Three Elements of Investment Success

Christopher M. Quigley
B.Sc., M.M.I.I., M.A.


1. Compounding

Success in a career in investing requires knowledge, patience, focus and discipline. It is not a path to “getting rich quick”. When you see such “quicky” schemes advertised for any investment “product” you should run a mile. “Quick rich” schemes aside, disciplined investing can offer excellent returns when married to the “magic” of compounding.

Here is what Richard Russell, of Dow Theory Letter fame, has to say about compounding:

“Compounding: One of the most important lessons for living in the modern world is that to survive you've got to have money. But to live (survive) happily, you must have love, health (mental and physical), freedom, intellectual stimulation -- and money. When I taught my kids about money, the first thing I taught them was the use of the "money bible." What's the money bible? Simple, it's a volume of the compounding interest tables.

Compounding is the royal road to riches. Compounding is the safe road, the sure road, and fortunately, anybody can do it. To compound successfully you need the following: perseverance in order to keep you firmly on the savings path. You need intelligence in order to understand what you are doing and why. And you need knowledge of the mathematics tables in order to comprehend the amazing rewards that will come to you if you faithfully follow the compounding road. And, of course, you need time, time to allow the power of compounding to work for you. Remember, compounding only works through time.

But there are two catches in the compounding process. The first is obvious -- compounding may involve sacrifice (you can't spend it and still save it). Second, compounding is boring -- b-o-r-i-n-g. Or I should say it's boring until (after seven or eight years) the money starts to pour in. Then, believe me, compounding becomes very interesting. In fact, it becomes downright fascinating.”

2. Value
To me the fundamental reality of the stock market is that it is not efficient. Quite often the market does not correctly value a company and when you diligently search for value and have the courage to trust your judgment you will “beat the market” consistently. This is the key to the success of investors such as Warren Buffett and his partner Charlie Munger.
In his classic essay “The Superinvestors of Graham-and-Doddsville” here is what Warren Buffett has to say about value:

“I'm convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a "herd" on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.
I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, "I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million." I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million, particularly if you do it by buying ten $40 million piles of $8 million each. Since you don't have your hands on the $400 million, you want to be sure you are in with honest and reasonably competent people, but that's not a difficult job.”

3. Patient Risk Aversion
Of all the personal qualities required to make a successful investor for me patience is on the top of the list. The patient investor waits until he finds value. Once invested the patient investor allows time for the target investment to grow in value. The patient investor avoids the emotion of daily swings and roundabouts. The patient investor if she does not find value sits on her hands, in cash, protecting her capital. The patient investor seeks to avoid losses first and make money second.

Now patience might seem like a simple everyday quality but unfortunately it is not. Many investors equate “activity” with success. In fact in my experience the opposite is the case. “Smart inactivity” is the key to long term portfolio growth.

Now risk aversion does not mean you completely avoid risk. No, risk is the nature of the investment game. However, the risk must be worthy and this means that the risk reward probability ratio of the chosen equity or instrument must provide excellent upside potential once the market starts to correctly price in identified inherent value. Taking the time to ferret out correct risk reward candidates and then waiting for the market to signal the correct time to invest is not something that is exciting or “sexy”.

Patient value investing does not require two, three or four “workstations”; it does not require subscription to forty financial publications; it does not need five TV screens tuned into CNN, Bloomberg, CNBC, BBC World News and Asia Today. For these reasons it is almost the exact opposite to the fashionable media driven profile of the modern investor. But who ever said making money had to be “sexy” or “exciting”. This is why most investors lose money because instead of doing what they should be doing they do what they think they should be doing. Of course the perverse reality about this state of affairs is that the longer the majority of investors carry on “chasing their tail”, trading instead of investing and losing their fortunes the easier it is for patient intelligent investors to prosper. Long may it last.

“Rich Man, Poor Man”
(The Power of Compounding)
Richard Russell
Dow Theory Letters Inc.

Essay: “The Superinvestors of Graham-and-Doddsville”
Warren Buffett
The Intelligent Investor
Harper Business, 1973 September 2010