The Joys of Compounding
"Someone who was compounding money at a high rate, I thought, was the better party to be taking care of the philanthropy that was to be done 20 years out, while the people compounding at a lower rate should logically take care of the current philanthropy."
- Warren Buffet (commenting on why he waited so long to give away money)
On June 25, Warren Buffet made headlines when he announced that he had committed 12 million B shares of Berkshire Hathaway (worth over $42 billion) to five foundations. Most notably, the Bill and Melinda Gates Foundation will receive 10 million shares (to be disbursed 5% per year).
Soon after that, a friend with whom I've attended many Berkshire shareholder meetings sent me copies of letters written by a young Warren Buffet from 1957 to 1970, when he was managing money for limited partners. These letters reveal the modest beginnings of the world's wealthiest investor:
"Buffet Associates, Ltd. (predecessor to Buffet Partnership, Ltd.) was founded on the west banks of Missouri, May 5, 1956 by a hardy little band consisting of four family members, three close friends and $105,100."
Who put up the $100? It was Warren Buffet, "the General Partner putting his money where his mouth was." He was 25 years old at the time. By the time he decided to liquidate the partnership, Buffet had amassed a net worth north of $25 million thanks to his share of profits over the years (Buffet got 25% of all profits above 6%). That small fortune is now worth roughly $50 billion thanks to Berkshire's growth over the ensuing decades.
Reviewing Warren Buffet's track record is a simple way to illustrate the power of compounding. Virtually all of his fortune is due to the compounding of just one number - Berkshire Hathaway's stock price (the A shares, which have never split). His salary and bonus is only $100,000, less than 1% of what average CEOs of multi-billion dollar companies make, he has never received stock options or grants, and until recently (due to the commitments to foundations) he has never sold.
Buffet's letters reveal that he started buying Berkshire in 1962 at $7.60 per share. He kept buying and acquired control in 1965. As we approach the end of 2006, those shares trade at $105,200 per share (plus or minus a thousand or two). This represents an increase of 24.2% per year over 44 years (a gain of 13,847x).
To hit the point home on compounding, Buffet's letters provide three amusing examples. In his 1963 letter, he included a section entitled "The Joys of Compounding":
"I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter's rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000 (that's $2 trillion for those of you who are not government statisticians) by 1962."
The next year (1964), he wrote the following:
"Since the whole subject of compounding has such a crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world.
Francis I of France paid 4,000 ecus in 1540 for Leonardo da Vinci's Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the ecu, 4,000 converted out to about $20,000.
If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000. That's $1 quadrillion or over 3,000 times the present national debt, all from 6%. I trust this will end all discussion in our household about any purchase of paintings qualifying as an investment."
In 1965, he wrapped up his multi-year treatise on compounding with the following analysis:
"Our last two excursions into the mythology of financial expertise have revealed that purportedly shrewd investments by Isabella (backing the voyage of Columbus) and Francis I (original purchaser of Mona Lisa) bordered on fiscal lunacy. Apologists for these parties have presented an array of sentimental trivia. Through it all, our compounding tables have not been dented by attack.
Nevertheless, one criticism has stung a bit. The charge has been made that this column has acquired a negative tone with only the financial incompetents of history receiving comment. We have been challenged to record on these pages a story of financial perspicacity which will be a benchmark of brilliance down through the ages.
One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12 1/2 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6 1/2% return (the tribal mutual fund representative would have promised them this) to obtain the last laugh on Minuit. At 6 1/2%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion.
So much for that."
Conventional wisdom is that it is impossible to beat the market by large margins for really long periods. So how did Buffet do it for four decades?
Most people consider Buffet as the greatest value investor of all time (certainly the wealthiest). In the world of venture capital and private equity, investors try to differentiate themselves as "value-add investors" and LPs have bought that pitch investing hundreds of billions over the years. But no-one has come close to matching Buffet's track record for so long.
As it turns out, Buffet is also the ultimate value-add investor. As the CEO of Berkshire for 36 consecutive years, the longest tenure of any CEO of a large company, he has built a $100 billion corporation which will most likely continue to grow for decades. When he retires, his job will be split in two - one person in charge of the operating businesses and one in charge of investments.
As CEO, Buffet has led and built one of the most admired corporations in America. In his own words, "Berkshire Hathaway is the company I wanted to create. It's not the company Alfred P. Sloan wanted to create. It fits me. I run it with our investors and managers in mind, but it is designed to fit me." It has also been one of the most consistent value creation machines in the world. According to annual reports, Berkshire's per-share book value has grown at 21.5% per year for 39 years (1965-2005). Such compounding is even more remarkable when considering that it was accomplished after-tax. During that time, the intrinsic value of the company has grown at an even faster rate resulting in the corresponding rise in stock price.
In the venture capital world, entrepreneurs and investors strive to grow companies and the value of their investments at very high rates. However, in our next post, we will discuss how the power of compounding, as simple as it is, still seems to be tough to grok for most people.
