Foreword
Everyone is out to find the next long term compounder — a company with such a strong business model that its earnings compounds steadily over the years. The thinking is that for such a company, if you have a long time horizon, then the price mostly doesn’t matter — simply buy and hold, and eventually, the compounding will make it all worthwhile.
Or will it?
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
Consistent, long term compounder
Consider the revenue graph of company X, which compounds from $20.22B in 2000 to $58.03B in 2022, a CAGR of about 4.9%:
And its earnings graph, which compounds from -$1.39B in 2000, to $3.74B in 2001, to $16.72B in 2022, a CAGR of about 7% (from 2001 to 2022):
It should be clear, visually, that this company is doing pretty well — even in the depths of the Great Financial Crisis, it was holding up pretty well, and since it first became profitable in 2001, company X has never even flirted with the 0 earnings line at any point in time.
So, if I told you that company X has an all time market cap high of $Y, where do you think its market cap is today?
- $Y
- Within 5% of $Y
- Within 10% of $Y
This is the market cap chart of company X, also known as Cisco (CSCO) from the same source of the graphs above (Companies MarketCap):
23 years after annualized growth of ~5% revenue and ~7% earnings, the company’s market cap is DOWN about 30%. (edit: I was informed that this is misleading — CSCO pays a dividend and has had for years, so if you include the dividends, the performance is much better. That said, the return will still be subpar due to the high entry price.)
How’s that for a consistent, long term compounder?
Relevance
As we come out of what appears to be (at least, temporarily) a downturn in the markets (in 2022), a point to remember, is that by most historical metrics (1), the markets are pretty expensive today. They were, of course, much more insanely expensive in 2021, when the markets had truly gone wild, but Q4 2021 and 2022 brought us back down to Earth just a little bit.
However, even as most of the market, minus the Magnificent 7, appears to be close to fairly priced (again, by historical metrics (1)), it is important to remember that there are still pockets of excessive exuberance, of stocks priced to such ridiculous extremes that the probability of them returning a generous rate of investment returns (2) over the long term seems rather unlikely.
To be clear, while it is possible to make a handsome profit if you are speculating (2) in these stocks in the short term, investment returns (2) requires holding that position for the long term and profiting only off its productive output, i.e. not selling to a greater fool.
And remember — the higher the price you are paying for a share of a company’s future productivity, the more speculative that position generally becomes.
So, short everything!?
And this is where some folks will start pointing fingers and start screaming “perma bear”. The truth is, if you follow me on StockClubs (3), you’ll realize that my portfolio is actually pretty long the market (levered long right now actually), and other than a brief period from early August to early November, it has generally been long.
There is, always, some assets that are overvalued, and some assets that are undervalued. Yes, sometimes, the only undervalued asset is “cash”, but that’s relatively rare.
Rational, long term portfolio management isn’t about putting money on things you like, or things that others like, or even things that are doing well now — it is to weigh the pros and cons of every position, figure out what is likely undervalued, and then overweight your portfolio towards those assets.
Certainly, overvalued assets can become more overvalued — that is how we get bubbles, after all. And certainly, undervalued assets can become more undervalued, which is how we get depressions.
But it is my opinion that if you consistently weigh your portfolio towards (4) what is undervalued, and underweight what is overvalued, then over the long term, reversion to the mean of ridiculously high (or low) valuations will generally work out in your favor.
Footnotes
- A constant consternation by some is my reference to “historical metrics”. By this, I mean things like trailing P/E, P/S ratios, etc. For an example of what the the S&P500 looks like today relative to its past in terms of P/E ratio, please see https://www.multpl.com/s-p-500-pe-ratio.
- For a description of investing vs speculating, please see https://jankythoughts.com/2021/04/12/investing-vs-speculating/.
- Disclaimer: I am an investor in StockClubs, and I’m only sharing one (out of 10+) of my brokerage accounts on the app.
- To be clear, “weigh your portfolio towards” does NOT mean sell everything else and only buy something or other. It simply means giving something more weight in the portfolio.
Janky Thoughts 