1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Grahamites
Grahamites
Articles (314) 

Sources of Capital Gains

Different approaches to achieve targeted IRR lead to different mindsets

December 12, 2018

In the past, I’ve written about the total return formula of investing and the implications thereof. To recap, our total return from holding a company’s equity securities comes from three sources: fundamental growth, valuation change and dividend payout. Valuation change matters more with a shorter holding period and less with a longer holding period. This is the first level conclusion.

But so what? Then what? The second level implications will have dramatic influences on one’s investment process and thinking.

It’s imperative for us to think about which component of the return is the most desirable, which is inextricably wound up in our time horizon for holding an asset. Let’s say you have an IRR target of 15% a year. How do you plan to achieve the 15% is an enormously important question. You can aim for getting most of the 15% from the fundamental growth of the business you invest in over a long period of time. Or you can aim for getting most of the 15% from repeating valuation changes over a period of time. Or you can get the 15% from a mix of both. It’s up to you.

But you have to figure it out first because it dictates the way you do research.

If you are looking for statistically cheap and statically mispriced securities with a reversion to the mean mentality, you will most likely get most of your returns from valuation change. And the faster the valuation change, the better. Therefore, a short holding period is actually desirable.

You probably don’t need to think about what the economics of the business will be like in 10 years because it doesn’t help much. You will be incentivized to think about why the valuation is low? What is a “reasonable” multiple of the company’s stock? Why investors hate this company? At what multiple should you exit the security? What the fundamentals of the company will look like in the next one to three years? You can spend a few days, or a few weeks to come up with some sort of conclusions with regards to those questions by reading annual reports, analysts reports, transcripts and so forth. You’ll buy the stock when the multiple is low and sell when the multiple is high.

If you aim to achieve most of the 15% return from fundamental growth of the business over a long period of time, you’ll naturally have an owner’s mindset and want to learn everything about the company. You’ll spend less time on investor’s sentiment towards the company’s stock, or on what the next few quarters will look like.

You’ll be curious about the history of the company, the management team, how the company gets to where it is now. How has the company done over the past few cycles? How has the company suffered in the past? What are the most important factors for the company to be successful in the long run? What has the company done that’s so different from steps taken by competitors? Have they been gaining share or losing share? Why?

You’ll want to talk to the customers, the distributors and the suppliers and understand how they view the company and the management team. It’s a lot more thinking and digging. You are less likely to think about when to sell the company because you’ll want to suffer with the company and management team in tough times and enjoy the good times together. It really is like a marriage.

Of course, all of the above boils down to the fundamental concepts of value investing – circle of competence. There are two major limitations to build a core circle of competence. First, few industries and companies are predictable. The situation is exacerbated by the growth of internet industry, which exposes even traditional businesses to more frequent and dramatic changes. Secondly, it can take years to build a core circle of competence, even for professional investors. The gratification is significantly delayed.

Faced with the significant challenge of building a circle of competence, many value investors compromise by taking the valuation change approach. It’s perfectly fine to achieve most of the targeted return from valuation plays. In fact, it’s probably the best option for most investors.

However, if you aspire to advance to higher level of value investing and really appreciate Buffett and Munger’s timless wisdom in the end, you might want to spend some time and think about whether your current research process lines up with that goal.

Read more here: 

Berkshire's 1995 Annual Meeting Transcript Notes

Why It's Almost Always a Mistake to Sell Compounding Machines

Berkshire's 1994 Annual Meeting Transcript Notes

About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 5.0/5 (4 votes)

Voters:

Comments

Please leave your comment:


Performances of the stocks mentioned by Grahamites


User Generated Screeners


pjmason14Momentum
pascal.van.garsseHigh FCF-M2
kosalmmuse6
kosalmmuseBest one1
DBrizanall 2019Feb26
kosalmmuseBest one
DBrizanall 2019Feb25
kosalmmuseNice
kosalmmusehan
MsDale*52-Week Low
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)

GF Chat

{{numOfNotice}}
FEEDBACK