Set Yourself Up To Let Compounding Work Its Magic

Includes: AXP, BRK.A, BRK.B, CL, GHC, JNJ, KO, PG, XOM
by: Tim McAleenan Jr.

In the chapter titled You Should Invest Like A Catholic Marries: For Life, of Mary Buffett's book "The Tao Of Warren Buffett", she has this to offer about Warren Buffett's approach to buy-and-hold investments:

Warren knows that if you view an investment decision from the perspective that you will never be able to undo it, you'll be certain to do your homework before taking the plunge. You wouldn't jump into a marriage without doing your research (dating) and discussing it with your advisers (your pals at the pub) and thinking long and hard about it…would you? Nor should you jump into an investment without knowing a lot about the company and making sure that you understand it. But it is the life part that really makes the money. Consider this: In 1973 Warren invested $11 million in The Washington Post Company (WPO), and he remains married to this investment even to this day, and over the thirty-three years that he has held on to it, it has grown to be worth $1.5 billion. The conviction to stay the course can bring heavenly rewards, as long as you have chosen the right one to begin with.

This sentiment closely correlates to the Buffett quote: "Invest as if the stock market will be closed for the next five years." It's a great mental exercise for determining a short list of stocks worth investing in. If I had to name the five companies that I think are most likely to be making profits 10 years from now, they would be: Exxon Mobil (NYSE:XOM), Berkshire Hathaway (NYSE:BRK.B), Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), and Colgate-Palmolive (NYSE:CL). They are fine firms with diversified income streams and very strong competitive advantages. Your list will most likely be different. But it's a great way to quickly gauge the strength of a firm's business model by trying to determine just how durable its competitive advantage may be. A durable moat is probably the single most important characteristic of a long-term investment.

Why is that? Because a durable moat has a very strong correlation with consistent profits that often grow at a rate greater than inflation. Many investors spend a lot of time trying to replicate the investment success of Warren Buffett, wondering how to recreate the investment returns of historically successful Berkshire Hathaway (NYSE:BRK.A) investments like The Washington Post, Coca-Cola, American Express (NYSE:AXP), and Gillette [now Procter & Gamble (NYSE:PG)]. It's clear that the recipe for this investment success boiled down to two components: spending a lot of time identifying the excellent companies, and then spending a lot of time owning the same excellent companies.

This is the part where Buffett has truly differentiated himself as an investor. As the quote above says, it is the life part of the investment that makes the money. Time, time, time. It's about finding an excellent business and then holding onto it for 15, 20, even 30. It's especially helpful if the excellent company pays dividends. That way, you benefit no matter what prices do. If prices go up, you are making money as the net worth of your investment increases. If stock prices are going down, then you are reinvesting the dividends at lower prices, accumulating more shares, which means even more dividends and a larger claim on retained earnings. The lollapoolaza effect occurs when you look back later on the value of those reinvested dividends in the early years of the investment and the stretches of time when the stock trades at depressed prices.

Of course, most of us don't have the gumption to hold onto shares of any company for decades at a time. We get spooked at the wrong times. When we see shares fall 30%-40% during the financial crisis, we strongly consider selling, and often do so. My antidote for this impulse is to limit my investing universe to excellent companies. The best way to cope with a crisis is to know that the companies owned will emerge stronger once the troubled times pass. If you know your firm is making more and more profits each year, the thought of holding high-quality stocks through thick and thin becomes much more palatable. At that point, you can let the power of compounding work its magic.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.