You Don’t Grow Rich Taking a Profit
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Monday, August 11, 2014
“It’s time in the market, not timing the market that makes for successful investing.” – Thomas W. Phelps, 100 to 1 in the Stock Market (1972)
There is an old adage in the investment business: “you don’t go broke taking a profit.” True, but neither will you grow rich. While we’re being somewhat facetious, we can’t overstate the value of owning excellent businesses over a long period of time.
One of the reasons buy-and-hold strategies work so well, is that capital is allowed to compound tax free. Warren Buffett has built an enormous fortune by appreciating this advantage. In his 1989 letter to shareholders, he describes the taxable portion of unrealized gains as an “interest-free loan” from the government, payable at the investor’s time of choosing. While taxes should not be the primary driver of investment decisions, wealth compounds much faster when there is more of it working to an investor’s advantage.
In 1972, Thomas Phelps wrote an excellent, now out-of-print book, titled 100 to 1 in the Stock Market, dedicated to finding 100-baggers, or companies that would increase 100-fold in 25 years or less. The hard part, according to Phelps, isn’t necessarily finding great businesses – it’s holding on to them. Investors are instinctively wired to think that trading will produce riches; Wall Street and Bay Street naturally take advantage of this penchant by bombarding investors with short-term trading advice. However, the really great investors capitalize on time horizon arbitrage by focusing on where businesses will be years down the road rather than becoming carried away by short-term trends.
Excessive activity often undermines long-term returns, leading investors to miss out on the growth of great businesses due to poorly-timed trades. While the masses are zigging and zagging and trying to outsmart other investors, it is often best to do nothing. Warren Buffett emphasized this in his 1991 letter to shareholders, stating that “the stock market serves as a relocation center at which money is moved from the active to the patient.” Patient investors who buy and hold great franchises and let capital compound on a pre-tax basis will do well. Great businesses have durable competitive advantages that allow them to produce above average returns on the capital they invest. A company’s share price will ultimately reflect the favourable economics of the underlying business over the long run.
Owning great businesses has served Odlum Brown clients well. Since inception in December 1994, the Odlum Brown Model Portfolio has grown at a compound annual rate of 15.8%. In recent years, that annual turnover has been less than 20%, meaning we own companies for an average of more than five years. The average holding period for NYSE-listed companies is less than two years. Astonishingly, that is up from a transient five-month holding period in 2009!
As Thomas Phelps states in his book, “In Alice in Wonderland, one had to run fast in order to stand still. In the stock market, the evidence suggests, one who buys right must stand still in order to run fast.” In other words, when investing in great businesses, inaction can sometimes be the best course of action for long-term wealth generation. The next time you find yourself in the fortunate position of having built-up unrealized gains in shares of wonderful companies, think twice before you harvest the gains. Not taking a profit might prove to be most profitable.