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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 14292  
Subject: Re: Investing on margin among falling knives Date: 8/30/2008 7:48 PM
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I find it interesting that you're a member of the Fool community yet you think 11% returns are overly optimistic.

Generally speaking, I'd have to agree that 11% is a bit of a "stretch goal".

US markets in the last 157 years have averaged about 6.5% per year,
including dividends and after inflation. If you assume 2% inflation,
that's around 8.5% as the "base rate". This is a remarkably steady
attractor, true for pretty much any 40+ year period which doesn't
start or end in a period of unusually high or low valuation. It's
so steady it's referred to as "Siegel's constant".

In very round numbers, the 20 best investors of all time have managed
records of 20+ years of beating the market by around 5% per year.
That would imply that knocking it out of the park would mean a return
of somewhere around 13.5%, again assuming inflation in the 2% range.

Obviously those are only averages, and long run ones. There will be
times when returns will be easier, and times when they will be tougher.
Generally speaking, it's tougher in a bear market and it's tougher
when you're starting when average valuations are above average.
Both of those are true right now.

Just to throw out a couple of numbers, in the average month in the last
century and a half, the earnings yield (real total return) of the S&P
500 and its predecessors has been about 7.74%, measuring earnings as the
current point on the real trend earnings line. Obviously you can't
measure today's point on the trend line without looking into the future,
but it can be estimated pretty accurately. Based on such an estimate,
the real trend earnings yield right now is about 4.98%, which is around
the 15th percentile. In other words, the broad market has only been
more overvalued about 15% of the time. To be at an average valuation
multiple based on the trend earnings, the S&P would have to be at 789 today.
Historically when valuations have been in this neighbourhood, index
returns (not counting dividends and inflation) in the following
1-4 years have averaged 0-2%. So, the best guess for the S&P
in a few years' time is roughly where it is today.

So, with such a near-impossible task (based on the records of the best)
and the long run typical return, and on the fact that we're starting
from an unusually difficult point, I have to agree that saying 11%
is a very tough goal isn't much of a stretch. As a first step in
trying to achieve this goal, don't invest in any company which uses
11% as the assumed return on its pension plan! : )

Obviously I think I'm smarter than average, as most people do, so I
think I can do it too. Alas, this probably doesn't make me right.

So, what's a greedy guy to do?
For whatever it's worth, I do note that the current trend growth rate
in intrinsic value of Berkshire Hathaway is still over 11% per year,
and though it is gradually slowing over time, it is still on trend to
remain over 10% for the next decade. The price of any firm can go up
and down unpredictably in the short term, but is always attracted to the
intrinsic value and its growth trend over time.
If you really want to get a high goal with a bit of leverage, I'd
recommend 1.8x leverage on a 100% Berkshire portfolio. Historically
it hasn't usually dropped more than 40% in any short period, so the <4x
leverage after such a drop won't get you sold out on a missed margin call.
1.8 times 11% minus the long run average prime rate of 6.5% on
your 80% margin loan implies a total return of about 14.6%.
Conveniently there is no short or long term cap gains tax on a single
holding, though you'll have to add cash continually for the margin
interest to avoid selling any stock at inopportune times.
On bonus is that the valuation of Berkshire (as opposed to the broad
market) is well below typical at the moment, so you would be starting
with a good tail wind, and better safety: the valuation is low enough
tha the price has very rarely dropped more than 20% starting from similar situations.
Just a random thought!

I can point to a number of companies that are growing their businesses at rates far greater than 11%...
You mention they are at good valuations, which is key, so the following
comment may not apply. I just like to type a lot.
One theoretical comment: absent any other knowledge, a firm growing
at 11% isn't worth any more than a firm growing at 5%. To grow,
almost all firms need additional capital, and the additional capital
will ensure that the growth in the total value of the company does not
show up as a growth in value per share, because of either reduced
return due to debt interest, or dilution, or both. This is true both
theoretically and empirically. If you consider low-PE companies
versus high-PE companies, and low-growth companies versus high-growth
ones, of the four combinations the best performers are the slowly
growing low-PE companies. Most people overpay for growth.

Jim
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