/default-source/analysis---annual-letters/annual-letter-to-shareholders-2017.pdf
Comments, questions or E-mails welcome: ajbrenninkmeijer@gmail.com
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