Here's a thought experiment. Let's say you could invest in a risk-free opportunity that produces a compounded annual return of 12%-14%, guaranteed, in perpetuity. Would you do it?
The catch is you couldn't invest in anything else. I mean nothing. No stocks, no bonds, no gold, no real estate, no private companies ... absolutely nothing. Still interested?
I've run this poll on a couple of our message boards, and it usually breaks down as follows: 75% say "yes" and 25% say "no."
Given the fact that the market, since 1900, has returned roughly 10% on average, you might think accepting the option to beat the historical market averages, with no "risk," would score even higher.
Furthermore, screening for stocks that delivered 13% compounded average returns over the past five years yielded only about 200 candidates, which comprises less than 5% of North American companies that trade on major exchanges. Even more challenging is the fact that most of these stocks were not your large blue-chip stocks, but rather under-followed companies that were navigating very unique events and special situations.
5-year % change
||783%||55%||Misunderstood IPO, cyclicality low|
||734%||53%||Undervalued gold deposits|
||449%||41%||Cargill's complex ownership stake, uncertain phosphate and potash pricing|
||403%||38%||"Unremarkable egg producer," historical high short interests|
||330%||34%||Undeveloped and undervalued gold deposits|
||212%||26%||Misunderstood master limited partnership|
||207%||25%||Stigma related to founder's legal woes|
Yet despite these apparent hurdles, fellow Fools had a host of objections to taking these above market average returns:
"I can do better"
Assuming you can easily crush the market year after year is pretty hubristic given that roughly 75% of all professional money managers fail to beat the indexes. Don't get me wrong; I don't believe it's impossible to do so, but a healthy fear of the market is the beginning of wisdom.
"I want the opportunity to do better"
Several respondents who chose "no" in our poll cited the potential of runaway inflation as a reason for potentially foregoing this opportunity. In 1998, Buffett warned investors not to use their rearview mirrors to forecast returns:
Let's say you put $1 million into the 14% 30-year U.S. bond issued Nov. 16, 1981 and reinvested the coupons ... At the end of 1998, with long-term governments by then selling at 5%, you would have had $8,181,219 and would have earned an annual return of more than 13% ... And so here's what equities did in that same 17 years: If you'd invested $1 million in the Dow on Nov. 16, 1981, and reinvested all dividends, you'd have had $19,720,112 on Dec. 31, 1998. And your annual return would have been 19%.
Clearly, maintaining both mental and capital flexibility matters.
"I enjoy investing"
Buffett says that he's a better investor because he is a businessman and vice versa. Several Fools cited the inability to invest in start-ups, real estate, or private businesses as the main reason for taking a pass. Good point, given that between 1980 and 2005 the top private equity firms delivered average annualized returns of 39%. Heck, any business owner who has successfully grown even a mid-sized company from scratch has probably been compounding their invested capital at rates above 30% for five years or more.
Let me end by saying that there is no "right" answer -- only the right answer for you. Temperament and self-awareness are the only factors that should dictate whether you're part of the vast majority of investors who would be well-served by taking this proposition or the select few with the aptitude and attitude to be compounding machines.
As an analyst for Motley Fool Special Ops, I'm part of an investment team that believes that it can not only crush the market over a rolling 3-5 year period, but also compound capital at rates that would have those "75 percenters" rethinking their choice. In our first year, our average recommendation is up 16.5%, with our best performer up 67%.
One opportunity we like today is Fidelity National Financial
So if you'd like to learn more about how Motley Fool Special Ops team is targeting special situations to produce these returns, simply enter your email address in the box below today. We will send you the details on how you can begin capitalizing on these opportunities in your own portfolio.
This article was adapted from a piece originally published on Jan. 26, 2011.
Motley Fool research analyst Andy Louis-Charles owns options and shares of Fidelity National Financial. However, his mother is quite happy that he will finally be putting his law degree to work, performing complex due diligence on the next great "Special Op" stock. The Fool owns shares of Cal-Maine Foods and Rubicon Minerals. The Fool also owns options and shares of Fidelity National Financial. Motley Fool Alpha owns shares of Seabridge Gold. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.