The Joys of Compounding: East Coast's Q3 Letter ~ market folly

Wednesday, October 20, 2010

The Joys of Compounding: East Coast's Q3 Letter

Chief Investment Officer Christopher Begg is out with East Coast Asset Management's third quarter letter. Readers will recall that back in the second quarter, East Coast offered a prudent exercise in consensus versus variant perception in the markets. This time around, Begg focuses on the joys of compounding.

The Joys of Compounding According to Warren Buffett

Upon revisiting the early Partnership letters from Warren Buffett, Begg extracted two major observations: Buffett emphasized the importance of compound returns and he diligently assessed what types of investments would allow him to earn such returns.

Importance of Compound Returns

To illustrate the power of compound returns, Warren Buffett used investment examples of Isabella's $30,000 underwriting of Columbus's voyage to find the new world, Francis I of France's $20,000 purchase of Leonardo da Vinci's Mona Lisa, and Peter Minuit's $24 investment to buy the island of Manhattan.

Using Buffett's rate of a 6.5% compounded return, Queen Isabella would have earned $4.4 quintillion, Francis I would have earned $98 quadrillion, and Peter Minuit would have made $763 billion. Obviously compounding is quite a powerful force.

Buffett's Investment Categories

Perhaps the most useful information from Buffett's "Joys of Compounding" exercise is his categorization of investment ideas. He utilized three categories including: generals, workouts, and control.

Generals were undervalued securities where he had no timetable for when the undervaluation might turn into fair valuation. In 1965, Buffett wrote that, "over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories."

Workouts were companies dependent on corporate action for financial results rather than supply/demand factors in markets.

Control investments were obviously where Buffett sought control of a company to institute change. Just yesterday we discussed how Buffett's biggest mistake was actually buying Berkshire Hathaway, a company he took control of.

East Coast's Three Investment Categories

Expanding on Buffett's methodologies, East Coast Asset Management utilizes three investment categories of their own: compounders, transformations, and workouts. Compounders are "strong businesses whose intrinsic value is growing at a healthy rate." Transformations are loosely "businesses where the economics are improving." And lastly, workouts are "opportunistic situations where a structural, observable catalyst is in place to unlock value." To get further feel for their investment process, we've in the past highlighted equity specific research from East Coast with their bullish case on Becton Dickinson (BDX).

For an in-depth look at the categorization of investment ideas and the benefits of compounding, embedded below is East Coast Asset Management's third quarter letter:

You can download a .pdf copy here.

Be sure to also check out Begg's excellent previous insight that focused on consensus versus variant perception in the markets as well as their past look at the deflation-reflation continuum.

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