This piece is published on csinvesting – hope you all will like it. The post covers all the ‘questions by readers’ and their ‘answers given by the author’ of csinvesting.

A reader writes: Your emphasis on capital compounders raises a question in my mind. WEB (Buffett) famously said that if he was running a million bucks, he could get returns of 50% per year. If you reverse engineer this statement, you have to think he would be investing in the following: small caps, special situations, and catalysts.

I don’t think you can get those kinds of return with capital compounders. Thoughts?

My response: Good point. By the way, any future questions that you have for Warren can be answered here: http://buffettfaq.com/.  An organized web-site of all of Buffett’s articles, writings, and speeches organized by subject, source and date–an excellent resource for Buffaholics.  Buffett said he could compound a small amount of money at 50% as he mentions below:

Interviewer to Buffett: According to a business week report published in 1999, you were quoted as saying “it’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” First, would you say the same thing today? Second, since that statement infers that you would invest in smaller companies, other than investing in small-caps, what else would you do differently?

Buffett: Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.

Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.

The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn’t have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the 50?s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.

  • Source: Student Visit 2005
  • URL: http://boards.fool.com/buffettjayhawk-qa-22736469.aspx?sort=whole#22803680
  • Time: May 6, 2005

So the Wizard of Omaha agrees with you that returns are probably to be found in small caps where greater mis-pricing on the downside and upside can occur. The problem you have is paying higher taxes on short-term (less than one year and a day) gains and reinvestment risk.  Once you sell you have to be able to find other attractive opportunities to redeploy capital.  Special situations like liquidations may give you high annualized returns but the positions may only be held for four months until the investment is liquidated.

Investing in a Coca-Cola may give you high risk adjusted returns but not 50% annual returns because of its side and lack of reinvestment opportunities. Unless you find an emerging franchise which is quite difficult, then if you hold Coke for years, you will eventually earn the company’s return on equity.

This writer organizes his investment world into franchises and non-franchises. With non-franchises you are hoping to buy at enough of a discount to asset value and earnings power value to generate attractive returns. A catalyst like a special situation or corporate restructuring may increase the certainty and lessen the time needed to close the gap between price and your estimate of  intrinsic value. Often, with non-franchises you do not have time on your side. You must buy at a huge discount to have a chance at 50% returns.  These opportunities may be limited to micro-caps with large discounts  partially due to illiquidity issues.

By the way, I am a big fan of small cap special situations, and I plan to post my library for readers, but we have to go step-by-step in posting material.

THE REASONS I WANT TO FOCUS ON FRANCHISES ARE THE FOLLOWING:

  1. A study of franchises will teach us about investing in growth which is difficult to value.
  2. Studying competitive advantages will hone our skills in business analysis making us better investors.
  3. Knowing that a company is not a franchise is also important, because–then with no competitive advantage–the company must be managed efficiently. We know what to look for in management activity. Diversification would be a warning signal, for example.
  4. Investing in franchises can be quite profitable if bought at the right price. Say 3M (MMM) at $42 back in 2009 was purchased, then you would be receiving today about a 5.5% to 6% dividend with growth in cash flows of 8% to 10% or more, then in a few years you will have a 14% dividend yield leaving out any rise in share price. You compound at a low base while you defer taxes and reinvestment headaches. I think Buffett receives double in dividends each year more than the original purchase price of Washington Post.  MMM_35
  5.  The biggest gap today in industry and company research is the lack of interest or knowledge in analyzing competitive advantage. Rarely do you ever see an analyst focus on barriers to entry in their valuation work. My hat is off to Morningstar, Inc. because their stock research is geared toward franchises. Many managements have no idea what are structural competitive advantages are. Often, they say their company’s competitive advantage stems from “culture.”
  6. Finally, you want to avoid Hell. Hell is paying a premium for growth for a non-franchise company. Look at Salesforce.com (“CRM”) as an example for today. Full disclosure: I have held short positions in CRM.   Thanks again for your question.

ANOTHER READER:

First I would like to thank you for the quality work you are doing. I am new to Austrian economics and I would really appreciate if you can walk us on how to get started and how is it different from other Keynesian and mainstream economics. I, also, want to know why Austrian economics would be more valuable to value investors than other schools. I also wonder why we have not been taught

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