The Joys of Compounding. Gautam Baid

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The Joys of Compounding - Gautam Baid Heilbrunn Center for Graham & Dodd Investing Series

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action, and spirit. Over the course of our lives, we will face difficult situations in which being truthful is painful up front. Following the path of righteousness during such times delivers enormous rewards in the long run. Our goodwill compounds exponentially over time when we live life according to the inner scorecard.

      Again, Munger shares some great thoughts:

      I think the best single way to teach ethics is by example. And that means if you take in people who demonstrate in all their daily conduct a good ethical framework, I think that has enormous influence on the people who watch it. But if your ethics slip and people are rewarded [nevertheless, then] it cascades downward. Ethics are terribly important, but best taught indirectly by example. If you just learn a few rules by having ethics taught in school so they can pass the test, it doesn’t do much. But if you see people you respect behaving in a certain way, especially under stress, that has a real impact [emphasis added].15

      The principle of reciprocity states, “Treat others the way you would like them to treat you” and “Do unto others as you would have done unto you.” Character is how you treat others when you have the upper hand and no one is watching. Over the long term, “what goes around comes around.” Karma is a like a big snowball. So, acting in an ethical manner with everyone is the most honorable way to lead one’s life. Our world’s moral fabric would be completely transformed if all of humanity imbibed, as a way of life, Seneca’s golden words: “Cherish some man of high character, and keep him ever before your eyes, living as if he were watching you, and ordering all your actions as if he beheld them.”16

       THE KEY TO SUCCESS IN LIFE IS DELAYED GRATIFICATION

       Someone’s sitting in the shade today because someone planted a tree a long time ago.

      —Warren Buffett

       If you’re glued together and honorable and get up every morning and keep learning every day and you’re willing to go in for a lot of deferred gratification all your life, you’re going to succeed.

      —Charlie Munger

       People who arbitrage time will almost always outperform. The first order thought of instant gratification is a crowded path, ensuring mediocre results at best. Delayed gratification, which requires second order thinking, is less crowded and more likely to get results.

      —Shane Parrish

      In the 1960s, Walter Mischel, an American psychologist specializing in personality theory and social psychology, conducted a famous experiment at Stanford University’s nursery school. In the experiment, now widely known as the Stanford marshmallow experiment, four- and five-year-olds were presented with a difficult choice. They could eat one treat—a marshmallow—immediately, or they could wait fifteen minutes more and be rewarded with two marshmallows.

      Over the next forty years, the children were included in follow-up studies. It was found that the children who were willing to delay gratification and waited to receive the second marshmallow ended up having higher SAT scores, lower levels of substance abuse, lower likelihood of obesity, better responses to stress, better social skills as reported by their parents, and better scores on a range of other life measures.

      In other words, the experiment demonstrated the virtues of delayed gratification—doing what is hard now rather than doing what is easy. Over time, this builds up the muscle of discipline, strengthens one’s skills and capabilities, and compounds into a much greater level of success and satisfaction than taking the easier path.

      Charlie Munger has always been a big proponent of delayed gratification. He has emphasized the importance of patience and being prepared to act at scale when great opportunities arise. These are rare and fleeting, so we need to be patient, prepared, and decisive to seize them. Munger has shared an inspiring example. He had been reading Barron’s magazine for more than fifty years and found only one actionable idea in it. It was a cheaply valued auto parts company (the name is widely speculated to be Tenneco), which he bought at $1 per share and sold a few years later at $15 per share, earning him $80 million in profits. Munger then gave Li Lu the $80 million and Lu turned this into $400 million. Through just two investments, Munger turned a few million into $400 million. This example illustrates the significance of extreme patience, deferred gratification, and displaying strong decisiveness at the right moment. It is why Munger has said, “It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities [emphasis added].”1

      The only way to win is to work, work, work, work, and hope to have a few insights.

      —Charlie Munger

      How much insight does one need in a lifetime to be a successful investor? Not much, as Warren Buffett explains:

      I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.2

      Munger repeatedly brought up the topic of deferred gratification during the 2017 Daily Journal Corporation meeting. He talked about how most investors are looking for a quick buck, but the best investors defer their gratification for much larger gains that come later, in the distant future.

      Long-term investors look for management teams that are willing to defer gratification. These teams are focused on building a durable economic franchise. They are focused on the longevity of the business. They are willing to forgo near-term earnings to increase long-term value. Let’s look at the compound interest formula and view it in a way that helps us think about building long-term value:

image

      where a = accumulated future value, p = principal or present value, r = rate of return in percentage terms, and n = number of compounding periods.

      All too often, management teams focus on the r variable in this equation. They seek instant gratification, with high profit margins and high growth in reported earnings per share (EPS) in the near term, as opposed to initiatives that would lead to a much more valuable business many years down the line. This causes many management teams to pass on investments that would create long-term value but would cause “accounting numbers” to look bad in the short term. Pressure from analysts can inadvertently incentivize companies to make as much money as possible off their present customers to report good quarterly numbers, instead of offering a fair price that creates enduring goodwill and a long-term win–win relationship for all stakeholders. The businesses that buy commodities and sell brands and have strong pricing power (typically depicted by high gross margins) should always remember that possessing pricing power is like having access to a large amount of credit. You may have it in abundance, but you must use it sparingly. Having pricing power doesn’t mean you exercise it right away. Consumer surplus is a great strategy, especially for subscription-based business models in which management should primarily focus on habit formation and making renewals a no-brainer. Most businesses fail to appreciate this delicate trade-off between high short-term profitability and the longevity accorded to the business through disciplined pricing and offering great customer value. The few businesses that do understand this trade-off always

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