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The Investor's Shangri La

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By emiller8988
July 26, 2005

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This comes from several notes I made in other places. J Siegel's new book THE FUTURE FOR INVESTORS contains some wonderful information on long term investing and its merits. He talks about very long term holdings and the importance of dividends. It has occurred to me that there is a way for the casual or "amateur" investor to give index investing a very good run for the money without 3 hrs a day of research and reading.

I used to be a pretty fair amateur golfer and it has recently struck me how there are lots of similarities with investing and golf. Just like golf, some of the more talented amateurs move into the professional ranks.... and the occasional professional falls back into the talented amateur ranks. So, to me... instead of "individual investor", it looks like amateur investor is a more descriptive term.

I've gone back in my own investing career and looked at the truly great investments I've made. From my own experience, the most rewarding investments I've made have all shared one great characteristic... I have waited and waited and waited and forgotten and I've absentmindedly held them long enough such that they've blown the back end out of their terminal values....

What do I mean? Look at the typical DCF, I see something along the lines of this...
"we think growth over the next 5 years will be 17%. Over the next 5 years, we'll see growth gradually decreasing to a terminal growth phase of 3 or 4%..." or what ever... You see this over and over... the "terminal growth" phase 6 or 10 or at most 15 years out and it's always 3 or 4%... the rate of the general economy. It's the idea that no tree grows to the sky, growth can't continue forever. But, growth can continue for a very long time, far longer than 10 or 15 years.

I've got a patient who is in his 80's right now. He recently donated a large sum of money to a local orphanage. We were talking about it and he told me that in 1948 he bought 10 shares of stock for around $1100. He bought this particular stock because he got two bags of horse feed per year as a dividend. He had to go pick the feed up at a local train depot.... if I could find a stock that paid it's dividend in horse feed I would buy in a heart beat. Anyway, after a few years it got bought out and then bought and bought and it ended up being worth over 250K... he donated the money to the local orphanage, as he and his wife were never able to have children. Now... this is not a globe trotting wine sipping MBA :) this is an old dirt farmer who still gets up on his tractor, feeds the cows, has a big garden, and has more money than he knows what to do with... he's Warren Buffett in old overalls.

One of my partners bought 100 shares of a local generic drug co in 1983. The company had 6 employees and it was a $1000 purchase. He wrote the check, gave it to the CEO (!)  who had the accountant issue the shares... no MM's there. The company was bought and bought and bought and finally bought by FRX. So my partner now owns 600K of FRX on a $1000 purchase 22 years ago... and he worries on a daily basis (look at FRX's chart). He won't sell because of cap gains, so he lives and dies month to month with FRX.... lots of the brainy people would laugh at him for not selling.... but NOT SELLING 18 years ago, 15 years ago, 10 years ago... got him 600K of a great company and he's yet to pay a dime of taxes. FRX is a great company and it'll do fine... it's again much like Buffett and KO and not selling a few years ago.

I've repeatedly argued that individual investors should "live in the terminal value". By that I mean if we (amateur investors) pick stocks that have a good shot of outstripping the terminal value calculations the compounding becomes huge. I really believe that good Mr. Buffett has a total focus on "terminal value". Take BUD... if it grows at an average CAGR of 9 or 10 percent for another 20 years... it completely blows the back end out of any three stage DCF using 5 year tiered x3-x2-3% staged numbers no matter how elegantly you reduce them... and if BUD or WMT or MSFT.... if they do grow at 9-10% for another 25 years.... they are grossly undervalued right now.... but only for the guy that buys and holds for 25 years

My own salvation as an "amateur investor" has been blindly stumbling into the investor's Shangri La... the glorious land of excessive terminal values... :)

There was a grand old movie from back in the 1930's called Lost Horizon. There's a plane crash in Tibet and the survivors are blindly lead into the glorious mountain utopia of Shangri La. They get there by accident... it's nearly impossible to find.

The land of excessive terminal values is a similarly difficult place to find. It's shrouded in mystery. Loads of active money managers think it's an investing myth for gullible investors, a place that can only be found via dumb luck. Thoughtful investors fight its existence... "How can we predict or see more than 2 or 5 years into the future?" How could that farmer and my partner have foreseen the events that lead to their largesse? They couldn't have... but they could- and did- sit still as long as the business they'd invested in kept functioning the way they thought it should.

Between every investor and that glorious terminal growth gold mine, there lies a great pit of quicksand that captures smart investors much more than dumb ones. It is periodic overvaluation. The "smart" professional investor is able to see the apparition of intermittent equity overvaluation and, as a result, has a nearly impossible time with a long term buy and hold strategy. The novice investor faces a different obstacle; a mountain of excessive trading for trading's sake.

I absolutely cannot imagine how Warren Buffett sat in his chair with KO at a PE of 65 and twiddled his thumbs. With his level of understanding... that inactivity was amazing. I well know his acknowledgement that it was probably a mistake... but it might also have been a very smart move, considering the times and a lack of clarity on better investments. Berkshire would have had to pay 37 or 39% of the profit taken in income taxes. By leaving it be, BRK has received the equivalent of a 4% dividend on the money that BRK actually gets to keep. The 40 odd percent that is Uncle Sam's amounts to a tax free loan that pays a 2%+ dividend. Also... it's almost a guarantee that KO will be overvalued again at some future point... and offer another chance to exit having to pay the exit fee only once instead of over and over.

Who knows... for amateur investors like us... the tortoise approach of shooting for blowouts on terminal value (just like W Buffett) actually seems like a vastly easier task than the rabbit approach of constant research and moving through stock after stock... clearly best left to the professionals who devote hours a day to such pursuits.

That's why my rule #1 for investing is....

I want to eliminate the sell decision by striving to choose investment in wonderful businesses at great valuations that will be able to grow and grow earnings for many, many years.

It's the only way to find the investor's Shangri La.... the land of excessive terminal values :)

So tell me... who has an investment they fully intend to hold for the next 25 years... or 50 years (!)... unless the business itself deteriorates or it becomes grossly overvalued?

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