📈 10 Essential investment lessons of

Warren Buffett
Warren Buffett has been writing annual shareholders letters for more
than 4 decades. I read them all and summarized them in 10 key lessons.

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Principle 1: The longer you invest, the better.

Today, Warren Buffett’s net worth is equal to more than $100 billion.
More than 95% (!) of this wealth was created after his 65th birthday. The
power of compounding is truly beautiful.

Principle 2: Do not borrow money to invest

“My partner Charlie Munger says there are only three ways a smart
person can go broke: liquor, ladies and leverage" - Warren Buffett

Principle 3: Boring companies are usually great investments

Invest in what you understand. When you don’t understand what you
buy, you are not able to make good and rational investment decisions.
Boring companies are usually great investments. Good investing is as
watching paint dry.

To give an example: when you would have invested $1.000 in Coca-

Cola in 1989 and reinvested all quarterly dividends, you would collect
more than $56.000 (!) in annual dividends today.

Principle 4: Invest in companies with integer management

The interests of management and shareholders should be aligned. When

a management with a reputation for brilliance tackles a business with a
reputation for bad economics, it is the reputation of the business that
remains intact.
Principle 5: Buy quality businesses

In the long term, earnings growth is the main determinant for increasing
stock prices. Invest in robust companies with a healthy balance sheet and
high margins which can grow their earnings attractively.

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Principle 6: Be disciplined

Every investment strategy will underperform the market from time to

time. As an investor you are running a marathon, not a sprint. Write
down your investment goals and stick to the plan.

Principle 7: Market fluctuations are your friend

The best thing that can happen to investors who will still be buying
shares in the next 10 years, is falling stock prices.

Use it to your advantage.

Principle 8: Invest in companies who can reinvest a lot in organic
growth

Organic growth is the most preferred source of growth. When you invest
in companies which can reinvest their earnings in organic growth for
years or even decades, the earnings of the company will explode over
time.
Principle 9: Your best ideas should have the largest weight in your
portfolio

When you know what you own, overdiversifying can be harmful to your
results. More than 40% of Buffett’s portfolio is invested in Apple. 87%
(!) of Berkshire Hathaway’s assets are invested in only 10 stocks.
Principle 10: Pricing power is crucial

A company with pricing power can pass increasing costs to their

customers. Companies with pricing power are usually characterized by
high gross margins. When a company has a very high and stable gross
margin, it is usually also a good indication that the company has an
economic moat.

The end. Do you want to learn more about Warren Buffett’s investment
strategy? I mapped all annual letters of Berkshire Hathaway in 1 PDF.
You can download the PDF for free here:

GC
Aug 11Liked by Quality Compounding

Hi there, thanks for all the wonderful work you are doing!

I have one comment on point 9 in this article. "87% (!) of Berkshire Hathaway’s assets
are invested in only 10 stocks.". While this is true for their investment portfolio, it is
far from true for their entire asset base. They have many other wonderful businesses
that are not visible on that image. BNSF, BHE, GEICO, etc. In any case, even if we
look at all of their assets, I am sure that the concentration will still be there, so your
 points are directionally correct. Only the numbers might be slightly off.

Cheers and keep it up!

3ReplyCollapse
1 reply by Quality Compounding

Mohan Lal Tejwani

Sep 17Liked by Quality Compounding

Thanks for sharing a invaluable wisdom of legend 🙏

My Quality Investment
Philosophy
Dear reader,

Via this way, I warmly want to welcome you to this blog. This blog of
Quality Compounding focuses – as you might suspect - on quality
investing.

The beautiful thing about quality investing is that quality companies (or
compounders) manage to grow their free cash flow exponentially
thanks to a combination of favorable characteristics. Once you have
done your homework and your view about the company was correct, you
can let the company work and compound for you. In other words,
quality investing is one of the only investment methods where you
can use a buy-and-hold strategy. When you invest in a value stock,
you buy a company that is undervalued. As a result, you should sell it
when the company’s stock price evolves to their intrinsic value
(calculated by you). Once that is done, the process restarts, and you
should find another undervalued company. This is in stark contracts
with quality investing because when you can buy a great company at
a fair price, you should never sell the stock. Some examples of long-
term great compounders since their IPO: IDEXX Laboratories (CAGR
of 21.2% since 1991), Microsoft (CAGR of 25.9% since 1986) and
Pool Corporation (CAGR of 26.3% since 1995).

For Terry Smith, Quality Investing is based on 3 metrics:

1. Buy good companies

2. Don’t overpay
3. Do nothing

Chuck Akre’s Three-Legged Stool is also a great framework for

quality investors:

Obviously the million-dollar question is how you can find these

quality companies. Quality companies often possess over the following
characteristics. We will go through them all in this article:
  A wide moat (competitive advantage)
 Integer management
 Low capital intensity
 Good capital allocation
 High profitability
 Attractive historical growth
 A secular trend / optimistic outlook

Some great examples of quality companies can be found in the

portfolio of Terry Smith (Fundsmith):

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Wide moat (competitive

advantage)
“A good business is like a strong castle with a deep moat around it. I
want sharks in the moat. I want it untouchable.“ – Warren Buffett

As a quality investor, you are not looking for The Next Big Thing.
You want to invest in companies that have already won. In other
words, you want to invest in companies that are clear market leaders
with strong pricing power that managed to outperform the stock
market for years and preferably even decades in the past.

Wide moat stocks outperform the market in general:

Think for example about companies like S&P Global and Moody’s.
Both companies are active in the credit rating business and are truly
essential for the global debt market. Every US listed company that wants
to issue debt, needs a credit rating from at least 2 of the 3 big rating
agencies: S&P Global, Moody’s or Fitch. Debt issuers practically have
no choice than asking for a credit from these companies and this gives
S&P Global and Moody’s a lot of pricing power. S&P Global and
Moody’s were industry leaders in the 1970s, are industry leaders today
and probably will still be industry leaders in 40 years from now.

Some other great examples of wide moat stocks: Nike and Adidas,
Visa and Mastercard, Assa Abloy, MSCI, and Equifax.

Wide moat stocks perform better than the market:

Integer management (skin in the
game)
“If management and the board have no meaningful stake in the company
– at least 10 to 20% of the stock – throw away the proxy and look
elsewhere.” – Martin Sosnoff

You want to invest in companies with an integer management.

Management’s interest should be aligned with the one of you as an
investor. Having skin in the game is very powerful.

That’s also the reason why, in general, family-owned business often

perform better than non-family business. Credit Suisse has written a
great paper about this wherein they conclude that since 2006, family
companies outperformed non-family companies with 3,6% per year. The
paper can be found
here: https://www.credit-suisse.com/media/assets/corporate/docs/about-
us/research/publications/cs-family-1000-post-the-pandemic.pdf

Some examples of great quality family-run business: LVMH,

L’Oréal, Kone, Copart, and Stryker.

Low capital intensity

“Asset-light industries are attractive since they require less capital to be
deployed to generate sales growth. The finest examples are franchise
operations, such as Domino’s Pizza, where growth is funded by
franchisees rather than by the company.” - Lawrence Cunningham

As a quality investor, you want to invest in low capital-intensive

business. These companies require very little capital to maintain
their current business and to achieve future growth. When you find
companies with a low capital intensity that have high profitability
margins and can reinvest a lot in future growth opportunities (high
ROIIC), you are investing in compounding machines. These are the
companies you seek as a quality investor. In general, you aim for
companies with CAPEX/Sales < 5% and CAPEX/Operational Cash
Flow < 15%.

Some low capex quality business: Automatic Data Processing

(CAPEX/Sales: 1.2%), Domino’s Pizza (CAPEX/Sales: 2.2%) and
Blackrock (CAPEX/Sales: 1.8%).

Great capital allocation

“Capital allocation is the most important task of the CEO. Organic
revenue growth (reinvesting in the business) is the most preferable
source of growth.” – Quality Compounding

When a company earns cash, they can do three things with the FCF
that is generated: reinvesting in the business, acquisitions /
buybacks, and dividends.

 Reinvesting in the business: This is the most preferred capital

allocation choice. You want to invest in companies that can
reinvest a lot of their FCF in future growth opportunities at high
profitability rates and great capital allocation metrics. The higher
the Return on Incremental Invested Capital (ROIIC), the better.
You want to invest in companies that can report organic revenue
growth figures of more than 7%.
 Acquisitions and buybacks: Companies can also use their FCF to
buy back their own shares (which increases the FCF per share
when these shares are destroyed) or to acquire other companies.
On the global stock market, there are great serial acquirers like
Constellation Software, Roper Technologies and Lifco.
 Dividends: Finally, companies can also pay dividends with its
FCF. Dividends are usually not the most efficient way to allocate
capital as it does not generate future growth and you as an investor
pay taxes on the dividend you receive.
In general, the greater the capital allocation of a company, the
better. Looking at ROIC and ROCE is a good start. We prefer
companies with a ROIC greater than 20%.

Some examples of companies in my investable universe with great

capital allocation metrics: Sherwin-Williams, Domino’s Pizza, Pool
Corporation, and Adobe.

High profitability
“When a company can report high FCF margins for decades, this is a
great indication of a wide economic moat.” – Quality Compounding

The free cash flow margin shows how much percent of sales are
translated into cash. When a company has a FCF margin of 30%, for
every $100 the company sells, $30 of cash is generated. In general,
companies can use their FCF to reinvest in itself, buyback shares,
acquire other companies, and dividends.

To become a part of my investable universe, the FCF margin of a

company should be at least 15% (and preferably more than 20%).
Furthermore, a high percentage (> 90%) of the companies’ earnings
should be converted into free cash flow. Free cash flow is a way more
important metric than earnings as it truly shows how much cash is
entering the business.

Some beautiful examples of companies with high profitability

margins: IDEXX, Ansys, Johnson & Johnson, and Fortinet.

A secular trend (bright outlook)

“When you invest in companies active in a strongly growing end market,
you have the wind in the sails as an investor.” – Quality Compounding

The trend is your friend. You want to invest in companies with a

strong secular trend. Think about themes like urbanization,
cybersecurity, datacenters, semiconductors, hearing aids, and
obesity. You want to invest in a company which is active in a market
that is growing strongly and where preferably the company you invest in
also can gain market share within this exponentially growing market. I
am aiming for companies which can grow their organic revenue
with at least 7% per year in the foreseeable future.

Some examples of companies active in an end market with strong

secular trend: Novo Nordisk (obesity), Kone (urbanization), Fortinet
(cybersecurity), Blackrock (passive investing), and Sonova (hearing
aids).

Valuation
“It's far better to buy a wonderful company at a fair price than a fair
company at a wonderful price.” – Warren Buffett

For quality investors, the quality of the business is more important than
the valuation. Obviously, you don’t want to overpay for quality as
beautiful companies can become terrible investments when you pay
way too much. You want to buy a beautiful company at a fair price,
as stated by Buffett.

In the long run, your return as an investor is equal to the FCF growth
per share plus the shareholder yield (buyback yield + dividend yield)
+/- multiple expansion/contraction. The longer you invest in a
company, the more important the FCF per share growth becomes.

Conclusion
“A stock that returns about 20% per year for 25 years multiplies your
money by a factor of 100x. An investment of $10.000 in that case
becomes $1.000.000.” - Christopher Mayer

To wrap it up: as a quality investor you want to invest in the best

companies in the world. You don’t want to invest in The Next Big
Thing but invest in companies that have already won. Looking at the
evolution of the stock price over the past years and preferably decades is
already a good indication for this. Personally, I am not investing in
companies that did not manage to generate a 15% CAGR for
shareholders since their IPO. Quality companies possess over the
following characteristics: a wide economic moat, integer management,
low capital intensity, good capital allocation, high profitability,
attractive historical growth, and a strong secular trend. When you
can pick up these companies at a fair valuation, you will end up with one
hell of a result over time. That’s the beautiful thing about investing in
compounding machines.

That’s about it. Hopefully you liked this first official article written by
me, Quality Compounding. Feel free to reach out if you have any
questions or feedback. Subscribing, sharing and liking this article is
greatly appreciated as it is very hard to start a new blog. Just like
investing in companies with a wide moat driven by network effects (e.g.
Visa/Mastercard), the more people are reading your articles, the greater
the compounding effect.

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12 Comments

Stephen Clapham (Steve) Author Smart Money Method

Writes Behind the Balance SheetJul 12Liked by Quality Compounding

Good article. Amazing that you grew a twitter account from 0 to 10k in a
month. Respect. You ever want to give up fund management, you can train
people in social media. I will be your first pupil. Well done and good luck
with the substack

10ReplyCollapse
josep
Sep 14Liked by Quality Compounding

ok. waiting ;). Thx

 1ReplyCollapse

How to invest in Quality Companies

(Terry Smith)
Terry Smith is one of the greatest Quality Investors in the world. Since
his fund launched in 2010, Fundsmith achieved an astonishing CAGR of
15.46% (!) after fees. In this article you will find 10 great investment tips
from the Quality Maestro himself. Furthermore, you can find a PDF with
all his annual shareholders letters at the bottom of this article.

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1. Invest in companies with wide

economic moats
When a company earns a lot of cash, it will attract rivals and reversion to
the mean takes place. However, this is not the case for wide moat stocks
as they have a superior service or product which rivals can’t
replicate. That’s why a moat is truly essential for quality investors.

Coca-Cola is a great example:

“If you gave me $100 billion and said take away the soft drink
leadership of Coca-Cola in the world, I'd give it back to you and say it
can't be done.” – Warren Buffett

2. Strong organic growth is a must

Organic growth is the most preferred source of growth. Looking at the
past is already a great indication. Seek for companies who managed to
grow organically over the past years and preferably even decades.

When these companies are still active in a strongly growing end market
today, this a great indication you have found a Quality Company.

3. Invest in companies with a high

Return on Invested Capital
(ROIC)
The higher the Return on Invested Capital (ROIC) of a company, the
better.

"Over the long term, it's hard for a stock to earn a much better return
than the business which underlies it earns. If the business earns 6% on
capital over 40 years and you hold it for that 40 years, you're not going
to make much different than a 6% return—even if you originally buy it
at a huge discount. Conversely, if a business earns 18% on capital over
20 or 30 years, even if you pay an expensive looking price, you'll end up
with a fine result." – Charlie Munger

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4. Revenue growth is the main

driver for value creation
Eventually, the stock price will follow the revenue and free cash flow
growth of a company.

"If you bought the S&P 500 at a P/E of 5.3x in 1917, and sold it in 1999
at a P/E of 34x, your annual return would have been 11.6%. Only 2.3%
p.a. came from the massive increase in P/E. The rest of your return came
from the companies’ earnings and reinvestments." - Terry Smith
5. Buy companies who translate
most earnings into free cash flow
Earnings are an opinion, cash is a fact.

A study found that between 1962 and 2001, companies that translated
most earnings into free cash flow outperformed companies that
translated the least earnings into free cash flow by 18% (!) per year.
6. A high gross margin is a good
protection against inflation
The higher the gross margin of a company, the better the company is
protected against inflation. An increasing cost of goods sold (COGS)
does not hurt high margin companies as much as low margin companies.

When a company has high, consistent gross margins, it is a great

indication that the company has a wide moat too.
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7. Be disciplined
When you invest in stocks, one thing is for sure: you will underperform
the market from time to time. No rider has ever won all stages of the
Tour De France. The same principle is valid on the stock market.

Always stick to your investment philosophy and strategy. Investing is a

marathon, not a sprint.

8. Look at ROCE instead of ROE

The Return on Capital Employed (ROCE) is a better metric than the
Return on Equity (ROE) because it considers all capital employed
(equity, debt and other liabilities).

The ROE only looks at the equity part and can be manipulated as this
ratio increases when a company uses more debt (and/or less equity) to
finance its operations.
9. Don’t overpay
Even the best companies in the world can sometimes be so overvalued
that you will end up with bad investment results. Pay a fair price for a
wonderful company, and you’ll end up with wonderful investment
returns.

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10. Do nothing
The best investor is a dead investor.

Trading too much harms your investment results. Be disciplined and

don’t trade too much.
💸 How to find multibaggers
It's the dream of every investor to make a 10-bagger (a stock that goes
up tenfold), or even a 100-bagger (a stock that goes up 100x).

Alta Fox Capital studied more than 100 (!) multibaggers. In this thread,
we will go through the 8 characteristics almost every multibagger has.

Start to learn here

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Lesson 1: Look for business with

a wide moat
A wide moat is essential for every Quality Investment.

Almost all multibaggers (91%) are characterized by a wide economic

moat. Barriers to entry are the most preferred moat source for
multibaggers (81%).
Lesson 2: Invest in financially
healthy companies
Great companies are very cash-generative and have a healty balance
sheet.

Seek for companies with a low net debt / EBITDA and high interest
coverage. When the company has a net cash position (more cash than
debt), this is a great surplus.

Lesson 3: Acquisitions can create

a lot of value
While many acquisitions fail to create value, the best performing stocks
often use acquisitions to bolster their returns.

If you want phenomenal returns, find companies that are great acquirers.
Constellation Software, Roper Technologies and Lifco are beautiful
examples.

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Lesson 4: Don’t rely on multiples
When you want to buy something great, you have to pay for it.

While it’s always better to buy a great business at a low multiple rather
than a high one, many of the top performing stocks started compounding
with multiples which were already high. Those multiples often expanded
even further over time.

“'It's far better to buy a wonderful company at a fair price than a fair
company at a wonderful price.” – Warren Buffett
Lesson 5: Invest in small caps
In general, small cap stocks perform better than large cap because they
have more upside potential.

When you can find an owner-operator small cap stock which is a market
leader in a niche with high margins, you have found a (potential)
goldmine.

Lesson 6: Margin expansion is

great
As a quality investor, you should love margin expansion.

When the profit margin of a company doubles, the EPS of the company
doubles too.

In the long term, earnings growth is the leading factor for stock price
performance.

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Lesson 7: Let your winners run
The only thing you need during a succesful investment career, is a few
big winners.

Between June 2015 and June 2020, the S&P500 returned 55,5% to
shareholders. Zynex Medical, the best performing stocks over the
studied period, returned almost 9200% (!) to shareholders.
Lesson 8: Revenue growth is the
most preferred source of growth
Organic growth is the holy grail for quality investors.

When you can buy companies which can reinvest a lot of their free cash
flow in organic growth opportunities at high margins, the company’s
earnings will explode over time.

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🏰 Don't Worry Invest Happy

#
In this series, we will teach you 5 things about the stock market in less
than 5 minutes. If you are reading this and are not subscribed yet, feel
free to join the Compounding Quality Family via the button hereunder:

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1️⃣ Don’t Worry Invest Happy

Don't worry. Just focus on the long term and you’ll be fine.

The longer your investment horizon, the better.

2️⃣ What’s really going on at

board meetings
Carl Icahn on what's really going on at board meetings.

This is truly shows why it is important to do your own homework. Retail

investors have BIG advantages compared to professional investors (and I
can know this because I manage an Equity Fund).

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3️⃣ One simple investment quote
Look at the fundamentals of the company and not at the stock price.

When the fundamentals of a company are still good but the stock price is
decreasing, you have no reason to sell at all.

“If a stock is down but the fundamentals are positive, you should buy
more of it.” – Peter Lynch
4️⃣ How to find owner-operator
quality stocks
Do you want to find owner-operator quality stocks? Use these criteria to
start your research journey.

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(Source: UncleStock)

5️⃣ Example of a Quality

Company
MIPS AB is a Swedish company which manufactures and sells sports
helmets. The company offers a brain protection system for helmet
market and is targeting 2 billion SEK in sales by 2027.

These are the kind of charts you want to see as a Quality Investor:
All you need is a few big winners
In this series, we will teach you 5 things about the stock market in less
than 5 minutes. If you are reading this and are not subscribed yet, feel
free to join the Compounding Quality Family via the button hereunder:

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1️⃣ The longer your investment

horizon the better
The longer you invest, the higher the chance you'll make money.

(Source: Returns 2.0)

2️⃣ How does Microsoft make
money?
Microsoft is a free cash flow machine (and a great quality company too).

Great graphic from Genuine Impact.

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3️⃣ One simple investment quote
Tough marker periods are usually the best times to invest in the stock
market.

Bear markets can make you very rich. You just don’t realize it at the
time.

“Most people get interested in stocks when everyone else is. The time to
get interested is when no one else is. You can’t buy what is popular and
do well.” - Warren Buffett

4️⃣ All you need is a few big

winners
A few big winners will form your returns as an investor.

Selling your winners too early, is one of the biggest mistakes you can
make.

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5️⃣ Example of a Quality

Company
In the screenshot below, you can find a great quality universe
from Professor Kalkyl. It is truly beautiful!
Let your winners run
1️⃣ Let your winners run
20% of your investments will generate more than 80% of your returns.
One of the worst investment mistakes you can make, is selling your
winners too early.
2️⃣ The Peter Lynch Playbook
Peter Lynch is one of the best investors in the world achieving an annual
return of 29.2% (!) between 1977 and 1990.

Do you want to make better investment decisions? Take a look at this

wonderful playbook of Peter Lynch:
3️⃣ One simple investment quote
Do you want to achieve great investment returns? Great investors think
in years and decades. The best time to buy a company, is when
everybody else is panicking.

"Nobody buys a farm based on whether they think it’s going to rain next
year. They buy because they think it’s a good investment over 10 or 20
years. It's the same with stocks. Think of stocks as a part ownership of a
business. It's not that complicated." - Warren Buffett

4️⃣ Podcast: Investing by the

Books
Do you want to learn about Quality Investing via podcasts? Investing by
the Books hosted by Eddie Palmgren and Niklas Sävås is truly great.
You can find it by clicking on this link.

5️⃣ Example of a quality

company
The write-up from Nick Sleep on Costco is pure gold.

The analysis hereunder was written in February 2005. Since then, the
stock is up more than 1000% (10X):
List of undervalued wide moat stocks

🏰 List of undervalued wide moat

stocks
In the list hereunder, you can find all undervalued wide moat stocks
according to Morningstar:
🏰 Percentage gains needed to fully
recover from a loss
If your investment loses 10% in value, you need to gain more than 10%
in order to break-even.
🏰 One simple investment quote
Bear markets can make you very rich. You just don't realize it at the
time. During bear markets, you lay the foundation of your future returns.

"Someone's sitting in the shade today because someone planted a tree a

long time ago.” - Warren Buffett
🏰 Some high quality books
Do you want to learn more about quality investing? Find some great
inspiration in this picture:
🏰 Example of a quality company
LVMH is a great example of a quality company. You can find an
overview of the conglomerate here:

More from us
Do you want to know more from us? Please subscribe on our Substack
where we provide investors with investment insights on a weekly basis.

25 Great investment tips from

Jeremy Siegel
In 1994, Jeremy Siegel, professor of Finance at the Wharton School of
the University of Pennsylvania, published his excellent book Stocks for
the Long Run. As quality investors, we can a learn a lot from Siegel’s
insights.

Grab a cup of coffee and become a better investor by these 25

investment tips.

‘I know of no way of judging the future but by the past.” – Patrick Henry
(1775)

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Lesson 1: Invest for the long term. In the short run, stock returns can
be very volatile, but they are very robust in the long run. Over time,
stocks always perform better than bonds. One dollar invested and
reinvested in stocks since 1802 would have accumulated to over $12.7
million (!) by the end of 2006.
Lesson 2: On average, you double your money in the stock market
every 10 years. The real return on equities (after inflation) has averaged
6.8% per year over the past 204 years. This means that purchasing power
has, on average, doubled about every 10 years when you invest in
equities. When you would invest in bonds, it would on average take 32
years to double your money.
Lesson 3: In the long run, stocks are less risky than bonds. For 20-
year holding periods, stock returns have never fallen below inflation,
while returns for bonds and bills once fell as much as 3% per year below
the inflation rate for two decades. When you invest for at least 10 years,
stocks have, on average, more than 80% chance to outperform bonds.
Lesson 4: Don’t try to time the market. As difficult it is to sell when
stock prices are high and everyone is optimistic, it is even more difficult
to buy at market bottoms when pessimism is widespread and few have
the confidence to venture back into stocks.

Lesson 5: Our world continuously changes. As a quality investor,

disruption is one of your worst enemies. Avoid companies who are
highly exposed to rapid changing industry dynamics.

“When the Dow Jones Averages launched in 1885, 10 of the 12 stocks

within the index were railroad stocks. The 10 largest companies
measured by market cap continuously change over the years.” – Jeremy
Siegel
Lesson 6: This time it’s not different. “The bull and bear markets of
the last decade were no different from the bull and bear markets that
preceded them. As stocks rose, the bulls came out of the woodwork, and
at the top they fabricated theories that would support even higher prices.
In the subsequent down markets, the bears would pounce with
justifications for even lower prices.” – Jeremy Siegel

“Most of the change we think we see in life is due to truths being in and
out of favor.” – Robert Frost (1914)

Lesson 7: Let your winners run. As an investor, you should let your
winners run.
Philip Morris is a great example according to Jeremy Siegel:

”From the end of 1925 through the end of 2006, Philip Morris delivered
a 17.2% compound annual return, 7.4% greater than market indices. If
you had invested $1.000 in the firm in 1925, it would be worth almost
$380 million in 2007.” – Jeremy Siegel

Lesson 8: Low stock prices are great for investors. If investors

become overly pessimistic about the prospects of a stock, the low price
enables stockholders who reinvest their dividends to buy the company on
the cheap. Bear markets and corrections are great opportunities for long
term investors.

Lesson 9: Invest in companies that translate most earnings into free

cash flow. Earnings are an opinion, cash is a fact. Academical research
found that companies that translate most earnings into free cash flow
perform significantly better on the stock market.

“Sloan found that from 1962 through 2001, the difference between the
firms with the highest quality earnings (lowest accruals) and those with
the poorest quality earnings (highest accruals) was a staggering 18% per
year. Accruals can be defined as the difference between earnings and
free cash flow.” – Jeremy Siegel

Lesson 10: The fundamental determinant of stock values remains

the earnings of a corporation. Between 1946 and 2006, real earnings
growth (after inflation) has been equal to 3.4%. The return of you as an
investor is equal to the earnings growth plus shareholder yield (dividends
and buyback yield) +/- multiple expansion / contraction.

Lesson 11: Look at the equity premium. Over the past 200 years, the
equity premium (the spread between the return of stocks and return of
government bonds) has averaged between 3% and 3.5%.

Lesson 12: In general, small cap stocks outperform. Smaller stocks

generate a higher return on the stock market. Between 1926 and 2006,
the smallest decile stocks compounded at a CAGR of 14.0% compared
to 10.3% for the S&P500.
Lesson 13: Cheaper stocks outperform the market. Based on the
price-earnings ratio, the 20% cheapest stocks outperformed the S&P500
by 3.2% between 1957 and 2006.
Lesson 14: Do not invest in IPOs. From 1968 through 2000, a buy-and-
hold strategy on IPOs underperformed the index in 29 out of 33 years
that were studied.

“IPO: It’s Probably Overpriced.”

Lesson 15: Investors can outperform by using factors. There are

many strategies that can be used to outperform the market (low
volatility, value, quality, …). It is important to note that you should stick
to your plan as no strategy outperforms all the time.

Lesson 16: In the long run, stocks are a great hedge against
inflation. However, they are not in the short term. In general, the
stock market performs better during interest decreases compared to
interest increases. In the long run, stocks are extremely good hedges
against inflation while bonds are not:
Lesson 17: The stock market is a leading indicator for the economy.
On average, the lead time between what happens on the stock market
and what happens in our economy is equal to 6 months.
Lesson 18: Don’t use macro-economic factors to make investment
decisions.

“The worst course an investor can take is to follow the prevailing

sentiment about economic activity. The reason is that it will lead the
investor to buy at high prices when times are good, and everyone is
optimistic and sell at the low when the recessions near its trough and
pessimism prevails.” – Jeremy Siegel

Lesson 19: The short term is highly uncertain. Less than 25% of all
major market movements can be linked to a news event of major
political or economic importance. This confirms the unpredictability of
the market and the difficulty in forecasting moves in the short term.
Lesson 20: On average, the stock market fluctuates with more than
1% one day per week.

“The percentage of trading days when the Dow Industrials changed by

more than 1% has averaged 23% between 1834 and 2006, or about once
per week. “ – Jeremy Siegel
Lesson 21: Over the past 2 decades, September has been the worst
month on the stock market by far.

“September is by far the worst month of the year, and in the US, it is the
only month to have a negative return including reinvested dividends.
September is followed closely by October, which has a disproportionate
percentage of crashes (e.g., the crash of 1989). “ – Jeremy Siegel
Lesson 22: Investing between Christmas and New Year is usually a
great idea. Over the past 120 years, daily price returns between
Christmas and New Year have averaged 10 times the average return of
normal periods.
Lesson 23: If you want to invest periodically, the best moment to do
this is in the middle of the month. The reason for this is that at the
beginning and end of each month, a lot of institutional investors are
receiving inflows which they invest, resulting in higher stock prices.
Lesson 24: Be fearful when others are greedy and greedy when
others are fearful.

“The rational man – like the Loch Ness monster – is sighted often,but
photographed rarely.” – David Dreman (1998)

“The market is most dangerous when it looks best. It is most inviting

when it looks worst.” – Frank Williams (1930)

In the table below you can see that the lower the investor sentiment, the
better moment to invest in general:
Lesson 25: Establish firm rules to keep your portfolio on track,
especially if you find yourself giving in to the emotion of the
moment.

“The temptation to buy when everyone is bullish and sell when everyone
is bearish are hard to resist. Most investors who trade too often have
poor returns. The best investors are very disciplined.” – Jeremy Siegel

That’s it. To end up with a beautiful quote of Jeremy Siegel:

“In the long run, stocks are the best way to accumulate wealth.”
How to deal with market
downturns
1️⃣ How to deal with market
downturns
In 2009, Berkshire Hathaway was down 50%. A reporter asked Charlie
Munger whether he was worried about this. His response:

2️⃣ Compounding can be

beautiful
When you become 1% better every day, you will become a learning
machine. The same is applicable in the stock market. Most people
overestimate what they can do in a year and underestimate what they can
do in a decade.
3️⃣ One simple investment quote
Do you want to become rich in the stock market? The big money is not
in the buying and the selling, but in the waiting.

"Investing is where you find a few great companies and then sit on your
ass" - Charlie Munger

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4️⃣ Read as much as you can

Do you know what J.K. Rowling, Jeff Bezos and Warren Buffett have in
common? They became billionaires thanks to writing, selling, and
reading books.

Reading is crucial to become the best possible version of yourself.

5️⃣ Example of a quality

company
Pool Corporation ($POOL) is trading at it's cheapest valuation since
2010. Great company with great capital allocation:
 pancharathna k athmaram
Aug 28Liked by Quality Compounding

I would like to learn to be peaceful when my POrtfolio is down 50 percent

1ReplyCollapse
1 reply by Quality Compounding

How to find Compounding

Machines (Chuck Akre)

Quality Compounding
Jul 26
21

Chuck Akre, who retired in 2020, is one of the best quality investors in
the world. His insights can be useful for all quality investors. Chuck
founded Akre Capital Management in 1989. Today, his firm has
approximately $16 billion in assets under management (AUM). In this
article, we will show you how you can invest in compounding
machines.

Let’s start with a story. In 1626, Native Americans sold the island of
Manhattan for an estimated $20 worth of beads and trinkets. Could you
guess how much this $20 would be worth if these Native Americans
invested this $20 at a rate of return of 9% per year and stuck with this
investment program for the following 380 years? The correct answer is
more than $3.335.000.000.000.000! It’s the same principle as when you
would double a penny every day for a month, eventually this penny
would be worth more than $10 million. This beautifully shows that you
don’t need an extraordinary return to achieve extraordinary results.
The only thing that is crucial, is having the ability to sustain an
investment program uninterrupted over a very long period.
Compounding can truly be beautiful.

Now let’s get back to Chuck Akre and compounding machines. Akre’s
investment philosophy can be summarized as follows:

“We focus our capital in a select number of what we believe to be

extraordinary businesses. These companies meet specific standards
related to the business itself, the people who manage it, and the
discipline they demonstrate when it comes to reinvesting free cash
flow.”

Chuck refers to this investment approach as “The Three-Legged Stool”.

As an investor you should buy great businesses with integer
management which can reinvest a lot of their free cash flow in future
growth. When you can find these companies, you discovered a
(potential) compounding machine. These are the companies you are
looking for as an investor.

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First and foremost, you want to invest in great businesses. You want
to invest in great companies with a strong competitive advantage.
When a company has a high and predictable ROE and FCF, pricing
power and a strong balance sheet, this is already an indication that you
are looking at a great company.
When you have found a great business, you should look at the integrity
of its management. Do they have skin in the game? Are the interests
of you as a shareholder and management aligned? You want to invest in
companies where management focuses on long-term value creation.

“Never ask anyone for their opinion, forecast, or recommendation. Just

ask them what they have in their portfolio.” – Nassim Taleb
So, now you have found a great business with integer
management. Finally, secular trends are very important for quality
investors. You want to invest in companies that can reinvest a lot of
their free cash flow to achieve future growth. These kind of
companies can grow their free cash flow per share exponentially. Look
at See’s Candies for example. Warren Buffett bought See’s Candies in
1972 for $25 million. Today, See’s Candies has generated more than $2
billion (!) for Berkshire Hathaway.

The ROIIC or Return on Incremental Invested Capital is a great

metric to look at reinvestment opportunities. You can calculate the
ROIIC by dividing the change in the net operating profit (NOPAT) in the
current period by the change in invested capital in the previous period.
When you found a great business with an integer management and
plenty of reinvestment opportunities, you have found a (potential)
compounding machine. These companies are quite rare as only a few
companies in the whole world meet all 3 criteria.

If you can buy compounding machines at a fair price, you will end up
with great investment result.

“It’s far better to buy a wonderful company at a fair price than a fair
company at a wonderful price.” – Warren Buffett
When we look at the results of Chuck Akre, we conclude that as of today
the Akre Focus Fund managed to grow with 421% since 2009
compared to 275% for the S&P500. Chuck Akre’s fund grew at a
CAGR of almost 15% since 2009. When you would have invested
$1.000 at the launch of the fund your investment would be worth $5.214
today:
Mastercard, Moody’s, American Tower, Visa, and Constellation
Software are the five biggest positions today of the Akre Focus
Fund. American Tower has been in Chuck’s portfolio since the launch
of the fund in 2009, meaning that Chuck made a tenbagger on this stock.

Chuck Akre is a great investor who we can learn a lot from. All
positions of the Akre Focus Fund and some fundamental
characteristics can be found here:

Do you want to learn more about Chuck Akre? His Google Investment
Talk ‘Trying To Solve The investment Puzzle’ is very insightful:

3 Comments
 Wide moat investing
(Morningstar framework)
1. In this thread, we will go through the wide moat investing
framework of Morningstar. Over the years, stocks with wide moats
defined by Morningstar managed to outperform the market by a
significant margin.

2. Morningstar rates companies based on their economic moat or

competitive advantage. There are 3 categories: wide moat, narrow
moat, and no moat. Obviously, we want to focus on the wide moat
stocks.

3. Morningstar describes a moat as a structural business characteristic

that allows a firm to generate excess economic returns for an
extended period of time. In other words, the ROIC should be higher
than the WACC. A wide moat stock should be able to generate a
ROIC > WACC for at least 20 years.

4. So in general, the Return On Invested Capital (ROIC) is truly

essential to determine whether a company has a wide moat:

5. Morningstar states that there are 5 moat types: switching costs,

intangible assets, network effects, cost advantages and efficient scale.
6. Intangible assets can provide companies with a wide moat. Think
about brands, patents, and regulatory licenses. Intangible assets can
prevent competitors to duplicate a company’s product. Think about
Coca Cola for example:

“If you gave me $100 billion and said take away the soft drink
leadership of Coca-Cola in the world, I'd give it back to you and say it
can't be done.” – Warren Buffett
7. Switching costs: when the value of switching exceeds the expected
value of the benefit, switching costs are created. Companies with
switching costs often enjoy a lot of pricing power. Stryker and
Salesforce are great examples.

8. When a company can operate at sustainable lower costs than

competitors, cost advantages are created. Firms with a structural cost
advantage can either undercut competitors on price while earning similar
margins, or can charge market-level prices while earning relatively high
margins. Ikea and Walmart are two companies with strong cost
advantages.

9. Scale economies is the fourth moat source. It is the dynamic in

which a market of limited size is effectively served by few companies.
Incumbents generate economic profits, but new entrants would cause
returns for all players to fall to a level in line with or below the cost of
capital. Think for example about US railroad stocks like Union
Pacific.
10. The fifth and last moat source are network effects. Network effects
are one of the most preferred sources of an economic moat. The more
people use a certain product or service, the more valuable the network
becomes. Think about companies like Visa/Mastercard, Facebook
and Alphabet.

11. Does it help to focus on wide moats? YES! Between 2002 and
today, the Morningstar Wide Moat index returned 14.45% per year
to shareholders, compared to 10.3% for the S&P500 and 9.2% for the
MSCI World.

12. Over a period of 5 and 10 years, wide-moat stocks based on

network effects seemed to report the best performance. Cost
advantages and efficient scale are the least preferred moat sources:
13. Via Van Eyck, you can invest in the Morningstar Wide Moat
Index. Currently, these are the top 10 positions of the Morningstar
Wide Moat Index:

14. All positions with their current weight in the Morningstar Wide Moat
Index can be found here:
15. Finally, all undervalued wide moat stocks according to Morningstar
are listed hereunder. This list contains a lot of insights for quality
investors. When you would use the companies below as your
investable universe, you are making a great start.
16. The end. Feel free to reach out to me if you have any questions.

Thanks for reading Quality Compounding - A newsletter about Quality

Investing! Subscribe for free to receive new posts and support my work.

Monday Minute: 120 years of stock

market history in one chart

✅ 120 years of stock market

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history in one chart

In the long run, stocks are the best way to build wealth. If you invest
$1000 today for 120 years at a return of 8% per year, you’ll end up with
more than $14 million.
✅ 20 Golden investment rules from
Peter Lynch
Do you want to become a better investor? Learn from Peter Lynch, one
of the best investors of all time:
✅ One simple investment quote
"In bear markets, stocks return to their rightful owners." - J.P. Morgan

✅ Book recommendation: Only the

Best Will Do
Only the Best Will Do from Peter Seilern is a great Quality Investment
Book. In this book you learn how you can find companies that reliably
deliver steady and strong growth for the long term. According to Peter
Seilern, quality growth businesses are the ultimate assets for those
serious about making their investments work for them over the long term
while minimizing the risk of permanent loss of capital.

Example of a quality company

In the chart hereunder, you can find a list of companies with the best
business model according to Morgan Stanley: