Constructing a portfolio of 30-35 companies diversified across economic sectors and led by managements capable of managing in any economic environment can generate superb long-term investment success. Diversification is one of the free lunches in the investment business.
Europeans talk about their “industrial champions” usually in the context of their need to be successful, sort of “too big to fail” or necessary for their economies to succeed. A long term investor might take a cue from this line of thinking and build a portfolio of two-to-three dozen “champions” (companies that can grow and thrive under almost all envisioned economic scenarios) and be confident that their investment performance will assure that their capital will compound at a healthy “real” rate (i.e. in excess of inflation) and that it should meet any reasonable investment objective (i.e., CPI, CPI +5%, S&P 500).
What the market does on any given day, week, month, year is a random walk. It can rise 20% and it can decline 20% in a short period of time, in a year or over three years. In the short run stocks are very risky relative to cash and bonds. But over longer periods of time it is cash and bonds that are risky relative to stocks from an opportunity cost standpoint. It’s an enigma that many might not appreciate. Over 20 and 30 years a well-constructed portfolio (the “champions” example) should outperform inflation, cash, and bonds and provide an 8%-10% total return, 2% will be cash yield, 6%-8% will be appreciation, in line with EPS growth. So that means your original capital (assume $1 mm) will double in 10 years (at 7%) and double again in 20 years resulting in $4 mm at the end of the 20-year period, excluding 2%-3% annual inflation that would mean your capital is growing 5% in “real” terms every year. However, stock market returns are not linear over time. It is entirely possible, in fact likely, that while one may look back after 20 years and say the money compounded at 7% a year for 20 years that a quarter or a third of the time the money was declining or stagnant. It wasn’t growing each and every month, quarter or year. It’s why there is an age-old expression that there are many wealthy investors but few wealthy traders. “Recency” bias is a very strong influence in the investment business and a major reason most individual investors’ portfolio performance lags the S&P 500 by 2%-4% points. When stocks are rising that is the “recent” experience and it colors people’s thinking, often times in a bad way — they buy. They do the opposite in a down market — they sell. Both at the wrong inflection points which leads to performance drag on long term return results. But as a long-term investor one should long for those periods when stock prices are weak as that’s when it is most advantageous to build a long term investment portfolio.
After a ten year bull market there is complacency amid accumulated wealth and high returns. It is only human nature that 15% compound annual total returns (CATR) are extrapolated into the future. But that is when expecting a period of below average returns to follow is most appropriate. After all one needs a decade of 5% CATR returns for the overall period return to average 10%.
Your portfolio manager and the firm are committed to finding those 30-35 companies that have all the right ingredients or characteristics to be excellent long term investments. To stand the test of time through unpredictable economic and financial cycles companies have to be adaptive, have excellent managements, profit margin and financial characteristics that will generate consistent high returns on capital and equity, fund dividends and share buybacks and be relatively insulated from the unforeseen cost pressures that will inevitably occur. Managing through all those possible environments is what management are paid to do. Selecting company characteristics and management teams is what professional investors do for their clients. Thinking a lot about what kinds of businesses do you want to be an owner of or what kinds of managements do you want managing your capital over time is the proper way to think about long-term investing. If you are interested in having your capital invested over decades in dominant successful companies whose financial results will command premium valuations and enviable stock market valuations then contacting Woodstock Corporation will reduce your anxiety about the future and about your investment prospects.
Senior Vice President and Portfolio Manager