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