The value of any financial asset is the sum of its future cash flows discounted to present value.
This logical valuation idea was popularized in 1938 in John Burr Williams’ book "The Theory of Investment Value." Seventy-eight years later, the idea is still prevalent.
Ideas that have been around a long time are more likely to be around in the future than new ideas. Old ideas are tried and true. New ideas are unproven.
This truism is captured in the Lindy Effect, which states that for non-perishable items (businesses, ideas, books, etc.) the observed lifespan of the non-perishable item is most likely to be at its half-life.
Said another way, if a business is 100 years old, we should expect it to be around for another 100 years. We would expect a 10-year-old business to be around for another 10 years.
The Lindy Effect gives an average life span. It does not hold true for each individual business. On average, a business with a 100-year life would be expected to live another 100 years. Of course in the real world, other factors also come into play, and some 100-year-old businesses will fail in the next year. Some will exist for hundreds of more years.
This is great for Coca-Cola (KO, Financial), which was founded in 1892. Based on its history, a reasonable guess for Coca-Cola’s future is another 124 years. This puts the company’s expiration date at 2140.
It also paints a more troubling picture for newer businesses. Facebook (FB, Financial) was created in 2004. The Lindy Effect gives it another 12 years of life. Of course, each year Facebook is around adds to its expected future life.
Intuitively, we know it is more likely that people will be enjoying branded beverages from Coca-Cola 100 years from now versus using online social networks. Branded beverages have been around for hundreds of years. Online social networks have been around since 1996. The beverage industry has the edge in longevity.
The Lindy Effect and discounted cash flows
Combining the Lindy Effect with discounted cash flow analysis yields interesting results. If the value of an asset is a function of the sum of its future cash flows, and businesses that have been around longer are more likely to be around longer, then older businesses should therefore be expected to create more cash flows and have command higher valuation multiples.
The degree to which this effect is material is depended upon the discount rate used, or more accurately, the difference between the growth rate and discount rate used to calculate fair value. A small difference of 1% will make company life far more important than a large difference of 10%.
Imagine you expect a company to grow its dividend payments at 6% a year, and you have a discount rate of 7%. That business pays $1 a year in dividends. How much would you pay for that company if you knew how long it would exist?
- $9.47 if it lived 10 years
- $18.03 if it lived 20 years
- $39.10 if it lived 50 years
- $62.76 if it lived 100 years
- $100 if it existed in perpetuity
The longer you reasonably expect a business to be around, the more its value. If the Lindy Effect holds true, we would expect older businesses to command higher valuation multiples, all other things being equal.
This does not appear to be the case. Young businesses tend to trade at higher market valuations as investors clamor over their potential.
When tried and true businesses trade are trading for less than younger businesses with similar growth characteristics, long-term investors can buy into established businesses and reap long-term rewards as they profit from these companies.
Warren Buffett (Trades, Portfolio) and the Lindy Effect
Warren Buffett (Trades, Portfolio)’s investment philosophy is summed up in the quote below:
“We select such investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business:
(1) favorable long-term economic characteristics;
(2) competent and honest management;
(3) purchase price attractive when measured against the yardstick of value to a private owner; and
(4) an industry with which we are familiar and whose long-term business characteristics we feel competent to judge.”
The first thing Buffett looks for is favorable long-term economic characteristics. Item 4 on the list also stands out. Again, Buffett looks for industries whose long-term business characteristics he feels competent to judge.
Industries that have been around for over a hundred years (banking, insurance, disposable consumer goods, food and beverages, and others) are easier to judge than new industries (social media, search, biopharmaceuticals) because there is more history to them.
You can analyze the changes in the food and beverage industry. There is simply not much history with which to judge the online social media industry.
An established business in an established industry is likely compound your wealth over the long run. The probability of success is higher.
If you look at Buffett’s portfolio, you will find that it is filled with dividend stocks with long histories.
Buffett’s top four holdings are Kraft-Heinz (KHC, Financial), Wells Fargo (WFC, Financial), Coca-Cola (KO, Financial), and IBM (IBM, Financial). Together these four stocks make up over 60% of Berkshire Hathaway’s (BRK.A, Financial) (BRK.B, Financial) portfolio, and have an average dividend yield over 3%. The dates these companies were founded (tracing back through mergers, etc.) are shown below:
- Kraft-Heniz was formed from the merger of Kraft and Heinz (as the name suggests). Kraft was founded by J.L. Kraft in 1903. Heinz was founded by Henry John Heinz in 1869.
- Wells-Fargo was founded in 1852.
- Coca-Cola was founded in 1892.
- IBM was founded in 1911.
Every single one of these businesses traces its history back over 100 years. Every single one also has an above average dividend yield. Three of the four (IBM is the exception) exist in slow changing industries. The banking and food/beverage industries are extremely unlikely to become obsolete.
Where to find tried and true businesses
The Dividend Aristocrats List includes 50 businesses with 25+ years of consecutive dividend increases. These are businesses with long histories of success.
The Dividend Kings List doubles the requirement of the Dividend Aristocrats. It is comprised of just 18 businesses with 50+ consecutive years of dividend increases
This list of 30+ blue chip stocks with 100+ year operating histories and 3%+ dividend yields is also of note for investors looking for long-term, high quality businesses.
Further reading and final thoughts
Nassim Taleb explains the Lindy Effect in this 2012 article on Wired. It is a quick read for those looking to learn more about the Lindy Effect.
This article by Boris Marjanovic also applies the Lindy Effect to investing. It is an interesting read and provides additional resources for finding long-term businesses in which to invest.
The Lindy Effect gives a compelling reason why tried and true businesses should command higher valuation multiples. Saying "a business has been around 100 years, it is safe," is not sound analysis.
Looking at businesses with long histories and then analyzing their future prospects will help investors save time by focusing on businesses more likely to stand the test of time.
Disclosure: I am not long any of the stocks mentioned in this article.
