I noticed a lot of people talked about their Investment policy statement lately. Since my investment style tend to differ a lot from other members, I thought it would be a good exercise to layout my investment philosophy. of course, it may be amended with future experiences.
Julianek’s Investment Policy Statement:
„Take a simple idea and take it very seriously.“ Charlie Munger
I decided to apply the idea of compound interest with utmost seriousness.
My goal as an investor is to compound my wealth at the highest rate possible. A compounding machine has three components:
- Seed Capital: How much money I put in the machine initially
- The amount of time during which the machine is compounding.
- The rate of return at which I compound this seed capital
Part 1) Seed Capital
I will continuously save between 65% and 70% of the money I am earning through my job, until I become financially independent (saved up 30 times annual expenses), which I expect to happen in approximately 7 years (give or take 2 years depending on market conditions). After which I may stop working (or at least stop exchanging my time against money when considering an occupation).
Part 2) Time horizon
This one is easy: Being currently 32 years old, I expect to let my compounding machine run at least 30 or 40 years, hopefully much more depending on my health.
A nice tool when we have a long term horizon is the rule of 72, which gives you the amount of time needed to double your money by compounding.
- If you compound your money at 7% per year, it will double in 10 years
- If you compound at 10%/year, the capital double in 7 years
- At 15%, your money has doubled in 5 years
- At 20%, a doubling occurs every 3.8 years
- And at 26%, it only takes 3 years to double your money
It is all about the number of doubles occurring in your time horizon. With a 10 years horizon, there won’t be that many doubles, even compounding at 26% (there would be only 3.33 doublings in this case).
But with a 30 years runway, the number of doublings can be huge! Between 3 and 10 doublings using above rates (and 2^10 is a very sweet number where your money has been multiplied by 1’000…)
Part 3) Rate of return
This is the part where I actually invest the money.
- The most fundamental principle is how I should think about stocks. It is not a piece of paper whose price bounces around in a funny way, but a share of ownership of a business. It ensues from this that I must think as a business owner and always ask myself: „Is this a good business? At which price would I be happy to own this business? At what price is it currently selling for?“
- The second concept is how to think about market fluctuations: although markets are often efficient, they are not always efficient , and this matter a lot for my returns. Markets have regularly episodes of manic-depression or excessive euphoria, from which I should take advantage, provided that I know the value of the businesses I am concerned with.
Imagine I have a small farm, that is yielding 50k CHF per year on average. Imagine on the other side of the street there is a neighbor, who has exactly the same fair as I do. On top of that, this neighbor comes everyday to my door, and tells me at which price he would buy my farm, or at which he would sell me his, with no obligation from my part. Most of the time the price quoted would be roughly in line with the 50k CHF yielded by the farm. But in some occasions, the price would be way off: - At 10kCHF, I would for sure buy his farm, this is a no-brainer
- At 5 million CHF, I would sell him my farm, again a no-brainer
- But most of the time when the price is in line, I would just go on farming without acknowledging him. The market is here to serve me and not the other way around.
3a) Buying
- I believe choosing what not to invest in is as important for results (or even more important) than choosing what to invest in.
- Therefore, I am not interested in buying a stock unless there is a high probability that I will double my money in two or three years.
- The above rule is very unreasonable on purpose and forces me to invest only in no-brainer situations. In investing, I am not rewarded for complexity or the elegance of my thesis. I could decipher a very complex business and only earns 5%/year, in which I have no interest whatsoever. I only consider situations where it is obvious that there is good money to be made.
- Those situations can often be described as „Heads, I win, Tails, I don’t lose much“, with little downside and big upside.
So far, I have classified these occasions in five categories:
- Wonderful businesses, with a bullet-proof competitive advantage and strong tailwind, that can be run by idiots (and often have been ran by idiots). If I can buy them at a good price, they will compound at a high rate for a very long time. Example: Credit Rating Agencies. if their behavior during the subprime crisis (equivalent to selling poison to customer) did not suffice to kill their business, nothing will kill the business, and its economics are wonderful. Every bond issuer has to go to rating agencies to have its credit-worthiness rated, otherwise the cost of its debt will be much more expensive. The agencies operate in a de facto oligopoly which reinforces network effects: everybody goes to Standard & Poor’s or Moody’s, so to be taken seriously you have to be rated by them. When a company or a government issues debt (let’s say $1 billion), the agency will charge 10 bps (or $1 million) to rate the debt, while its only costs are a computer and an analyst that it can afford to pay at a good salary, let’s say $200’000. A wonderful business indeed. Looking forward to buying at the next market downturn.
- Wonderful businesses with good competitive advantage, good tail winds, but that cannot afford to be ran by idiots. (the difference with 1. is that because of this they cannot become a „buy for life“ decision). These are often business achieving very high returns with either:
a) Razor-thin margins compensated by a high turnover (ex: COSTCO)
b) A lot of float that has to be wisely invested (ex: Berkshire, Markel)
c) all the advantage comes from the capital allocation of the manager (ex: Teledyne with Henry Singleton) - Situations with Low risk but High uncertainty : markets hate uncertainty and usually punish really hard businesses that are not predictable. Those businesses are trading usually at depressed multiples (even sometimes at P/E of 1), and if I can find a situation with a good downside protection (for instance with the assets on the balance sheet), then buying at depressed earnings result on average in very good returns. This is the quintessence of „Heads I win (=>if the business continues earning some money, buying at P/E=1 or 2 is very good for the returns), Tails I do not lose much(=> If the business stops making money, I am protected on the downside with the liquidation value)“
- Special situations and especially Spinoffs. Spinoffs have statistically over performed the market by at least 10% annually over the last 30 years, and it has been confirmed by various studies. No additional comments, other than strongly suggesting to read Joel Greenblatt’s book on the subject.
- Other situations with little downside and big upside. Example : Net nets, where you are buying cheap assets at a steep discount and statistically tend to close the gap between price and Net Current Asset Value. My position on Net Net stocks has returned on average 28%/year, but such occasions have become practically inexistent on the market since last year.
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The circle of competence is very important. If I am not able to understand how a company is making money, which factors are driving its earnings, where its competitive advantage comes from and how this advantage is likely to endure in the future, I should automatically pass to the next opportunity.
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One last point : such occasions are usually found in smaller stocks. It is easier to go from a market cap of $100 million to $1billion (a lot of companies did it) rather than from $100 billion to $1trillion (very few did it) or from $1trillion to $10 trillion (no company ever did it).
3b) Selling
This one is easier. I will sell when:
- A company has reached its potential and it is not obvious that it will keep compounding at a high rate
- The reasons for which I bought the company are not valid anymore
- I made a mistake in my appreciation of the business, which makes my investment thesis void
- I found another opportunity with much more potential and I am already fully invested.