How History Can Help You Beat The Market Over The Long Run

In 2001, the Oracle of Omaha made a fantastic speech to the MBA students of the University of Georgia (seen here) and one specific example he gave caught my attention. In 1950, Mr. Buffett bought half an interest in a Sinclair Gas station with a friend who was in the Naval Guard. In the early 1950s the station was not doing well and Mr. Buffett eventually lost his entire investment, which at that time was roughly $2000. However, in his speech Mr. Buffett indicated that the true cost of his investment was not $2000, but rather close to $6 billion (in 2001 dollars).

The Oracle has not made many blunders when it comes to capital allocation but this small example got me thinking about the powers of compounding and the drastic effects of opportunity costs. The most famous example of compounding is Peter Minuit who was the Director of the Dutch colony of New Netherland from 1626 until 1633. History has it that he purchased the island of Manhattan from the Native Americans on May 24, 1626 for goods valued at 60 Dutch guilders, which in the 19th century was estimated to be the equivalent of US$24. The island of Manhattan today is worth roughly $9 trillion which means that his initial investment has compounded at an estimated average rate of return of over 7% per year for the last 388 years.

There are many other real life examples of incredible wealth creation by very smart investors who intuitively understood opportunity costs and the effects compounding. One of the most successful investors is Mr. Theodore R. Johnson who was an employee of the United Parcel Service. Mr. Johnson never made more than $14,000 a year, yet managed to plough every penny of his annual savings into only one stock – UPS. When he reached the age of 90, he shocked his relatives and friends by announcing that his net worth was a little over $70 million. Mr. Johnson also re-invested all dividends earned into UPS stock.

Another brilliant investor is none other than Shelby Cullom Davis. Mr. Davis received his bachelor’s in Russian history at Princeton (1930), his master’s degree at Columbia (1931), and his doctorate in political science at the University of Geneva (1934). He worked many odd jobs and was also a freelance writer and author. Starting at age 38, he took $50,000, provided by his wife Kathyrn, and amassed it into a $900 million portfolio in 47 years. This amounts to an annual compounded rate of return of over 23% during that time span. Mr. Davis always bought on margin (which undoubtedly helped his returns) but what’s incredible about Mr. Davis is that he only invested in one particular industry, which was insurance. Mr. Davis was relentless in his study when searching for insurance stocks. He largely focused on fundamentals before choosing his investments, looking for a solid balance sheet and making sure the insurer did not hold risky assets like junk bonds. He then focused on management quality and made trips to meet with the management team. By the mid-1950’s he held up to 32 insurance companies, and by the end of his life had amassed large stakes in AIG, AFLAC, and Chubb. He even bought a piece of GEICO when it was being left for dead and a young Warren Buffett bought a large stake in the business for pennies on the dollar. Mr. Davis also lived very frugally, often never writing anything down in order to save paper. His extreme frugality helped him to save every penny he could to invest in “compounding machines,” as he called them.

However, my favorite real life example is Ms. Anne Scheiber, who is possibly the greatest investor of all time. Ms. Scheiber lived quietly in her rent-stabilized studio apartment on West 56th Street that was bereft of luxuries: paint was peeling, the furniture was old and dust covered the bookcases. She walked everywhere, often wearing the same attire. She worked for the I.R.S. for 23 years as a tax auditor, leaving the bureau in 1944 with a total savings of $5,000. Ms. Schieber never made more than $4,000 a year, and never received a promotion in her entire career.

Over the next half century, she parlayed that $5,000 into a portfolio of blue-chip stocks that included Coca-Cola, Paramount, Schering-Plough and re-invested all dividends. On January 9th 1995, at the age of 101, that $5,000 portfolio was worth about $22 million and she donated the entire amount to Yeshiva University. One can only imagine how wealthy Ms. Schieber could have been if she had started her investment career much earlier and continued to work while re-investing all of her earnings, but it is safe to assume that the portfolio would be worth more than quadruple the final amount.

How can these history lessons make you a better investor?

There are two important lessons that an investor at any age can learn from these stories. First, the overwhelmingly most important factor for any investor is discipline. As seen with these examples, a substantial amount of wealth is created when human beings refrain from doing moronic things, which in the investment world means constantly buying and selling. Taking the “sit on your ass” approach to investing so famously coined by Charlie Munger creates absolutely incredible results over the long-term. Forget making a quick buck trading volatile options, forget that lucrative pharma stock you think will jump 25% in a day, forget “riding” a sector rotation involving basic materials and cyclical stocks and absolutely forget the new tech company that has no revenue whose stock is jumping 35% because another 10,000 users just joined its social media platform. The opportunity costs are far too great and that quick 50% you made trading TWTR in an out-of-the-money call option expiring in June actually just cost you tens of millions of dollars (or more depending on your age and capital) because you didn't have the ability to take a large position with a tiny bit of leverage in a very high quality business with a substantial ‘moat’.

That leads me to the second lesson which is identifying high quality businesses. All of the investors mentioned above have very concentrated portfolios (Mr. Johnson only had one stock) in which they invested all their capital and rode for a very long period of time.

But what makes a quality business? Let’s start by indicating what industry provides the best returns. According to a study by Patrick O'Shaughnessy, the number one sector that has provided the highest average annual returns since 1963 is Consumer Staples with an average compounding rate of 13.33%. Health Care and Energy are second and third with 12.52% and 11.44% respectively. The worst sector? Technology with 9.75%.

The single best stock over the past fifty years has been Altria (MO) which has a total return of more than 1 million percent in that time frame. That’s a compounding rate of 20.23% per year, every year. If one were to have $1000 of Altria (then Philip Morris) in 1963 that amount would be worth more than $8 million today (that includes dividends and stock splits). Anheuser-Busch, Pepsico, Coca-Cola and Hormel were also near the top of that list according to the study.

Why have consumer staples done so well? Part of the reason is that these companies offer scale and recognizable brands leading to wide ‘moats’. Other reasons include basic inflation, psychology, rising population growth and increasing consumer incomes which are all factors that have been in place for the last 100 years. These trends have been well documented and it is safe to say that they still will be in place for the next fifty years, perhaps growing at a faster rate given the incredible potential of Asia, Africa and Latin America.

So the next time you hear an analyst pitching an iron condor options trade, a broker selling the next hot issue, or your neighbor rushing into a ‘once-in-a-lifetime’ start-up, I would urge you to filter out the noise, stick to your core competency and become a student of history. As Bill Gross once said, “there is no better teacher than history in determining the future… There are answers worth billions of dollars in a $30 history book.”