The Joys of Compounding. Gautam Baid

earnings growth for the next four to eight quarters and may even see a decline resulting from incremental depreciation and poor initial margins (because of low capacity utilization). Even if they are expected to experience an exponential jump in earnings growth after that, the stock markets generally do not initially increase the market value of these businesses. They do re-rate them, however, around the time when the earnings growth is clearly visible.

      As investors, we get an edge over competition if we pick these companies and have the patience and conviction to hold them. Although these businesses are clearly undervalued on a longer-term basis, it is psychologically challenging to invest in them and even more so to hold on to them. These difficulties result in a lack of investors and the subsequent mispricing of these stocks, because the price discovery is weak when investors’ attention on these stocks is low.

      Capitalizing on businesses that operate on a long-term timeline of value creation is possible only if we operate with a long-term view as well. When you focus on long-term outcomes, expect to be frequently misunderstood in the short term. This is true not only in business and investing but in life and relationships as well. To invest in companies with “the capacity to suffer,” we must be willing to suffer along with them. In other words, we need a high tolerance for short-term pain.

      You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

      —Seth Klarman

      A money manager must have the resilience to suffer through periodic bouts of underperformance. During 1999, Russo was invested in high-quality businesses like Nestlé, Heineken, and Unilever, among others. They were terribly out of favor relative to the speculative forces that were driving the market at the time. Russo’s fund was down 2 percent for the year and the Dow was up 27 percent. During the early part of the following year, he was down 15 percent and the market was up by 30 percent. Russo was able to stay the course because he had the capacity to suffer. The same can be said of his investors at the time. This is why the success of an investment manager is as much about his or her ability to vet prospective clients as it is to say no to the wrong type of investment idea.

      Equity investing is like growing a Chinese bamboo tree. We should have passion for the journey as well as patience and deep conviction after planting the seeds. The Chinese bamboo tree takes more than five years to start growing, but once it starts, it grows rapidly to eighty feet in less than six weeks. As prominent blogger Anshul Khare once aptly remarked, “In the initial years…compounding tests your patience and in later years, your bewilderment.”¹²

      Peter Lynch’s investing experiences share a symbolic resemblance to the inspiring bamboo tree story: “The stocks that have been most rewarding to me have made their greatest gains in the third or fourth year I owned them.”¹³ Stocks can stay cheap for longer than we expect and then may be repriced much more quickly than we expect.

      We should judge our businesses based on their operating results, not on the volatility of their stock prices. The stock market is focused on the latter, but investing success is based on the former. If the management team executes, the stock eventually follows. In fact, not getting immediate returns on our existing high-quality growth stocks builds antifragility. Patience plays a critical role during such times. For instance, Berkshire Hathaway’s stock has delivered a CAGR of ~21% over the past 42 years (as of October 2019). But if you bought it in 1997, you would have had to wait five years before you saw any positive return on the stock. Similarly, investors in Adobe (which, as of October 2019, has delivered a CAGR of ~24% since its IPO in August 1986) had to undergo a period of thirteen years (2000–2013) during which they made nil return on its stock. Investing is hard. Very hard.

      It pays to have a long-term view. But a long-term investment horizon must be married with an investment process willing to continually question the core investment thesis. Investors should exercise active patience, that is, diligently verifying their original investment thesis and doing nothing until something materially adverse or negative emerges. All too often, when a stock doesn’t work out as planned, we call it a “long-term investment.” When we spend a lot of time getting to know a business and its management team before investing, as we investors often do, it becomes difficult to change our mind. Investors don’t want to feel like all that time was wasted learning things that they didn’t act upon. We gain an advantage over time by staying intellectually honest while studying new ideas and existing holdings, and only investing in the few in which we think the odds are significantly in our favor. Investors tend to become complacent and stop questioning their existing holdings when their stock prices are going up. They resume analyzing in detail only when the prices start falling. Don’t analyze your holdings only when they fall. Just because the stock price of an existing holding is going up doesn’t necessarily mean that nothing negative is happening in its business.

      An Investor’s Biggest Edge

       If you want to make money in Wall Street you must have the proper psychological attitude. No one expresses it better than Spinoza the philosopher…Spinoza said you must look at things in the aspect of eternity.

      —Benjamin Graham

       To make money in stocks, you need to have vision to see them, courage to buy them and patience to hold them. Patience is the rarest of the three.

      —Thomas Phelps

      An investor who can hold on in the face of all of the advice and temptations to ensure a profit by selling an existing position demonstrates a quality of mind quite out of the ordinary.