Buffett's 50% per year on small sums

[petec]

That's a great chart!

[antao]

I am finding it unbelievable that you guys on this value oriented board are doubting that Warren Buffett could rack up 50% returns on small sums of capital. You can get those returns too. No, you don't need leverage. No, I am not crazy  8).

 

How? Let's take some value investor mindset and combine it with math.

 

Assumptions:

 

• Use Owner Earnings for all calculations as defined by Warren Buffett (we all know reported "Net Income" is sometimes ridiculously off base)
  
• An average company earns a 10% return on invested capital (Owner Earnings/Invested Capital) and can re-invest capital at 10% rates of return
  
• An average company is worth 15x Owner Earnings (simplistic, but you can and should adjust for debt. You should not subtract 100% of debt necessarily - low yielding debt is actually value creating if the company is used to generate returns higher than its cost. Also increased borrowing base is something that increases as a company earns more money which can cause a virtuous circle)
  
• It takes 3 years, on average, for a company to reach its fair value
  
• Some companies will take less than 3 years and some will take more. The ones that become fairly valued sooner you sell and invest in companies that are more undervalued.
  

 

From the above assumptions, if you buy X company when it is at 15x Owner Earnings, you will earn about a 10% rate of return per year.

 

What happens if you buy the company at 10 x Owner Earnings?

 

The value of this stock, on average after 3 years, would be (15 x Owner Earnings/10 x Owner Earnings) x (1 + 10%)^3 = 1.99x the value today (i.e. doubling in value after 3 years).

 

If your stock doubles in value after 3 years, this is a compounded annual return:

 

(10^(LOG(1.99)/3)-1) = 25.9% annual rate of return.

 

So, if you buy average companies when they are undervalued by about 33%, and sell them when they reach fair value, you will earn about a 26% rate of return over time.

 

If we required a 50% rate of return, then, we would need a stock to go up by this much every 3 years:

 

(10^(LOG(X)/3)-1)=50%

 

Solved for X: X = 3.38

 

We would need each stock, on average, to increase by 238% (3.38 minus the original value of 1) over 3 years.

 

How undervalued would this average stock need to be when we bought it to earn a 238% return over 3 years?

 

(15 x Owner Earnings/Y x Owner Earnings) x (1 + 10%)^3 = 3.38x the value today

 

Y = 5.9

 

Therefore if you bought average companies by the definition above at 5.9 x Owner Earnings and they are revalued to their fair value in times averaging 3 years, you will earn about a 50% rate of return.

 

Companies at 6 x Owner Earnings definitely exist. Generally you have to dig a little deeper than the income statement to understand depreciation versus maintenance capital expenditures (talk about a walloping difference for some real estate companies), cases where amortization is recorded as an expense but definitely isn't one, investments and/or expenses (even on the income statement) that will generate future growth, etc.

 

On top of that, businesses that are above average may deserve a higher multiple and will grow at higher rates than 10%.

 

So yes, it is definitely possible Buffett could beat 50%+ returns.

 

HowMuchValue, Although your reasoning is theoretically accurate, in the real world this is not so straightforward. I will not even discuss the real-word difficulty to each and every time correctly assess owner earnings, return on invested capital, return on incremental invested capital, their respective future growth rates, unexpected developments in the company or in its industry, broad market corrections, and so much more. But even if this was possible and one could correctly know these factors in advance with 100% accuracy, market acknowledgment could be off by 1 year or 2 (to be generous), severely impairing your reasoning.

 

I believe the problem with compounding at a 50% rate is not so much the theoretical possibility - which exists up until a certain point, no one doubts it - but the practical challenges of doing so.

 

BTW, your post reminded me of an advice from Will Rogers about investing: "Buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it."

[HowMuchValue]

Antao,

 

I did not say earning 50+% per year would be easy. The factors you described (and a multitude of others) are where investing skill, analysis, history, and hard work are required.

 

However:

 

[*]You can range bound some of them (owner earnings this year was 9.9 to 10.8 million) (return on reinvested capital has averaged 12.9% over the past 14 years with a standard deviation of 2.3%)

[*]You are encouraged to factor in a recession into your estimates.

[*]Some of the factors are very knowable. For example, I know of a company that has an under-used line of credit with ~3% interest yield and has issued some long term debt yielding ~8.5%, which is redeemable in about 2 years. What will happen in 2 years? I can tell you with certainty they won't issue more long term debt at 8.5% - maybe they will pay it down with cash, maybe with their line of credit, or maybe with long term debt at a much lower interest cost to them.

[*]Sometimes it will take longer than 3 years while sometimes it will take shorter. If you have looked into long term results of how long it takes for an undervalued company to reach fair value and you find it is 5 years instead of 3 years, you can choose to invest at an even lower Price/Intrinsic Value ratio, or you can accept that you aimed for 50+% and landed on 35%.

[*]Of the many factors that will affect the companies whose stocks you own, many will be positive and many will be negative. In a portfolio where you own 10 to 20 positions, these factors will generally be pretty balanced (provided 5 of the companies you own aren't all competitors). A related topic is that when you estimate a company's intrinsic value, make sure more of the qualitative factors are on your company's side, and/or estimate and reduce your value estimate by the negative ones. For example, if there is a law suit outstanding and you estimate the worst loss to the company is $100 million, reduce your estimate by $100 million. If they are suing someone else for $100 million, include only the legal expenses of the law suit (valuing the company as if they will lose). This will be a little too conservative but in those circumstances where they do lose the law suit, you already had that factored in so you already passed on the company or bought at a cheap enough Price/Intrinsic Value to feel comfortable.

 

If you are going to take my advice, look for stocks that are priced at 40% or less than your well thought out realistic and slightly conservative estimate of their intrinsic value if you are aiming to earn a 50% rate of return.

[sae85400]

Here is a good chart from Frederik Vanhaverbeke's book Excess Returns: A comparative study of the methods of the world's greatest investors.

 

Spoiler alert: return scale "only" goes to 30% per year...(I believe it is returns over S&P 500, so maybe add another 10% to get absolute returns).

 

:)

 

That is a great chart...

 

Would have thought Druckenmiller would have had more years..But I bet they don't count the years (88-00) when he was running Quantum fund for Soros(so technically Soros number isn't his)

[bci23]

"If Charlie and I had $500,000 or $2 million to invest, we'd find little things we could do, not all of it in stocks"

 

I think the bolded part is the most important when it comes to compounding a small amount of money at 50%/yr+, investments outside of stocks. A couple ways i know of people earning high returns outside of stocks, one buys and sells web domains, another buys and resells clothing, and another is a professional gambler. The individual selling clothing has done over 100% pre-tax returns on invested capital each of the last 5 years. Invested capital is a mid to high 5 figure $ amount. A professional gambler should be able to earn 100% pre-tax returns on bankrolls up to $250k with some being able to do it with $500k-$1m.

[bizaro86]

I think one of the little things would probably be real estate, as mentioned above. There are, what 20,000 public companies in the US? By comparison, there were ~500k houses sold in the US last year, so there are way more opportunities for something to be mispriced. The other big factor is leverage. 5:1 leverage would be pretty standard in real estate, and given that you can get fixed rate, non-callable (and non-recourse where I live) leverage, that's a lot different than a margin loan. If you make the payments, you never get called, even if your collateral drops materially in value. Plus, non-recourse makes it close to a put (with credit consequences, but still).

 

The biggest factor that would allow someone to make 50% plus would be turning over properties quickly. I've sold 6 properties for gains, and the IRRs varied directly with how long I owned them. I have them below in descending order:

 

1) <1 year 199%

2) <1 year 180%

3) ~1 year 136%

4) ~1 year 120%

5) 3.5 years 27%

6) 5 years 9%

 

A couple of notes. I didn't take credit for the less than a year holding time, so the 180% was a 1.8X multiple of my investment. I didn't take credit for positive cash flow, which was present but wouldn't meaningfully change the results. The real estate market was moving up ~1-2% per year during this time frame. These assume 20% downpayments. In actuality, I borrowed the downpayments on a heloc, which makes the IRRs infinite. The sums are very small.

 

The last qualification is by far the most relevant. The largest gain was a condo unit I purchased for a net cost (inc. purchase, renovations, and legals) for $75k. Of that 18.6k was downpayment/renos. I sold it for $112k within a year.

 

The lowest one had a bit of bad luck (a tenant did tens of thousands of water damage, and the complex changed their deductible without telling me, leaving me on the hook for overages on my insurance) but the IRR was mostly reduced by the longer holding period. It was just as good a buy, and would have been a >100% IRR if I had sold it within 1 year.

 

Basically, longer holding times cause the ROE to revert closer to the cap rate of the property, which have universally been single digits. The huge returns have been from the free equity on a bargain purchase/smart renovation.

 

It's probably fair for me to make a couple of other comments. There's probably some labour value unaccounted for here from me project managing renos, and doing some of the carpentry work myself. I hire licensed trades for plumbing/electrical, and have a guy I use for tile/etc. These are a subset of my real estate portfolio. I bought 11 properties from 2009-2013, and sold 6. I sold the ones that were the lowest quality on a "headache reducing" basis. Some of the properties I've kept would have produced higher returns if sold right away, but I didn't have good reinvestment options so I kept them.

 

50% a year requires buying cheap stuff and turning it over quickly. That's true with stocks and real estate, imo. Compounders aren't going to get you 50%, imo, it will require higher turnover.

[netnet]

So here is a question, Walter Schloss, another acolyte of Graham, has been routinely described as somewhat of a dim bulb, at least as compared to Munger and Buffett.  So, gentlemen and woman of the jury, is it possible for the, ahem, less well intellectually endowed to make that 50%??  Assuming the right temperament, humility and clear definition of circle of competence.

[rb]

So here is a question, Walter Schloss, another acolyte of Graham, has been routinely described as somewhat of a dim bulb, at least as compared to Munger and Buffett.  So, gentlemen and woman of the jury, is it possible for the, ahem, less well intellectually endowed to make that 50%??  Assuming the right temperament, humility and clear definition of circle of competence.

Brilliant comment! It always surprised me why a hall of famer like Walter Schloss is marginalized while so many pray at the altar of the likes of Bill Ackman. Schloss was a fantastic investor. I guess he was just too cheap to hire a publicist.

[Jurgis]

So here is a question, Walter Schloss, another acolyte of Graham, has been routinely described as somewhat of a dim bulb, at least as compared to Munger and Buffett.  So, gentlemen and woman of the jury, is it possible for the, ahem, less well intellectually endowed to make that 50%??  Assuming the right temperament, humility and clear definition of circle of competence.

 

Assuming it's not a trick question and assuming exchange-quoted investments only: No.

 

Temperament and shrewdness or entrepreneurship without stellar IQ might be enough to make this off-exchanges in some situations.

 

Although we always have Forest Gump as shining star.

[AzCactus]

Just thinking through things...are there ANY managers anyone here knows who has averaged 50% per year for any reasonable length of time? This seems like Buffett just (or at least partially) saying something because you can't really prove him wrong on it.  He obviously manages a bit more than 1, 5 or 50 million....

[blainehodder]

Not a manager, but Ericopoly has crushed the market like that.

[KCLarkin]

FYI, he kind of answered this question recently:

https://blogs.rhsmith.umd.edu/davidkass/

 

Today, with $1 million, he and Charlie would probably invest in four stocks

[spartansaver]

Bizaro86, are there any books you would recommend that walk you through your process or you thought were very helpful along the way. Seems like a fruitful area for people with small (relative to investment funds) sums of money.

[augustabound]

I bought 11 properties from 2009-2013, and sold 6.

 

Just curious, based on your profile pic, are these all in Calgary?

[bci23]

So here is a question, Walter Schloss, another acolyte of Graham, has been routinely described as somewhat of a dim bulb, at least as compared to Munger and Buffett.  So, gentlemen and woman of the jury, is it possible for the, ahem, less well intellectually endowed to make that 50%??  Assuming the right temperament, humility and clear definition of circle of competence.

 

Assuming it's not a trick question and assuming exchange-quoted investments only: No.

 

Temperament and shrewdness or entrepreneurship without stellar IQ might be enough to make this off-exchanges in some situations.

 

Although we always have Forest Gump as shining star.

 

I don't think buffett ever implied he would earn 50%/yr in exchange traded investments only. Didn't he say something to the effect of "not just in stocks"? Implying his focus would be in off-exchange situations/ entrepreneurship. At least that was my interpretation.

[LR1400]

IQ seems to be the least important factor, at least when IQ is above average.

 

As important, if not more important for an entrepreneur:

 

1. Enough confidence to step out and try something/take a little risk.

2. Enough humility to hire smarter people in certain specific areas.

3. Drive and hustle. A deep drive to be successful, wealthy, rich, etc...

4. Preparation meets opportunity.

 

The people I know who have net worth of $50 million and up were above average intelligence but also had people working for them who were smarter in some certain area. The area could be finance, accounting, or operations/engineering.

 

The common characteristics were drive/desire to be rich, smart and frugal enough to avoid too much leverage and risk, and lastly, there was an outsized opportunity that they were smart enough and lucky enough to capitalize on.

 

[alwaysinvert]

IQ seems to be the least important factor, at least when IQ is above average.

 

As important, if not more important for an entrepreneur:

 

1. Enough confidence to step out and try something/take a little risk.

2. Enough humility to hire smarter people in certain specific areas.

3. Drive and hustle. A deep drive to be successful, wealthy, rich, etc...

4. Preparation meets opportunity.

 

The people I know who have net worth of $50 million and up were above average intelligence but also had people working for them who were smarter in some certain area. The area could be finance, accounting, or operations/engineering.

 

The common characteristics were drive/desire to be rich, smart and frugal enough to avoid too much leverage and risk, and lastly, there was an outsized opportunity that they were smart enough and lucky enough to capitalize on.

 

I think you are probably very poorly calibrated as to what an average IQ actually constitutes. An IQ of 100 means you are average for the whole population, not scholarly unexceptional at an Ivy League School (average graduate IQ of 142) or even at college at large (113). You can judge for yourself how many dumb people you think you went to college with and chances are they are above average in IQ even if they performed poorly academically.

 

Merely above average IQ is by no means sufficient to be outstanding at any cognitively intense task. Buffett speaks of 120 being sufficient to be a good investor, which means 90% of the population is disqualified right off the bat. Personally, I think he might be quite generous in the assessment of the cutoff. Note also that all the attributes you mention most probably correlates positively with IQ, that is more intelligent people are more likely to fulfill them.

[InspireByReason]

IQ seems to be the least important factor, at least when IQ is above average.

 

As important, if not more important for an entrepreneur:

 

1. Enough confidence to step out and try something/take a little risk.

2. Enough humility to hire smarter people in certain specific areas.

3. Drive and hustle. A deep drive to be successful, wealthy, rich, etc...

4. Preparation meets opportunity.

 

The people I know who have net worth of $50 million and up were above average intelligence but also had people working for them who were smarter in some certain area. The area could be finance, accounting, or operations/engineering.

 

The common characteristics were drive/desire to be rich, smart and frugal enough to avoid too much leverage and risk, and lastly, there was an outsized opportunity that they were smart enough and lucky enough to capitalize on.

 

I think you are probably very poorly calibrated as to what an average IQ actually constitutes. An IQ of 100 means you are average for the whole population, not scholarly unexceptional at an Ivy League School (average graduate IQ of 142) or even at college at large (113). You can judge for yourself how many dumb people you think you went to college with and chances are they are above average in IQ even if they performed poorly academically.

 

Merely above average IQ is by no means sufficient to be outstanding at any cognitively intense task. Buffett speaks of 120 being sufficient to be a good investor, which means 90% of the population is disqualified right off the bat. Personally, I think he might be quite generous in the assessment of the cutoff. Note also that all the attributes you mention most probably correlates positively with IQ, that is more intelligent people are more likely to fulfill them.

 

Someone here's looking for 7 foot bars to jump over.

[LR1400]

IQ seems to be the least important factor, at least when IQ is above average.

 

As important, if not more important for an entrepreneur:

 

1. Enough confidence to step out and try something/take a little risk.

2. Enough humility to hire smarter people in certain specific areas.

3. Drive and hustle. A deep drive to be successful, wealthy, rich, etc...

4. Preparation meets opportunity.

 

The people I know who have net worth of $50 million and up were above average intelligence but also had people working for them who were smarter in some certain area. The area could be finance, accounting, or operations/engineering.

 

The common characteristics were drive/desire to be rich, smart and frugal enough to avoid too much leverage and risk, and lastly, there was an outsized opportunity that they were smart enough and lucky enough to capitalize on.

 

I think you are probably very poorly calibrated as to what an average IQ actually constitutes. An IQ of 100 means you are average for the whole population, not scholarly unexceptional at an Ivy League School (average graduate IQ of 142) or even at college at large (113). You can judge for yourself how many dumb people you think you went to college with and chances are they are above average in IQ even if they performed poorly academically.

 

Merely above average IQ is by no means sufficient to be outstanding at any cognitively intense task. Buffett speaks of 120 being sufficient to be a good investor, which means 90% of the population is disqualified right off the bat. Personally, I think he might be quite generous in the assessment of the cutoff. Note also that all the attributes you mention most probably correlates positively with IQ, that is more intelligent people are more likely to fulfill them.

 

Fair enough.

I personally know people that I know I am smarter than, yet they are more wealthy than I am and more wealthy than I may ever be. They are more wealthy than 99% of the people on this board, unless this board is full of people who exceed $100Mill net worth or even $50mill net worth.

 

I do not believe a 145 IQ will lead to more success than a 135 IQ. Same with a 155 versus 145.

 

The people I know with the most wealth had an insatiable desire to be rich. They all have people who are smarter than them in a certain area, working for them. They are all extremely driven.

[alwaysinvert]

IQ seems to be the least important factor, at least when IQ is above average.

 

As important, if not more important for an entrepreneur:

 

1. Enough confidence to step out and try something/take a little risk.

2. Enough humility to hire smarter people in certain specific areas.

3. Drive and hustle. A deep drive to be successful, wealthy, rich, etc...

4. Preparation meets opportunity.

 

The people I know who have net worth of $50 million and up were above average intelligence but also had people working for them who were smarter in some certain area. The area could be finance, accounting, or operations/engineering.

 

The common characteristics were drive/desire to be rich, smart and frugal enough to avoid too much leverage and risk, and lastly, there was an outsized opportunity that they were smart enough and lucky enough to capitalize on.

 

I think you are probably very poorly calibrated as to what an average IQ actually constitutes. An IQ of 100 means you are average for the whole population, not scholarly unexceptional at an Ivy League School (average graduate IQ of 142) or even at college at large (113). You can judge for yourself how many dumb people you think you went to college with and chances are they are above average in IQ even if they performed poorly academically.

 

Merely above average IQ is by no means sufficient to be outstanding at any cognitively intense task. Buffett speaks of 120 being sufficient to be a good investor, which means 90% of the population is disqualified right off the bat. Personally, I think he might be quite generous in the assessment of the cutoff. Note also that all the attributes you mention most probably correlates positively with IQ, that is more intelligent people are more likely to fulfill them.

 

Fair enough.

I personally know people that I know I am smarter than, yet they are more wealthy than I am and more wealthy than I may ever be. They are more wealthy than 99% of the people on this board, unless this board is full of people who exceed $100Mill net worth or even $50mill net worth.

 

I do not believe a 145 IQ will lead to more success than a 135 IQ. Same with a 155 versus 145.

 

The people I know with the most wealth had an insatiable desire to be rich. They all have people who are smarter than them in a certain area, working for them. They are all extremely driven.

 

You are right that there is nothing necessarily deterministic about 145 vs 135, but thinking a higher IQ doesn't equal higher earnings on average is a profound misunderstanding of what IQ is. Of course you aren't very likely to get rich if you have a high IQ and spend your days writing poems. All the data however suggests that, all else equal, higher IQ means more financial success. So you are wrong in that it doesn't matter above a certain point and anecdotal evidence or your personal belief doesn't really help your case.

[LR1400]

Show me this data please.

 

 

[alwaysinvert]

Sure, here is a good readable breakdown: https://pumpkinperson.com/2016/02/11/the-incredible-correlation-between-iq-income/

 

Otherwise there is lots of academic literature on the subject and if you don't feel like consulting that you can read The Bell Curve. The conclusion, however, is the same wherever you go:  there is no evidence for the breakdown of the correlation between IQ and earnings above a certain threshold. In fact the evidence that exists points squarely in the opposite direction, at the very least if we are not talking about the extreme tail of the distribution where, due to the extremely small total population, outliers have potentially huge impact.

 

This doesn't mean you absolutely need a very high IQ to get rich, or that it is sufficient to get rich in and of itself, but I'm sure you understand that.

[bizaro86]

@Spartan I've read everything on real estate I can get my hands on. Most of it is crap. One author I like is William Nickerson. His books are horribly titled "How I turned 1000 into 1 million in real estate in my spare time" and old (the section about the benefits of desegregating an apartment building blew my mind that it was even a thing) but good on the mental models. The basic process he describes is to buy something that is in poor condition at a bigger discount than the cost of repairs, and then pyramid up to larger properties.

 

Personally, I have a few basic criteria. It has to have positive cash flow (after renovations) even assuming I put zero down. This eliminates basically everything, and leaves principal paydown as a worst case scenario.

 

The other thing is I want to buy at a discount to the current value, and a bigger discount to the after repaired value. If nothing works, don't buy. No called strikes.

 

@Augusta All in metro Calgary. The 4 lowest priced deals were all in a small town within commuting distance. I seriously considered doing Phoenix in 2009, but backed off on concerns if I went down to buy I might buy something inappropriate if I couldn't find anything that fit, since the travel would be a sunk cost.

[augustabound]

@Augusta All in metro Calgary. The 4 lowest priced deals were all in a small town within commuting distance. I seriously considered doing Phoenix in 2009, but backed off on concerns if I went down to buy I might buy something inappropriate if I couldn't find anything that fit, since the travel would be a sunk cost.

 

There was a guy on another forum (Financial Webring Forum) and he was also featured in Moneysense, Jim Chuong, he invested in Phoenix around that time. He was buying 2br condos and homes for $30-40k (paid in cash, so no carrying costs) and renting them out for ~$1500 a month IIRC.

 

He found a reputable property management company so trips to Phoenix are rare I think. He also has multiple properties so the PM makes sense too.

[tombgrt]

Personally, I have a few basic criteria. It has to have positive cash flow (after renovations) even assuming I put zero down. This eliminates basically everything, and leaves principal paydown as a worst case scenario.

 

 

 

What do you mean with cash flow positive exactly? Net positive cash inflow after paying for mortgage and other costs?  ??? How is that possible? Where does such an inefficient market find these stupid renters? Maybe I'm misunderstanding you. Maybe you include principal paydown in your cash flow?

 

Wouldn't even come close here. I'm renting a brand new home at an estimated 2.4-2.8% rental yield (depending on whether you include one time property taxes, which you should) for the buyer. Buying it without personal equity inlay would cost me double with an intrest free mortgage over 20 years.