Penny wise, pound foolish

I spent almost 7 years as a stock analyst early in my career at Chicago-based research firm Morningstar, working out of their Sydney office and covering a range of stock market listed companies. It was a humbling experience and one which, in hindsight, was the best training ground for building an investment framework which I then went on to use for the rest of my life.

I learnt two very important lessons over those 7 years:

1) How to think about investment returns; and

2) Patience is the most important investment virtue of them all

Investment returns in context

There’s a big difference between people who give advice and those who invest money into the market for a living. The sideline critic will tell you a whole bunch of things they’ve learnt or heard. But the guy or girl investing in the market, taking hits, making wins will always give you a different picture from experience doing the real thing.

This is the difference between learning investing at University from a lecturer or learning in the markets, alongside traders with grey hair. One of the biggest eye openers for me was in the way money managers, particularly those investing in stocks, think about income generation and long term returns.

Most investors think a 5% yield is better than a 4% yield, thus they are lured into the 5% investment over the 4% investment. But this is only one dimension and often a trap. The income you generate from an investment expressed in % per annum needs to be tested against two other variables — its quality and its ability to grow.

The highest quality investments are often those with the lowest returns relative to peers. Lending money to the Australian government will give you a lower return than lending money to a stranger at the casino looking for a quick loan. The reason is risk and quality. The higher the quality, the lower the return and vise versa.

Banks generally pay less interest on term deposits than peer to peer lending sites or other types of innovations because there is more demand for deposits at the bank. They don’t need to compete like the new innovator does.

So keep in mind that a higher return is usually a trap when you compromise quality. Diamonds are always more expensive than crystals, gold is more expensive than silver and Bitcoin is worth more than Dogecoin because of inherit demand and supply principals.

Income growth is key to understand

The second variable is income growth. Often a 4% yield is better than a 5% yield if it can grow faster and cheaper over the long term. This is what many investors don’t understand and a lesson I learn from a colleague who spent 20 years investing in small companies, often at their infancy, before they became big household names.

Let’s use a simple example of two investments making 4% pa and 5% pa respectively on an investment of $100,000. One gives you $4,000 and the other $5,000. Sounds pretty straight forward. But assume we’re talking real estate. Also assume that the one giving you $4,000 pa has the ability to grow its earnings by 20% pa because it is in a desirable location, near the ocean, close to transport, schools, amenity and recreation.

The other one which gives you $5,000 will only grow its earnings by 10% because it is in a new area where there will be more supply for many more years.

In 10 years time, the $4,000pa investment would have grown to $24,766pa while the $5,000pa investment would have grown to $12,968pa. They’ve both done exceptionally well, however the return of the lower starting investment is now double the return of the higher starting investment.

The lesson here is this: it’s not what yield of return on investment you get today, but what you get over the future and how this grows. Income from investments is about quality, reliability and growth over a long term horizon.

Focus on income growth

Tesla has a market value of around US$600bn and it makes around 120k cars per year. Ford, the oldest car maker in the world, is worth around US$50bn and makes 1.2m cars per year. Why is Tesla 12x more expensive than Ford when it makes 1/10th of the cars? Because the market thinks Tesla’s earnings have a higher rate of growth than Ford and is pricing that growth over the long term.

I actually think Ford is good value and I wrote this last week in my note, but I’m blind to the fact that Ford is mature while Tesla is the future. I don’t assume people buying Tesla are stupid or naive.

Often the people buying the lower %pa return are smarter and more experienced than those buying the higher 5%pa return. Don’t get fooled into buying a higher % return thinking that you can outsmart the market, especially in like and sophisticated markets like stocks and real estate. We call this being penny wise but pound foolish.

My key takeout from this week is for you to focus on buying a good quality investment, which higher rates of growth and putting into place a patient and strategic plan which will see you reap rewards over many years into the future.

“It's unwise to pay too much, but it's worse to pay too little. When you pay too much, you lose a little money - that's all. When you pay too little, you sometimes lose everything, because the thing you bought was incapable of doing the thing it was bought to do. The common law of business balance prohibits paying a little and getting a lot - it can't be done. If you deal with the lowest bidder, it is well to add something for the risk you run, and if you do that you will have enough to pay for something better.”

― John Ruskin

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