Why, do you ask, would I be inclined to do this when my regular investing results are so good? It’s simple: Insurance against ignorance and overconfidence, as Benjamin Graham called it. There’s no way I can possibly know everything, and as evidenced by the impressive work of Professor Jeremy Siegel, excellent businesses with reinvested dividends over several decades have crushed the broader market. One well-known financial news and commentary company points out in an online product description that only $2,000 invested in Pepsico 25 years ago has now grown to over $150,000; a single share of Coca-Cola bought for $19 with dividends reinvested in 1919 would now be worth more than $5,000,000+. Through market highs, lows, and in-between, these great businesses just keep on compounding. By owning a collection of them, in a retirement account, outside of the realm of my enterprising endeavors, businesses, and active investment portfolio, it’s a quiet reminder to manage my affairs conservatively (as would an insurance company that guards against a 1 in a 1,000 year storm) and let the companies themselves do the heavy lifting. It is also my hope to someday use the account as a sort of living, breathing didactic exercise to prove the merits of compounding to my children, grandchildren, and even – dare I say it – great grand-children.
In ways, it’s comparable to what Anne Scheiber did when she amassed a $22+ million fortune from her tiny New York apartment. By selecting value priced, blue chip stocks, the frictional expenses of active management, frequent big / ask spreads, commissions, and taxes are all greatly reduced, leading to more capital compounding for the investor. As Charlie Munger pointed out, by holdings stocks for long periods of time and paying only a single 35% tax at the end (these rates were before the Bush cuts on capital gains), a 15% return would by upwards of 13% by the time it is all done – compared to much, much less – 10% or 11% depending on the circumstances – if the money were made by frequent trading. Over a 50 year time period, a small 3% advantage can result in triple the wealth. You read that right. As one great investor said, this is a game of inches, not of feet and yards. You make the best decisions you can and over time, they amount to something meaningful.
How can you go about choosing which stocks should make the cut? Believe it or not, you shouldn’t just go with the cheapest or most undervalued company. That’s because over long periods of time, a stock is likely to compound at the rate the underlying business earns on shareholder equity. That is, provided you’ve paid a reasonable price (remember – Price is Paramount), and Wall Street maintains a consistent valuations as measured by the price-to-earnings ratio, a company earning 13% on shareholder equity will probably compound at that same rate, with dividends reinvested, provided it is held in a tax-advantaged account. Given a ten year or longer time span, you’d be better off owning this business than one earning 8% on shareholder equity but trading at a 30% discount to intrinsic value.
