Compounding with or without the Compounders...
Mathematically possible at 24% a year or maybe not
One of my friend asked incredulously on our 24% per year target… We did not attempt to answer during our chat as it is incredibly simple in explanation but confounding in practise.
We are sure that we will fall short on the target but anything slightly lesser is fine for us.
To the people who understand finance, they will think that any promise of 24% per year is a fraud! The usual response is “That is impossible to achieve!” Even Warren Buffett, the most famed investor in the world average 30% annually in his initial years and 20% thereafter.
To the people who do not understand finance, they will think that they could easily do it since the market is giving them 50 - 100% per year in 2020 and 2021. Compounding 24% per year seems like an underachieving exercise.
For us, the question is let us aim a bit higher and maybe fall short.
Or the more pertinent question is how do we mathematically hit the annual return of 24%?
We think 24% stuck in our head due to the rule of 72. It is nice to be able to double your money every 3 years. But technically, the percentage return could be any number.
The answer to __% per year compounding lies in 3 assumptions:
The ability to buy a company at X% of discount
The share price will be valued at fair value in Y number of years
The growth of the company will be Z% for the Y number of years
If we can get this 3 assumptions right, we could be close to the magical 24%!
X = 50% discount,
Y = 5 Years,
and Z = 8% growth.
Do your math* and you will know what we mean!
The general aim is to buy fifty cents on a dollar worth of value. If we are able to ascertain that the company might be fairly valued in 5 years time (due to special situation or general recognition of the potential of the company) and the company continue to grow at 8% per year, we would magically reached the 24% annual return!
Mathematically, the most common mistake that investor make is that they
bought the company with no discount (X = 0%)
do not know when the company would be fairly valued (Y=Infinity?)
had assumed too high a growth for the company (Z > 8%?)
In common investing framework, investor usually
buy without a margin of safety (X<0%),
do not have a catalyst to determine the time period Y,
assumed a too high rate of growth Z% which could not be delivered.
It all sound simple on paper (investing is really simple) but it ain’t an easy practise.
Getting to a successful investment requires
estimating the margin of safety X% (depends on your valuation skill),
estimating the time period Y (depends on your business acumen),
estimating the growth rate Z% (depends on the understanding of the industry).
In Special Situation investing (Special Portfolio), the margin of safety of X% and a time period Y is clearer. The problem is the growth rate Z%. Since it is a special situation we would not require growth to realise the value and we can safely assume that Z = 0%.
In Unrecognised Growth investing (Super Portfolio), the assumed growth rate Z% and time period Y needs to be reasonable by industry standards. By accepting a lower margin of safety X, we would be able to get a chance to buy at a reasonable expectation.
In Statistical investing (Statistical Portfolio), we are trying to assemble a portfolio of companies which has various X%, Y time period and Z% which on average should achieve 24% in return over time. The ability to accurately assemble such a portfolio become key to generating the required return.
Overall, coupled with some luck we should be getting close to our 24% annual return using a variety of X,Y and Z.
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*in excel, n=5, PV= - 0.5, FV = 1.08^5, =rate() and you will get 24%!