I received a comment on one of my last posts suggesting to talk about a lesson relating to Berkshire Hathaway and it's most recent annual financial report. Although there are many topics I could pull from the financial report (intrinsic value, share repurchases, book and market values, float), I'll instead tie it in with a lesson about compounding yields that I had planned for a few weeks down the road but instead I will discuss it here.
First let's review the compounding effect... the rule of 72 states that if you divide your average annual return into 72, the result will give you roughly how many years for your money to double. If I earn 7% return on my investment a year (market historical average), then it will take 72/7 = 10.3 years for my investment to double. The rule is based on the premise of compounding interest or yield: the compounding effect is the growth seen on an investment over time because of the annual returns "compounding" on top of each other. If I made 5% on my $1000 dollars in year 1, then I would have $1050 after year 1. In year 2, if I made 5% again on my investment, the 5% return is now based off of the $1050, so my year 2 end balance would be $1102.50. Do this for roughly 15 years at 5% and this $1000 becomes $2000 (rule of 72: 72/5 ~ 14.4 years).
A simple example... if someone were to invest $5000 a year starting when they were 18 years old until the age of 65, and received an average compounded annual return of 7% with an assumed inflation rate of 1.5% (effective yield of then 5.5%), they would end up with a total of $1.16 million dollars by age 65.
Now onto Berkshire Hathaway...
Berkshire Hathaway is Warren Buffet's multinational conglomerate holding company that consists of many large stock holdings in a number of big blue chip companies. Buffet's strategy, which has proven to be successful over his long investment career, is a "buy and hold" approach, where Buffet finds companies that are large blue chip undervalued stocks, and buys and holds them to realize compounding yields over a long period of time. The "dollar cost averaging" method into a particular stock involves buying a set quantity of shares at scheduled time intervals regardless of the price of the stock. Not only does this remove emotion from the decision making process, but this method takes advantage of low times in the market, which reduces the "average cost per share" of a particular stock holding.
This type of long term compounding yield value investing requires patience, and has consistently proven to outperform the market for Berkshire Hathaway over the last 50 years:
Investing in the S&P 500 from 1965 to 2016 would have yielded an average of 9.7% annually, compounding to an effective yield of 12,717% over the 52 year period. Investing in Berkshire Hathaway stock during that same time period would have yielded an average of 20.8% annually, compounding to a staggering 1,972,595% over the 52 year period. That's long term value investing at it's finest.
The link to Buffet's note to shareholders from the 2016 annual financial report can be found here.
In his note to shareholders at the beginning of the 2016 annual report, Buffet summarizes the historic performance of his holding company, and explains how vastly the American economic system has grown and flourished since the industrial revolution. He emphasizes the point of patient value investing over the ups and down of the market by stating that:
"Widespread fear is your friend as an investor, because it serves up bargain purchases. Secondly, personal fear is your enemy."
What he means by this is that when there is widespread fear in the market, or in other words, when there is a big sell off and markets are declining, this provides investors a great opportunity to buy into the market and find great value because stocks are essentially "on sale" or discounted. His second point reiterates that trading with emotion is an investor's biggest downfall and will lead an inexperienced investor to sell into a market fall or buy into a market uprising (the buy high and sell low phenomenon mentioned in Lesson 3).
Looking at the historic performance of Berkshire Hathaway is proof of the effectiveness of compounding yield from long term value investing and how such a strategy can work over a long period of time. For the average investor that isn't a Warren Buffet (so 99.999% of us), dollar cost averaging into a market index such as the TSX or S&P 500 will suffice because this strategy will still provide annual returns that, over a long period of time, will compound to huge returns.
Just as the famous man once said: "Be greedy when others are fearful, and fearful when others are greedy."