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Animal spirits and the power of “compounders”
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By Fund Library News Wire  | Thursday, October 05, 2017


By Felix Narhi, CIO & Portfolio Manager, Penderfund Capital Management

“The markets are moved by animal spirits, and not by reason.” – John Maynard Keynes

The year started in the midst of one of the greatest bull markets in history. It has only strengthened in 2017. The S&P500 bull market is now the second longest (trailing only the 1990-2000 cycle during the dot-com era) and the third strongest in history.

In his 2016 year-end commentary, Pender President and Portfolio Manager, Dave Barr mused about the improving merger and acquisitions environment. Forecasting is often perilous, but given the backdrop, this was a relatively safe prediction. After all, M&A activity tends to pick up near the end of bull cycles, when confidence amongst executives tends to be highest, corporate coffers are gushing with cash after the good times, and executives take their cues from other acquisitive peers.

Times may change, but human nature does not. Pender certainly benefited from these improving animal spirits. Two of our largest holdings – Panera Bread and Whole Foods – became targets of takeout offers in the second quarter. In contrast to many investors, we only viewed one of the acquisition announcements as great news because of how we categorize our investment universe.

While many investors cheered the Panera Bread takeout news, we viewed the announcement as bittersweet. Why? Although we generated a very attractive return on Panera, we believed the ride ended far too soon. In our view, shareholders were about to enjoy a powerful move higher over the next few years as the payback from an unusually heavy investment period was just being unleashed, similar to other past cycles for Panera (like the patient kids of the famous Marshmallow Experiment – greater rewards come to those who wait!).

Compounders,” or those businesses we define as having the potential to increase their per share intrinsic value at mid-teens pace or better over time, account for the vast majority of the stock market’s total returns over time. Unfortunately, finding attractively priced potential compounders that are run by outstanding operators – like Panera Bread – is no small task.

We acknowledge that in some cases, we simply don’t understand a potential compounder well enough to make a big investment, and the ones that we feel competent enough to evaluate are often too pricey. But, once identified, we believe it is important to make meaningful commitments to these compounding companies and to not interrupt the compounding process unnecessarily. Buy low and let grow.

The power of compounding

Holding a portfolio of stocks for long periods allows the power of compounding to work its magic. As one can observe in an index over time, a portfolio comes to be dominated by winning stocks – i.e., Facebook, Amazon, Netflix, and Google (now Alphabet), commonly known as the FANG stocks – whilst losing stocks keep declining and eventually, become inconsequential. The positive contribution from winning stocks disproportionately outweighs the negative contribution of the losers.

A simple exercise illustrates this important point. Let’s imagine a hypothetical portfolio that consists of $100,000, evenly split between two stocks.

Mathematically, one can see that one great investment held over a very long period makes a huge difference to a portfolio, even if some other investments badly underperform. Now imagine what a real-world portfolio might look like after ten years if an investor sold out of Stock A in year one or two after capturing the initial gains of 25%-56% and therefore missed out of the rest of the run up to 831%. As famed investor Peter Lynch wryly noted, “You won’t improve results by pulling out the flowers and watering the weeds.” Unfortunately, we believe this describes the fate of the vast majority of investors.

Self-inflected wounds are dishearteningly common when investing (we have made our fair share!). When investing, there are endless ways to make mistakes. But mistakes are more visible when an investor misjudges the quality of a business, the ability and intentions of management, or overpays for a business. As a result, they pay the visible price when there is a permanent impairment to the business and the stock price declines in response. Stock B could be an example of such a mistake (mistakes of commission).

On the other hand, as the compounding example above illustrates, the more serious mistakes are invisible, and therefore often ignored by investors (mistakes of omission). Investors occasionally discover and buy terrific, fast-growing enterprises, but voluntarily stop the compounding process themselves by selling such stocks far too early. Indeed, we think virtually every experienced investor can tell stories about stocks that they bought and flipped for a quick profit and which are many-fold higher today.

At other times, independent third-parties interrupt the compounding process with takeout offers (as in the case of Panera). Like the example of an investor who sold out of Stock A early, they missed most of the returns that would have driven the overall portfolio higher over time. “Fast money” wins feel gratifying at first, but are often short-sighted when the stock sold is a compounder. After cashing in their chips, it is rare that the proceeds of quick flips find new reinvestment opportunities that produce returns anywhere near as good as the ones left behind on the compounder’s table (omission of those returns are invisible).

A big part of the problem when investing is widespread impatience. Portfolio turnover is unbelievably high – speculation is clearly rampant. As Warren Buffett once quipped, “We believe that according the name ‘investors’ to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a ‘romantic.’”

Growing wealth sustainably takes time. Where are the real investors? We believe patience is one of the scarcest attributes amongst investors and hence, one of the most valuable attributes. We believe investors should be greedy when winning with compounders.

Felix Narhi, CFA, is Chief Investment Officer and Portfolio Manager at PenderFund Capital Management. He works alongside David Barr, Pender’s President, in setting the direction of Pender’s overall investment strategy. This article first appeared in the Pender Commentaries. Used with permission.

Notes and Disclaimer

© Copyright 2017 by PenderFund Capital Management Ltd. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in net asset value and assume reinvestment of all distributions and are net of all management and administrative fees, but do not take into account sales, redemption or optional charges or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This communication is intended for information purposes only and does not constitute an offer to buy or sell our products or services nor is it intended as investment and/or financial advice on any subject matter and is provided for your information only. Every effort has been made to ensure the accuracy of its contents. Certain of the statements made may contain forward-looking statements, which involve known and unknown risk, uncertainties and other factors which may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.

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