“The first rule of compounding: Never interrupt it unnecessarily.”
- Charlie Munger
I love this Munger quote. (h/t to @LiviamCapital). I may have it pinned on my wall. (Right next to another Munger quote I have on my wall: “The goal of investments is to find situations where it is safe not to diversify.”)
I thought about Charlie’s first rule of compounding the other day when a friend asked if I trimmed a position that has run quite a bit this year.
I haven’t touched it.
Why not? Shouldn’t I trim when something becomes “expensive”? Shouldn’t I put the money in something “less expensive”? Isn’t that what “active managers” do?
I suppose, if I were superman and I could leap tall buildings at a single bound, then I could make such deft moves without error. But in the real world, making this a practice leads to a dizzying daisy chain of decisions that create lots of opportunities for making mistakes. (Besides making the IRS happy).
More important, however, is Munger’s point. Everyone seems to acknowledge the power of compounding. If you earn 20% per year for 25 years, you’ll wind up with about 100x your money -- the coveted 100 bagger. But people forget the math of this is heavily back-end loaded. After 20 years, you have ~38x. After 10, about ~6x.
So…. You don’t want to interrupt that compounding lightly. You better have a pretty darn compelling reason to sell a winning business just because the stock doubled in a year and looks “expensive.” Otherwise, your sale is going to look really costly some years later.
Trimming is one of those things that sounds so sensible, so smart. It also satisfies that itch to “do something.” Yet, if you own a really good business and take the long view, you’re probably better off leaving it alone.
There is a similar idea to trimming that sounds smart, but doesn't hold up if you’re a long-term investor. It goes like this: “X stock is too expensive, I need a 10% [or 20%] correction before I buy.”
If you’re a long-term investor, 10% or 20% is a rounding error.
Let’s say I find a business I really like. It checks all my boxes. The stock is $10 today and I think it will be worth $50 in a decade. But, shucks, I got a buy price sitting at $9 or $8. So, I’m just going to wait for it to hit my buy price.
Does that sound wise? What would Munger say?
Remember, you can always buy more if the stock goes down. Don’t be penny-wise and pound-foolish as they say.
If my potential return is such that paying $8 or $9 or $10 is the make or break on whether I buy it, then I tell myself go look for a better idea. Again, I’m speaking from the perspective of a long-term owner of businesses. And I don’t have to own many; 10-12 will do. If you’re flipping stuff, then the difference between $8 and $10 is the difference between eating and going hungry. But if that’s how you invest, you’re probably not reading this blog.
The Stock Market is a Market of Second-Hand Goods
“Why would you look at a new IPO? Don’t they do poorly? Aren’t you almost guaranteed to get a bad price?”
I know why people say this. A quick search online brings back lots of negative articles on the performance of IPOs. To wit, from Kiplinger earlier this year:
“Long-term IPO returns are nothing to brag about... IPOs that were bought at the first day’s closing price and held for 48 months posted a median decline of 17.4%, according to research firm IPOX Schuster, citing data from 1985 through 2019. Nearly 57% of IPOs in that four-year holding period had negative returns. “Most IPOs will underperform,” says firm founder Josef Schuster.”
And here is more from an older academic study:
“Issuing firms during 1975–84 substantially underperformed a sample of matching firms from the closing price on the first day of public trading to their three-year anniversaries.”
You get the idea. What we might say is the “base rate” of investing in IPOs doesn’t look too favorable. But be careful about drawing such broad conclusions… especially regarding investing where the outliers tend to drive performance.
Arguably, the “base rate” for investing equities is poor, not just IPOs. See Bessembinder’s famous study. He found most stocks didn’t beat the return on one-month treasury bills. And the top-performing 1.5% of stocks accounted for all of the stock market wealth creation from 1990 to mid-2020.
So, maybe we should ditch equities altogether? Or maybe we should see what kinds of stocks outperform...
What if you were to put in place some simple guardrails, such as investing only in profitable companies. That knocks out most IPOs in most years. What happens then?
And what if you stuck with reasonable valuations, high-quality insiders with proper incentives, in moaty businesses with good growth, high returns on capital, etc. etc. What then?
In other words, should you care if a stock is an IPO or not? Instead, run it through the same underwriting process as you would anything else. Ignoring a stock automatically because it has the “IPO” label stuck to it strikes me as kind of arbitrary.
A lot of these studies have short time horizons, too. What does performance look like after a decade?
I think some investors don’t like to look at fresh IPOs because there is a general feeling of unease at buying something so obviously and recently “sold.” You know, all those investment bankers hawking the shares, the hype, the excitement… These things don’t seem conducive to getting a great deal. I agree.
Except that… Every business you own in the public market is a business the original owner sold. The stock market is a market of second-hand goods. Every 100 bagger was once an IPO. Microsoft was once an IPO. So was Tractor Supply and Monster Beverage and Home Depot and the rest of them…
Think about that. This original owner (or owners) presumably knew more about the business than anyone. And they sold it.
What does this tell you?
Well, it tells me at least one thing I can think of right now: People who sell things don’t know what the future will bring any more than people who buy things.
An example: Vincent Bollore, a well-regarded capital allocator, is selling Universal Music Group. “Well,” some investors think, “I’d be wary of buying from him. He’s a smart guy!” Yes he is. But he also sold Activision Blizzard in 2014. Specifically, he sold 41.5 million shares for about $20.5 each. Today, those shares are worth $81. That’s 4x in 7 years.
I am sure there were investors who thought, “Gee, Bollore is selling. He’s a smart guy. I’m going to follow him.” Worse, Bollore took some of those proceeds and bought Telecom Italia. The stock has been cut in half since.
Investing is hard. Everybody makes mistakes. Everybody has stories of stocks they sold too soon and so on...
And yes, okay, there are exceptions where insiders know something and dump a stock before it tanks. Generally speaking, though, most insider selling is innocuous.
But how do we know when it’s not?
When Insiders Sell
Parsing insider selling is not so easy. People sell for all kinds of reasons. I always liked what Geroge Muzea had to say about insider selling.
He said you want to look for divergence from normal patterns. A normal pattern is to sell when something has gone up a lot. A normal pattern is to buy when something has gone down a lot. Nothing much to get excited about there.
But… when insiders start buying after a stock has already had a big move. Or when they start selling after it has taken a big hit… It is time to pay attention, says Muzea.
You’re looking for breaks in patterns. A CEO who routinely sells a little stock suddenly starts buying (or vice versa). Time to pay attention...
The Most Interesting Man in the World
And now, a lighter note, but a still important message about the nature of experiences...
I used to love those Dos Equis commercials featuring “the most interesting man in the world.” The setup was the same every time. It would go something like this:
Every time he goes for a swim, dolphins appear…
If he were to punch you in the face, you would have to fight off the strong urge to thank him...
His blood smells like cologne…
He once ran a marathon because it was on his way…
He is the Most Interesting Man in the World.
And then Jonathan Goldsmith, the actor who played the role, would utter his now famous lines, “I don’t always drink beer, but when I do…”
They were great. They created this hilarious Hemingway-esque character full of absurd anecdotes. What you may not know is that Goldsmith wrote a book: Stay Interesting: I don’t always tell stories about my life but when I do they’re true and amazing.
It’s low-brow stuff, but Goldsmith did turn out to have an interesting life. While I was writing the above, I remembered one thing Goldsmith wrote in his book. It had to do with him getting the part to play “the most interesting man in the world.” He was really good in his audition, apparently, but Dos Equis was thinking they might want to go younger. Goldsmith was nearing 70 when he auditioned.
But his agent, upon hearing this objection, said: “How can the most interesting man in the world be young?”
As Goldsmith put it: “Her rationale made sense. To be interesting, you have to have experiences. And to have had experiences, you needed time. And I had spent a lot of time having a hell of a time.”
“Let me call you back,” they said.
He got the part.
I have had a lot of experiences in my investing career. Sometimes, in a weak moment, I’ll rue that I didn’t learn the lessons I know now sooner. Goldsmith has those thoughts too. But here is what he writes on his success:
“If I’m being honest, I wish this all hadn’t taken so long. But, then again, maybe if success had come earlier it wouldn’t have meant as much as it does now… The harder knocks, disappointments, and travails one has, the more opportunity one has to gain awareness of who the devil we really are. I’m still trying.”
Cherish those experiences, even the “bad” ones. They taught you something. And they will make the later successes taste all the sweeter.
Thanks for reading!
Published September 7, 2021
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