Warren Buffett began his 2019 Shareholder Letter with a review of a short but groundbreaking book. The findings would change what the author, and everyone along with him, believed ever since.
Edgar Lawrence Smith set out to prove a theory that bonds were better investments than stocks during periods of deflation, while stocks were better than bonds during inflation.
Instead, he found that stocks were better investments all around. His work, Common Stocks as Long Term Investments would be published in 1924. The ideas didn’t catch on until John Maynard Keynes popularized the book with a written review in May of 1925.
Smith’s findings completely upended the widespread view that bonds were “safe” and stocks were speculative. And the book would go on to play a role in the ensuing market bubble that burst in 1929.
For the crux of Smith’s insight, I will quote an early reviewer of his book, none other than John Maynard Keynes: “I have kept until last what is perhaps Mr. Smith’s most important, and is certainly his most novel, point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest (Keynes’ italics) operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.”
Retained earnings, reinvested back into the business, will grow earnings and eventually be reflected in the price of the stock. It creates a compounding effect, that drives stocks (on average) to outperform bonds over the long run.
It’s a concept that doesn’t require Buffett’s skill in finding compounding machines to make it work either. It certainly helps, performance-wise, but all anyone needs is a willingness to invest in a basket of any growing businesses (at a fair price).
Then sit back and let the magic of compounding work. Of course, that’s easier said than done.
Stocks are Businesses
Charlie and I do not view the $248 billion detailed above as a collection of stock market wagers — dalliances to be terminated because of downgrades by “the Street,” an earnings “miss,” expected Federal Reserve actions, possible political developments, forecasts by economists or whatever else might be the subject du jour. What we see in our holdings, rather, is an assembly of companies that we partly own…
Ben Graham offered an important reminder years ago. Stocks are pieces of businesses, not paper. That can get lost amid the infinite number of financial products.
And the neverending noise created by the markets only makes it worse. It’s a psychological obstacle that every investor faces and some never overcome.
You can worry about the daily estimates, forecasts, and opinions and try to place bets on how the market might react to it. Or you can worry about whether the businesses you own are still good because that’s all that matters. Because compounding works best when it’s uninterrupted.
I have yet to see a CEO who craves an acquisition bring in an informed and articulate critic to argue against it. And yes, include me among the guilty.
Overall, the deck is stacked in favor of the deal that’s coveted by the CEO and his/her obliging staff. It would be an interesting exercise for a company to hire two “expert” acquisition advisors, one pro and one con, to deliver his or her views on a proposed deal to the board — with the winning advisor to receive, say, ten times a token sum paid to the loser.
Buffett highlights what happens to CEOs who essentially fall in love with an investment before it’s been made. Investors have the same problem with rose-colored glasses.
His solution is to hire someone to play devil’s advocate before a decision is made, which might get expensive after a while. A cheaper alternative is to purposefully look for the downsides in an investment. If you can’t find one, look harder. Every investment has a downside.
Then write a pre-mortem (it’s a postmortem written in advance). So write the outcome in advance of the decision but do it as if it was a total disaster. Why did it fail? What caused it? How bad was it?
It should help overcome the overconfidence, overoptimism, and overpaying that comes with only seeing the upside. And since investing is really about protecting yourself on the downside, you’re better prepared for that too.
2019 Berkshire Hathaway Letter