01 June 2023

On today’s episode, Clay reviews Thomas Phelps’s book – 100 to 1 in the Stock Market, and also highlights writings put out by Akre Capital Management.

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  • Common characteristics of companies that increased their share price by 100x.
  • Why most investors aren’t able to hang onto their winners as Phelps suggests.
  • Why good stock selection is much more important than good stock market timing.
  • Mental models Phelps uses to figure out the odds when investing.
  • Why we should invest with companies that align with our own values.
  • When to look for potential 100 Baggers.
  • The four categories of companies that were 100 Baggers in Phelps’s study.
  • Who is best equipped to be individual stock pickers.
  • Chuck Akre’s three-legged stool approach.
  • Takeaways from two of Akre Capital’s brilliant articles – ‘Why Compounding is so Difficult’ and ‘The Art of (Not) Selling’.


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

[00:00:00] Clay Finck: Hey everyone! Welcome to The Investor’s Podcast. I’m your host today, Clay Finck. And on today’s episode, I’m going to be covering a book by Thomas Phelps called “100 to One in the Stock Market.” As someone who’s on the front end of their investing journey, I want to take full advantage of the many years of compounding ahead of me.

[00:00:24] Clay Finck: So I’ve been reading books to help equip me to discover companies with relatively low risk but a long runway to grow and compound. Along with Chris Mayer’s book “100 Baggers,” this book by Thomas Phelps is another great one to help me continue to internalize these concepts related to buying and holding long-term compounders.

[00:00:46] Clay Finck: Towards the end of this episode, I chat about some of the things I’ve been revisiting recently from Akre Capital Management’s blog, and that’s had some really great pieces as you’ll find later on in this episode. And at the very end of this episode, I also mention the TIP mastermind community that we’ve recently launched in April.

[00:01:09] Clay Finck: So be sure to stick around until the end to hear more about that. Without further delay, I hope you enjoy today’s episode covering Thomas Phelps’ book “100 to One in the Stock Market.”

[00:01:23] Intro: You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

[00:01:43] Clay Finck: All right, so to give some background on this book, the book was published back in 1972. Every once in a while, I enjoy reading books that are a bit older. I get this feeling that people just think and write differently during these time periods, and I like how it sort of mixes up the type of content I’m consuming.

[00:02:07] Clay Finck: Thomas Phelps lived from 1902 through 1992, so he was around 70 years old when this book was published. He spent over 40 years in the investing world working as a private investor, a columnist, an analyst, and a financial advisor. So he held a number of different jobs and obviously was deeply fascinated with investing overall.

[00:02:30] Clay Finck: Phelps studied 365 different companies in his book that had the price of their stock increased by over 100 times, and he started from the year 1932 and then ended this study in 1971. So that’s a time period of 40 years. And then throughout the book, he shares many of his takeaways from studying these companies and how they increase their share price by 100 times.

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[00:02:57] Clay Finck: Phelps starts out the book with a parable of five Arabs where each Arab is given one wish. The first Arab wishes for one donkey. The second Arab called him a fool and asked for 10 donkeys. Then the third Arab wished for a bunch of different things. He wished for camels, donkeys, tents, food, wine, and a bunch of other stuff.

[00:03:22] Clay Finck: And everyone had their wish fulfilled and come to reality. And then the fourth Arab then wished to become a king, and then a crown appeared on his head. So his wish came true. And then Phelps writes, “having seen his companions in misery asking too little.” The fifth Arab resolved to make no such mistake and he wished to become a Alah.

[00:03:47] Clay Finck: Then, in a flash, he found himself naked on the sand, covered with leper’s sores. And the moral of this story is that those who ask for little in life are those who end up with little, and those who ask for much in life receive much. And then those who ask for too much get nothing. Most people in life ask very little and oftentimes don’t make much out of themselves, and very few people are asking too much.

[00:04:19] Clay Finck: Phelps relates this idea to investing, saying that most people are content with making a quick profit on their holdings or they’re content with making a small percentage of interest on their savings in a bank. For example, the takeaway is that most people don’t think big enough as investors. Most people don’t believe that they truly have a chance at owning a big winner in the stock market and making a ton of money off of picking individual stocks.

[00:04:51] Clay Finck: Those who realize that it is actually possible, you know, see other people doing well with it, or they have seen others in the past do well, and they want to learn how it’s actually done. Then Phelps says this line that I believe he’s quite well known for, “Fortunes are made by buying right and holding on.”

[00:05:14] Clay Finck: And this quote is just the recurring theme you’ll find throughout this book. Fortunes are made by buying right and holding on. Especially with how short-term most investors think today. Investors that apply this strategy are just so rare, and despite evidence of the past showing how well investors can do by buying right and holding on, it seems that people still today think way too short term.

[00:05:41] Clay Finck: When I talk with individual investors, one of the most common questions I get is what I think the stock market is going to do over the next year or so. I frankly have no idea what stocks will do in the near term. And to think that I do have any idea says more about what I don’t know than what I do know, and I almost never have someone ask me what stock I believe is a high-quality long-term compounder.

[00:06:14] Clay Finck: To me, that’s a much more interesting question than what do I think the stock market’s going to do over the next year or so? And when I look 10 or 20 years out, what the stock market does in 2023 really, in my mind, is largely irrelevant. And Phelps makes a case that since over 360 companies have increased by over 100-fold, finding winners in the stock market is anything but impossible.

[00:06:43] Clay Finck: It’s most definitely difficult, but not impossible. It reminds me of the saying that the best investors are those that turn over the most rocks. He argues that one could have invested $10,000 in just one of these 100 baggers and then eventually become a millionaire. And say if you had invested in 10 different companies, having just one of those being a big, long-term winner should more than make up for all the ones that don’t do nearly as well.

[00:07:16] Clay Finck: One amazing attribute of the stock market is that when you buy a stock, your upside is unlimited, but your downside is limited to what you invest. Assuming you don’t use any leverage at all, then Phelps goes on to tell the story of a regular, everyday person that built a massive investment portfolio over his life by buying right and holding on.

[00:07:41] Clay Finck: And he shared four of the things the individual looked for when investing his money. He figured that the fastest way to increase his wealth was to invest in a company that could sustainably grow their earnings at a fast pace for a really long time. So the first thing he wanted was for the company to be small because large companies by nature tend to not really have long growth runways ahead.

[00:08:10] Clay Finck: The second thing he wanted was for the business to be relatively unknown. Phelps writes, “Popular growth stocks may keep on growing, but too often one has to pay for expected growth, too many years in advance.” So first, the company must be small. Second, it has to be relatively unknown, so it isn’t trading at too expensive of a price.

[00:08:35] Clay Finck: Then third, it must have a unique product that can do a job better, faster, or cheaper than their competitors or provide a new service with prospects of great and long-continued sales increases in the future. And then finally, fourth, it must have a strong, progressive, research-minded management team, which is something we talk a lot about here on the show.

[00:08:59] Clay Finck: The interesting one I wanted to highlight here is to look for a business that’s relatively unknown. It can be easy for us to look for companies that a lot of other people have invested in. And one of the reasons is that the company has been through a thorough research process by some really smart people, like super investors.

[00:09:23] Clay Finck: But choosing not to rely on the research of others really forces you to do your own research, and it becomes so much more rewarding for us if the pick actually plays out. Companies that are small and not owned by institutions likely offer the biggest upside potential because it becomes a game of turning over a lot of rocks and looking where no one else is looking.

[00:09:50] Clay Finck: And today, this oftentimes leads people to microcaps because these are businesses that are really small, they’re relatively unknown, and their values are between 50 million and 300 million. So it’s not an area that a lot of people look. And speaking of Microcaps, I’m actually scheduled to interview Ian Castle on the show, who I would consider our Microcap guy, as he runs a service called Microcap Club.

[00:10:18] Clay Finck: If you have any questions you’d like me to ask Ian, feel free to shoot me an email at clay@theinvestorspodcast.com. We’re scheduled to record here in mid-June 2023, and I’m really excited to have the opportunity to chat with Ian. I’d encourage you to go back and check out our past two interviews we did with Ian. Those are episodes 431 and 480, if you’re interested in checking those out.

[00:10:46] Clay Finck: One of Phelps’ biggest takeaways from studying this investor that did really well was that he bought right and he held on. He wasn’t trying to trade in and out of different things, and he wasn’t incurring unnecessary friction in his portfolio, such as capital gains taxes, trading costs and commissions, and the spreads you have to pay on buying and selling.

[00:11:11] Clay Finck: There are two other lessons he shared related to buying right and holding on. And the first is that you should stay with your most successful stock investments as long as the companies are continuing to increase their earnings. It reminds me of Stig’s recent episode with Monish Pabrai, where Monish said that if you buy a high-quality compounder, you should hang onto it when it becomes fully priced and still hang onto it when it becomes overpriced.

[00:11:42] Clay Finck: The reason for this is that there are very few companies that are able to compound at high rates for a really long time. So if you were to sell a really big winner, you’re taking the chance that wherever you reallocate that money will be put into something that will do even better than the high-quality company you already owned. And then you have to take into consideration capital gains taxes, which is a really high bar.

[00:12:13] Clay Finck: The second lesson Phelps had is to be wary of people who tell you to take money off the table because oftentimes their interests are counter to your interests. For example, a stockbroker makes money when you continually trade in and out of positions.

[00:12:31] Clay Finck: Phelps says, “Who is talking often means more than what is said.” And again, this points to the incentives of the individual. Always look at the incentives to round out the first chapter. Phelps has this quote in there that I absolutely love from George Baker: “To make money in stocks, you have to have the vision to see them, the courage to buy them, and the patience to hold them. Patience is the rarest of the three.”

[00:13:02] Clay Finck: He has another excerpt later in the book that I thought fit really well in here. I quote, “I don’t know, which is harder: buying right or knowing enough to hold on? Mathematically, if you just stick pens into the quotation page, you have not one chance in a hundred of hitting a stock that will give you a hundred-fold appreciation, even if the future is as good as the past, which is no certainty. And after you have bought your stock, some of the best brains on Wall Street will be trying to persuade you to sell it and buy something else. Lots of times they’ll be right, at least for the short term. Every time they’re right, it will make it harder for you to heed their advice the next time. And the next time they may be advising you to sell your hundred-to-one stock after it has gone from one to two.” End quote.

[00:14:05] Clay Finck: In chapter two, he has this good bit on market timing. He writes, “There’s another reason why professional investors should de-emphasize market timing. That is because even if the market forecaster is right, he seldom can persuade others to act on his opinion. No one intends to buy stocks at the top of the market or sell them at the lows. On the contrary, bull market highs are made when the outlook for still higher prices is most broadly convincing. Conversely, bear market lows are made when the likelihood of still lower prices seems overwhelming to the preponderance of reasonable, well-informed investors. Since bull and bear markets are, to a considerable extent, manifestations of changes in mass psychology, it is fatuous for anyone to believe that he can persuade a representative group of investors to sell stocks when that mass psychology is bullish, or to buy stocks when it’s bearish. The wise professional who understands this concentrates on stock selection. Most investors are far less emotionally involved in deciding whether the market is going up or down to clinch the argument. It is readily demonstrable that far more money can be made by good stock selection than by good stock market timing.” End quote.

[00:15:26] Clay Finck: There’s one more quote a little bit later about market timing that I wanted to share here as well because I just think it’s such a good point. Some will argue that good market timing plus good selection is better than either alone. Bear market smoke gets into one’s eyes and blinds him to buying opportunities if he’s two and 10.

[00:15:51] Clay Finck: On market timing, the more successful one is at market timing, the greater the temptation to rely on it and thus miss the much greater opportunities in buying right and holding on. End quote.

[00:16:04] Clay Finck: Now, when you’re buying a company that’s increasing their earnings year after year and thus increasing their intrinsic value year after year, oftentimes these great companies will be continuing to hit new all-time highs. So even if the multiple contracts from say a multiple of 30 to a multiple of 25, you still may be purchasing a stock at a higher price because the earnings of the company have increased to make up for the difference.

[00:16:35] Clay Finck: In Chapter three, Phelps discusses mistakes that are made by professional investors that prevent them from buying and holding big winners. He argues that the answer to why professional investors don’t succeed in this strategy is found in investor psychology and statistics. He says, “Few investors, private or professional, seek the big game. They focus on chances to make five points here and 10 points there. If any later writes for the individual or institution really out to make a fortune in the stock market, it can be argued that every sale is a confession of error. Let this not be construed as advocating hanging on to everything willy-nilly. The only thing worse than making an investment mistake is refusing to admit it and correct it. Usually, the faster an error is rectified, the less it costs, but it’s still an error, a lost opportunity compared with buying right and holding on in a bull market. Correcting mistakes often means taking profits, but when we do so, let us not kid ourselves when we’re making money. The truth is, we are acknowledging missing vastly bigger opportunities and incurring a capital gains tax liability along the way.” End quote.

[00:17:54] Clay Finck: He then explains the difficulty investors have with rising and falling stock prices. People naturally assume that a rising stock price correlates with a good investment and a falling stock price correlates with a bad investment.

[00:18:08] Clay Finck: But sometimes great companies see their stocks fall, and bad companies see their stocks rise. The second fallacy he highlights is that investors tend to overemphasize the risks of being in stocks and underestimate the cost of not buying in or sitting on the sidelines or selling a stock too early. Even today, after the incredible bull market we’ve seen, there are countless examples of people who sold a great company too soon, only to watch the stock price continue to increase after they sold.

[00:18:42] Clay Finck: Phelps says that selling too soon can be frightfully expensive. He points out that if a stock manages to compound at 20% per year, then it takes 25 years to turn $1 into $100 or reach a hundred-bagger status. During this 25-year period, if you happen to sell in year 20, then you get less than 40 to one on your money, and the remaining $60 that you missed out on happens in the last five years.

[00:19:13] Clay Finck: He then expands on that and says that you shouldn’t sell an investment for a non-investment reason. A few examples he shows of this being the case are selling just because you believe the stock price is high, selling just because you have a profit, the stock price is no longer moving like other stocks are, or something that is going on in the news headlines.

[00:19:39] Clay Finck: Now, one of the biggest troubles with finding high-quality compounders is that they’re often trading at pretty high valuations, and this is what keeps people from getting into them. Of course, you don’t want to completely ignore valuation as paying a ridiculously high price can definitely get investors in trouble. But Phelps recommends that when you find a company that offers really attractive prospects and is at a fair valuation, enter a position and be ready to buy more if it happens to trade at a lower price in the future.

[00:20:16] Clay Finck: His reasoning is that you want to focus on the long-term business fundamentals, and whether the stock is at a PE of 15, 25, or 35, it really doesn’t matter too much when you look out 10 or 20-plus years. Because over the long run, the returns of the stock tend to approach the returns of the underlying business, as long as you aren’t paying a ridiculously high PE like, say, a PE of 100.

[00:20:46] Clay Finck: Another common error that Phelps warns against is doing substantial research on a company and not allocating enough capital for it to really make a difference if it does play out as you’d expect. Moving along to chapter six is where Phelps shows the entire list of 365 companies that increase by 100-fold.

[00:21:07] Clay Finck: There are many familiar names here, many of which have withered away over time. Some names I recognize include Aetna Life and Casualty, John Deere, Kodak, Sears, Lockheed Allegheny, Warner Brothers. Many of these names are staples of the economy, such as utilities, railroads, and energy. After looking at this list, I’m reminded of how Chris Mayer also curated an updated list in his book, “100 Baggers,” and it reminds me of how we shouldn’t look back at past winners and think that we’ve missed the boat because there are always companies in industries that are growing at a pretty rapid clip, and new hundred-baggers are currently in the making as we speak.

[00:21:52] Clay Finck: And there are opportunities that can be seized by anyone. Oftentimes, I’ll hear from investors that the stock market is just totally manipulated and rigged, and it’s totally driven by the Fed. But then I see other investors who did quite well in 2022 while the overall market was down. And these companies aren’t like a one-off event that happened to do well in 2022.

[00:22:18] Clay Finck: These are companies that have continued to increase their earnings over the past decade, and they continue to do really well despite all the macro headwinds and high interest rates, high inflation. In my personal opinion, it’s best to just ignore the people who say the stock market is totally rigged because if you look hard enough, you’ll always find companies that are continuing to grow quite well through any difficult environment. And that shouldn’t be any surprise because there are thousands of different companies we can invest in, and there are many tools online we can use to find them.

[00:22:59] Clay Finck: Then in chapter seven, Phelps starts to dive into the characteristics he found in the hundred-baggers in his research. He writes, “The only way to make more than the going rate of return on your capital is to buy values not apparent to most people at the time you buy because every stock buyer wants to make money. It’s almost a truism that nothing kills a money-making opportunity faster than its widespread popularity. It is true that time is on the side of the growth stock buyer if the growth and the expectation of growth continue. This is simple arithmetic. The price of a growth stock will increase year by year at whatever rate the earnings grow. If the stock’s PE ratio remains constant,” end quote.

[00:23:49] Clay Finck: So, for example, if we have a stock that has a PE of 25 and the company’s earnings grow by 15%, then if the PE ratio remains constant, it must be true that the stock price has also increased by 15% as well. And then to his point that nothing kills a money-making opportunity faster than widespread popularity.

[00:24:12] Clay Finck: This is what keeps me from buying into a lot of the market’s most popular companies because so many investors have already piled into them, and a lot of the growth is already priced into these really popular companies. A highly valued growth stock can do really well as an investment; it just needs a lot of things to go right for it.

[00:24:37] Clay Finck: It needs to continue growing at a high rate of return or have accelerated growth. It needs the market to expect that growth to continue, or in other words, the market needs to keep its PE high. And then it can’t experience a significant multiple contraction, and you need to ensure that the discount rate in the market doesn’t increase substantially.

[00:25:02] Clay Finck: Because if the market uses a higher discount rate, then this can significantly bring down the value of growth stocks because many of their big cash flows are priced far out into the future, say five or 10 years from now. And that’s a lot of what happened in 2022 with many of the non-profit companies getting absolutely obliterated.

[00:25:25] Clay Finck: Related to Phelps’s point on finding something that the market doesn’t find apparent, you have to have a different forecast than the market. If the market expects a company to grow earnings by four times over the next five years, and you agree with the market, then there probably isn’t much money to be made because the market has already priced it in.

[00:25:51] Clay Finck: And that’s why we should always try to come up with a conservative intrinsic value estimate of what we believe a company is worth and only purchase if the market price is well below our conservative estimate of value. Phelps writes, “To win in the stock market, as in checkers, one must think at least one move further ahead than the other fellow,” end quote.

[00:26:17] Clay Finck: In a perfect world, you would ideally have what Chris Mayer referenced in his book, “The Twin Engines of Growth”: a stock that increases its earnings by 40 times and its PE multiple increases by two and a half times. Then that gives you a hundred-bagger. For example, let’s say the earnings per share go from $1 per share to $40 per share, and then you have a PE multiple that starts at 15 and then goes to around 37.5.

[00:26:49] Clay Finck: So, definitely, a low multiple is preferred when purchasing these compounders, but it certainly isn’t a requirement. Multiples can also give you a good sense of the sentiment around a company. Low multiples are typically associated with poor sentiment, so you should be mindful that if you pay a higher multiple, the business’s earnings can continue to increase, but the multiple might fall or normalize.

[00:27:15] Clay Finck: And also, if you’re paying a higher multiple, you can’t purchase it speculating that the multiple will continue to expand. So buying something on the cheaper end definitely can give you a larger margin of safety because you’re not only benefiting from the earnings going up, but you’re also potentially benefiting from multiple expansion.

[00:27:36] Clay Finck: In Chapter nine, Phelps covers figuring out the odds. He states, “The point is that in the stock market, as in poker, the wise investor tries to make bets when the odds are heavily in his favor,” end quote. This is very similar to what Charlie Munger talks about when he says the stock market is like a parlay betting system.

[00:28:01] Clay Finck: Phelps outlines a few rules we can keep in mind to help figure out the odds when purchasing a company. The first rule is that the value of any security is the discounted present value of all future payments, which is also Buffett and Munger’s definition of intrinsic value. The second rule is that a dollar of income from one source is worth as much as a dollar from another source, which essentially means that when you value two assets and discount the risk associated with them, you can compare these two assets on an apples-to-apples basis.

[00:28:39] Clay Finck: And this allows you to judge all of your opportunity costs against each other. Then for the third rule, he writes, “Hints, it follows that when investors pay more for a dollar of income from one source than they need to pay for an equivalent dollar of income from another source, they’re expressing explicitly the opinion that the income stream from the first source will rise faster or dry up more slowly than the income stream from the second source. Otherwise, what they do makes no sense,” end quote. Then he has this quote from Robert Wise that says, “Investors don’t pay different prices for the same thing when they seem to be doing so. They’re paying like prices for different anticipations.”

[00:29:28] Clay Finck: Two commonly used gauges of differing expectations are the relative yields on stocks versus bonds and the relative PE ratios on different stocks. People oftentimes compare the S&P 500 earnings yield versus something like the 10-year Treasury yield because it can give a general gauge of market sentiment. Historically, these have been pretty correlated, but ever since the great financial crisis, interest rates have been artificially low, offering a low yield on bonds relative to the earnings yield on the S&P 500.

[00:30:01] Clay Finck: As of late 2023, the S&P 500 earnings yield is 4.2%, and the 10-year Treasury yield is 3.7%, so relatively comparable. Another consideration between the two, of course, is inflation. On a relative basis, it’s preferable to own stocks if there’s high inflation because stocks, in general, offer much better inflation protection than bonds.

[00:30:23] Clay Finck: Remember Phelps’s quote of buying right and holding on. Both are essential parts of the equation of owning a hundred bagger. It’s a lot harder if you pay an extraordinarily high multiple. He writes, “Buying right will do you little good unless you hold on. But holding on will do you little good and may do you great harm unless you have bought right,” end quote.

[00:30:49] Clay Finck: A simple measure to ensure you’re not paying a ridiculous multiple or paying too much is simply comparing a company’s PE to the overall market. So if you’re looking at a company in the United States, then it may be appropriate to compare it to something like the S&P 500, which as of recording is around a PE of 23.

[00:31:13] Clay Finck: So if you have a high-quality company with a normalized PE of around 23, then it seems like a reasonable multiple to pay because you’re getting a high-quality company at what is the market average. Once you get to around two or three times a market PE, say a PE of 46 or 69, then things start to get questionable for me personally. But everyone has their own approach and may have special knowledge or insights into some of these really exceptional companies trading at super high prices.

[00:31:48] Clay Finck: Long story short, in Phelps’s mind, buying right is just as important as holding on, and it needs to be well understood. Phelps also highlights not only the importance of the multiple you’re paying but also the quality of the earnings on that multiple, considering items such as how durable the earnings are, how fast they’re growing, and what the competitive landscape looks like for a company. They all factor into the quality of earnings.

[00:32:18] Clay Finck: Accounting considerations should also be considered to ensure we’re looking at an accurate figure for the company’s real true normalized earnings to ensure that the accounting earnings aren’t misleading, as they often are due to the shortcomings of gap accounting, as explained in Adam Cecil’s book, “Where the Money Is.”

[00:32:38] Clay Finck: One should also consider what the company is doing with those earnings. We’d much rather own a company that’s reinvesting back into the business at high rates of return, rather than deploying that capital in a way that isn’t value accretive to shareholders, such as by paying a dividend or making pricey acquisitions.

[00:32:59] Clay Finck: One other item I wanted to mention here is keeping an eye on how honest the management team is and what their track record looks like. It’s much better to partner with managers who have a track record of being honest and not trying to play accounting games because accounting numbers can easily be manipulated to try and hit these EPS targets.

[00:33:24] Clay Finck: Companies who take shortcuts with their EPS numbers eventually have things come back to haunt them in some way, shape, or form. And it’s typically the type of managers you just don’t want to associate with. Another item related to management is how they treat their employees. Do they pay their employees fairly and have high employee morale in the workplace, or do they squeeze everything they can out of employees to the point where the highest performers are inevitably going to leave and go somewhere where they’re treated much better?

[00:34:01] Clay Finck: Again, you want managers who are playing long-term games with long-term people, assuming that you’re looking to be a long-term shareholder yourself and a high-quality business. Phelps states, “The best safeguard against slate of handbook keeping is to have nothing to do with it or with the men who practice it,” end quote.

[00:34:22] Clay Finck: Jumping ahead to chapter 15, Phelps has a chapter titled “Profits in Ethics.” He’s a big proponent of investing in companies that make the world a better place and avoiding companies that make the world worse like the plague. Everyone has their own opinions on Facebook or Meta, but I personally just don’t want to own that stock no matter how cheap it is.

[00:34:47] Clay Finck: That was my opinion when I covered it on the show near its lows in November 2022, and now the stock is up well over 100%. Topics like this made me realize that investing is much more than all about the money. It’s all about aligning your investments with who you are and what helps you sleep well at night too.

[00:35:12] Clay Finck: This isn’t me saying that you shouldn’t buy Meta or you need to have the same opinion as me, but I’m just using it as an example since it’s such a well-known company. Phelps has the quote, “You should never do business with a man you do not trust.” He writes, “No matter how tempting the prospect, how alluring the chance for a quick profit, stay away from men, companies, and ventures based on defrauding rather than helping customers,” end quote.

[00:35:44] Clay Finck: This also ties into the Buffett quote that if you aren’t willing to own the stock for 10 years, don’t even think about owning it for 10 minutes. If you truly think about owning a business for over 10 years and actually commit to that mindset, then naturally, you’re going to shy away from managers who aren’t trustworthy.

[00:36:07] Clay Finck: Phelps writes, “If we buy stocks because we believe in them, expecting to hold them for the rest of our lives, the chances are good that others will come to appreciate them too. Then if someday we do decide to sell them, they will appeal to the wisest buyers, a market that is always liquid,” end quote.

[00:36:30] Clay Finck: Gotham also talks about this idea in his book where there’s always a market and there’s always liquidity for quality companies. In chapter 16, Phelps touches on the importance of the business reinvesting at a high rate of return, something we talk about a lot on the show here. As I’ve stated many times on the show before, a business’s returns over the long run trend towards the return of the company itself and what the company earns.

[00:37:01] Clay Finck: If a business continually reinvests into new projects at, say, a 20% return, then even if you pay a PE multiple of, say, 30, your stock returns are still going to be around 20% over the long run. Phelps encourages investors to stay away from businesses with low return on invested capital if you want to own a long-term compounder that even has a shot at becoming a hundred-bagger.

[00:37:29] Clay Finck: In chapter 19, Phelps expands more on where to find potential hundred-baggers. He lists a number of different things here, and it’s funny that the first thing he lists is one I totally disagree with. He says that the record of the last 40 years suggests that first, you want to look for inventions that enable us to do things we always wanted to do but never could do before.

[00:37:57] Clay Finck: And he uses the examples of an automobile, airplane, and television. And all three, I believe, are really bad industries to be in, mainly because there’s just so much competition nowadays and there’s low return on invested capital in these industries. Using the auto industry as an example, when you have so many different companies competing, it tends to turn into competing on price, which drives down profit margins for everyone.

[00:38:25] Clay Finck: But when you look at a company like Tesla, who’s doing much different things than the traditional players, or a company like Ferrari, who’s a luxury automaker, then it becomes a different story. Ideally, you want to be in an industry where you’re investing in the clear winner, and the industry isn’t cluttered with many different players. It’s dominated by just one or two players, and that’s the type of situation where I believe you’ve seen supernormal profits and very high investor returns.

[00:38:59] Clay Finck: One example that comes to mind here is Alphabet or Google and their search business. They had practically no competition, and they were able to earn supernormal profits over the last decade. So if you were to apply Phelps’s principle today of looking for industries with new inventions, things that come to mind here are AI, autonomous driving, electric vehicles, e-commerce, the cloud, and renewable energy on Phelps’s list. He does list ideas within this line of thought, whether that be looking at technology that makes things better, faster, cheaper, more efficient, or whether that be new or cheaper sources of energy.

[00:39:39] Clay Finck: Out of the 365 companies that increased by a hundred-fold in his study, he broke them all down into four general categories. The first is the advance of companies who recovered from extremely depressed prices during the Great Depression, which was the greatest bear market in American history. And then this also includes more generally companies that had a special type of panic or distress that caused their stocks to fall dramatically before recovering.

[00:40:09] Clay Finck: Phelps personally doesn’t bank on finding these super distressed situations because people’s willingness today is to risk higher inflation rather than risk another deflationary bust like what happened in the Great Depression. And after seeing what happened in the overall markets with the great financial crisis in March 2020, we know that the Fed will provide liquidity to the markets wherever necessary, at least for the time being, and they’re willing to risk inflation if that’s the way things head.

[00:40:41] Clay Finck: The second group of companies in his study was those who produce a basic commodity. If an oil producer, for example, sees the price of oil go up by, say, five times, then oftentimes you’ll see many oil producers increase by multiples much higher than that. Or maybe a company has a big unexpected discovery of a basic commodity that thus leads to explosive stock returns after the discovery is announced.

[00:41:09] Clay Finck: The third group of companies he lists here is the advance of those primarily due to great leverage in capital structure and long periods of expanding business and inflation. For this item, Phelps writes, “Leverage opportunities may result from situations where the senior claims on a company’s earnings and assets equal or exceed those earnings or assets, leaving no present value for the equity. When such a situation persists for many years with no visible prospect of change, the equity may sell at a nominal price. Opportunities for profiting by capital leverage are easy to find. What is hard is deciding whether the added profit potential outweighs the added risk.”

[00:41:53] Clay Finck: And then the fourth and final one is where the fun stuff is, in my opinion. And that is the growth of companies who’ve reinvested their earnings at substantially higher than average rates of return on their capital. One of the most important pieces when analyzing those in this category is ensuring that these businesses have a really impenetrable moat in place because businesses that earn really high returns are naturally going to attract a lot of competition.

[00:42:25] Clay Finck: I did an entire episode on moats and competitive advantages, and that was back on episode 524 for those who are interested in checking out that episode. Alphabet is actually a really good case study here to look at. I believe they IPOed in 2004 at a split-adjusted price of under $3 per share, and they’re currently trading around $124 per share, which is over a 40 times increase in their stock price.

[00:42:54] Clay Finck: All along the way, Google search had an impenetrable moat, and they greatly benefited from the transition to digital advertising, and then they delivered an exceptionally valuable service to their advertisers. There were, of course, some bumps along the road in terms of Alphabet’s stock price, but just looking at the top-line revenue of their business over the years, it has increased every single year since their IPO, and of course, that may change in the coming years. Time will tell whether ChatGPT or some other chatbot eats their lunch.

[00:43:30] Clay Finck: And then Phelps shows how many years it will take for a company to become a hundred-bagger at differing rates of return. To do it in 40 years would require a 12.2% average annual return. 30 years would be a 16.6% average annual return. 20 years would require a 26% average annual return. And to do it in 15 years would require a 36% annual return, which is in the ballpark of what Constellation Software achieved over the past 10 or 15 years. I covered that company back on episode 531, one of my favorite episodes and one of the fan favorites as well.

[00:44:11] Clay Finck: Over the long run, the growth in a compounder is really driven by the growth in their earnings. And then investors can also further enhance their returns by taking advantage of Mr. Market’s mood swings of optimism and pessimism. But if you misjudge those swings, then it may, of course, hurt your long-term returns. Trying to time it. Towards the end of the book, Phelps has a chapter here on ensuring you don’t miss the boat on the next hundred-baggers. He argues that the reason that so few people ever achieve such a feat is because so few people actually try to do it.

[00:44:53] Clay Finck: Oftentimes, people are told that stock picking isn’t for individual investors because mutual funds just can’t outperform the market, where many people are just playing very short-term games. Mathematically, it’s just impossible to achieve a hundred-bagger if you’re always selling your companies within one or two years.

[00:45:12] Clay Finck: He also argues that those wanting to multiply their capital by a hundred also run less risk than those with short-term time horizons. One reason for this, as I mentioned earlier, is that there’s always a market for the best of anything because people who appreciate quality always seem to have money.

[00:45:33] Clay Finck: It’s true for quality stocks, bonds, real estate, art, antiques, collectibles, you name it. Another reason he prefers investing with quality is because oftentimes you’re partnering with exceptional management teams. It’s relatively easy to buy, right, and hold on when you’re partnering with people who are exceptional at what they do, and they’re also honest and trustworthy.

[00:45:55] Clay Finck: Another item that comes to mind here is that investing with a short-term time horizon increases the need to be right on the valuation. When you get the company right and you’re willing to hold on for the long haul, then getting the valuation right becomes less and less important because if the earnings are increasing by so much over the course of a decade, then the valuation will take care of itself.

[00:46:25] Clay Finck: Here’s an excerpt I wanted to share as well: “Well, perhaps the greatest advantage of all in buying top quality stocks without visible ceilings on their growth is that when we do so, we give ourselves the chance to profit by the unforeseeable and the incalculable. Year after year, mankind achieves the impossible but persists in underrating what it can and will do in the future.”

[00:46:51] Clay Finck: End quote. And then Phelps also poses the question of whether individuals should be choosing and purchasing stocks themselves or if they should be hiring a professional to do it for them. He says that if you want to pursue the path yourself, you, of course, need to get educated on all things finance, investing, accounting, etc.

[00:47:14] Clay Finck: He also suggests that vast amounts of screening need to be done out of the thousands of companies to choose from. It’s super helpful to filter down on metrics like earnings growth, revenue growth, and so on. And that gives you a list of companies, and it really just narrows it down for you to study and then pick a handful or however many you’d like.

[00:47:40] Clay Finck: And then we also need to understand the psychological side and be sure we’re equipped to deal with things if they go wrong, such as if our stocks decline by 50% or if we end up being wrong about the business psychologically. Are we able to sleep well knowing that we may have made a crucial mistake with our investments?

[00:48:04] Clay Finck: All right. That concludes what I wanted to cover for Thomas Phelps’s book. During this episode, I also wanted to share some of the content that’s been put out by Akre Capital Management. They have some brilliant pieces on their website that I recommend all of our TIP listeners check out as their approach of concentrating into high-quality businesses is well worth studying and understanding.

[00:48:30] Clay Finck: I had the opportunity to grab lunch with one of their partners in Omaha for the Berkshire weekend, and I myself am just a huge fan of Chuck Akre. He’s given a Google Talk that’s out there on YouTube that I really enjoyed, and I believe that during his talk, he mentioned that over his investment career, he has had two 100-baggers that he still owns today.

[00:48:57] Clay Finck: The first being Berkshire Hathaway and the second being American Tower. Akre has made famous his three-legged stool approach, primarily looking for three things when selecting a high-quality business. First, he wants to own what he calls an extraordinary business. Second, he wants to partner with talented managers. And third, the company must have a plethora of reinvestment opportunities and a history of being able to reinvest at an above-average rate of return.

[00:49:26] Clay Finck: John Neff is one of the partners at Akre, and he wrote an article titled “Why Compounding is So Difficult,” which I feel ties really well into this content covering Thomas Phelps’s book. He explains that over the past 100 years, the world has gone through many very difficult things, such as depressions, wars, financial crises, inflationary periods, pandemics, terrorist attacks. The list goes on and on and on. Yet over the long run, the stock market continued to march upward to new highs over and over again.

[00:50:01] Clay Finck: Most people we know didn’t benefit from that entire ride up, and those who stuck with it and rode along with the bumps in the road built tremendous amounts of wealth over time. It wasn’t the events that derailed some people’s compounding or their money, but their reaction to those events.

[00:50:22] Clay Finck: Neff’s lists four counterproductive behaviors that investors take. The first is trying to sell before the next recession. The second is trying to buy just before the next bull market. The third is repositioning portfolios based on what is supposed to do better in the next paradigm. And the fourth is dumping stocks during a downturn, which deprives oneself of the means to eventually recover.

[00:50:48] Clay Finck: And then he writes, people do these things because they’re intuitive, because these actions appear rational in the face of heightened concern and uncertainty. This is precisely why compounding over the long term is so challenging and rare. It demands counterintuitive and seemingly irrational behavior.

[00:51:06] Clay Finck: End quote, and he shares the Buffett maxim that the stock market exists to serve investors, not instruct them. The point is that the movement of the stock price shouldn’t tell you whether you should buy, sell, or hold a company. What’s much more important is the actual performance of the business.

[00:51:27] Clay Finck: Investors who react to stock market moves by purchasing when shares are up and dumping when share prices are down are letting the market’s moods guide their actions, and it really hinders their performance. A lot of investors judge business performance by what the stock price is doing rather than what the actual business performance is.

[00:51:49] Clay Finck: Sometimes stock prices go down because of near-term worries or concerns. Remember that many people are trading in and out of stocks that you own, and they may be doing it for totally different reasons than you. They may be selling because they have liquidity needs. They may be trading based on some algorithm, or they may be simply selling because the stock price is down.

[00:52:15] Clay Finck: Their time horizon is oftentimes a lot different than yours. What really drives the stock price over the long run is the business’s performance and the growth of the company’s earnings power over time. Chris Cerone is another partner at Akre Capital, and he wrote this brilliant piece I absolutely love called “The Art of Not Selling.” He writes, “Of our most costly mistakes, over the years, almost all have been sell decisions. The mistake in virtually every instance has been selling too soon. Reflecting on these mistakes gave rise to this letter and its title, the Art of Not Selling. Taking a step back, our investment philosophy involves concentrating our capital in a small number of what we believe to be growing and competitively advantaged businesses.”

[00:53:06] Clay Finck: These kinds of businesses are rare and are only periodically available for purchase at attractive valuations. With that in mind, we do our best to hold on for the long term so that our capital may compound as the businesses grow. Holding on means resisting the temptations to sell, and there are many. We tune out politics and macroeconomics. To the surprise of many, neither valuation nor price targets play a role in our sell decisions.

[00:53:37] Clay Finck: Akre Capital really understands the true power of compounding. As Chris talks about here, they’re very careful in selecting businesses that are well positioned to compound in the future, and being very careful to not mistakenly sell these businesses because that interrupts that compounding process. He says that allowing our investments to compound uninterrupted is our north star.

[00:54:00] Clay Finck: He gives the example of a penny doubling for 30 days and how this force of compounding grows a penny to be worth over $10,000,030 days. The original penny doesn’t cross the $1 million mark until the 27th day, and in the final four days, it grows from around $700,000 to over $10 million. This illustrates that most of the benefits from compounding aren’t seen until really far out in the future.

[00:54:29] Clay Finck: So it’s a good reminder that when you sell a company and incur capital gains taxes, then you risk halting that compounding process that’s at play. It also illustrates that the compounding effect is not intuitive. Our brains are designed to think linearly, not exponentially.

[00:54:47] Clay Finck: Time is definitely a very important variable in the compounding equation, and it’s something you have a lot of control over. Increasing your returns does help, of course, but time plays a crucial role. You can achieve a 100% return in one year and double your money, but if you take a more modest return, say 10%, and apply that over 40 years, your investment would increase by 45 times. And if you manage to achieve a 15% return for 40 years, your investment would increase by 267 times.

[00:55:22] Clay Finck: Morgan Howell has a chapter in his book, “The Psychology and Money,” about this topic, and he discusses how the majority of Warren Buffett’s wealth was accumulated in the later part of his life due to the compounding force and the variable of time. One of the biggest reasons Buffett is one of the richest people in the world is because he has simply invested much longer than most of the other great investors and entrepreneurs.

[00:55:53] Clay Finck: Because of how powerful long-term compounding is, Chris explains that they’re very careful about determining a good reason to sell an investment. Their firm tends to tune out politics and the economy when making a sell decision, and they don’t let valuation play a big part in their sell decisions. As he writes, “We try to resist the temptation to sell or even trim on the basis of valuation alone. We are unfazed when our businesses are quoted in the market at prices above what we would pay for them.”

[00:56:29] Clay Finck: He then lists three reasons why they don’t sell solely based on valuation. The first is that oftentimes, when you sell based on valuation, you don’t get the opportunity to reenter that company at an attractive valuation in the future.

[00:56:45] Clay Finck: A great example of this is Constellation Software, a company that Akre’s firm has owned since 2014. Despite being considered expensive by many, since its IPO in 2006, the stock has increased by over 125 times without experiencing a drawdown of more than 30%.

[00:57:02] Clay Finck: An investor may have doubled their money in Constellation, become familiar with the business, spent a lot of time on it, and then sold it, deeming it too expensive. Perhaps they thought they would wait for a better price, only to watch the stock increase by tenfold while they remained on the sidelines.

[00:57:23] Clay Finck: This is precisely what Chris refers to when he talks about their biggest mistakes being selling too early. The second reason they’re hesitant to sell based on valuation is that finding an opportunity to buy another great business at an attractive price is rare when you’ve already sold a company you considered expensive.

[00:57:45] Clay Finck: At some point, the capital needs to be allocated elsewhere, but the timing of that opportunity is uncertain. The third reason is that the best businesses often surpass expectations. What may appear as a high price today could turn out to be an attractive price in hindsight.

[00:58:03] Clay Finck: Chris also discusses price targets and the conventional wisdom of value investing, which suggests buying something cheap relative to its intrinsic value and selling it when it reaches or approaches that value. However, with growing competitively advantaged businesses, the value of that proverbial dollar bill may be worth a dollar now, but they expect it to be worth a dollar twenty next year and a dollar forty the year after. When owning such businesses, they believe it’s best to hold them for the long term and allow them to compound.

[00:58:39] Clay Finck: They emphasize that to achieve a hundred-bagger, one must resist selling when the company doubles, becomes a five-bagger, a ten-bagger, a twenty-bagger, and even a fifty-bagger. However, this doesn’t mean that they should never sell their companies. It’s crucial to be clear about when it’s appropriate to do so.

[00:58:59] Clay Finck: Ocre Capital is comfortable selling out of a position in three primary scenarios. First, when the business is no longer growing at an above-average rate, as below-average growth expectations lead to below-average investment returns over the long term. Second, when the company’s competitive advantage becomes impaired, as a strong competitive advantage allows for reinvestment at high rates of return. And third, when there’s an adverse change in the management team.

[00:59:27] Clay Finck: Sometimes, even if there has been an excellent management team in place for years, they may need to pass the torch to someone else. Chris Ceroni mentions that they give new management teams time to settle in and may provide them with some extra leeway to get comfortable in their new roles.

[00:59:48] Clay Finck: In other rarer cases, they may sell to free up capital for a new high-quality business they have become familiar with or simply because they have changed their mind about an existing investment after gaining a deeper understanding over time. Towards the end of this piece, Chris emphasizes the importance of tuning out the noise to avoid the mistake of selling too early.

[01:00:13] Clay Finck: The financial press and Wall Street thrive on attracting attention and generating transactions from investors. They will continuously try to tempt you to sell something you already own. In line with this, Chris includes a quote from Thomas Phelps, highlighting that individuals whose self-interest is opposed to your own will try to persuade you to act every day.

[01:00:36] Clay Finck: To help tune out the noise, Akre’s firm focuses heavily on determining the true essence of a business and identifying the key variables that truly matter. They aim to narrow down the moving parts within a business to a few key variables, making it easier to evaluate if a company still deserves a place in their portfolio. This approach enables them to stay the course for the long term and fully benefit from compounding.

[01:01:06] Clay Finck: Concluding the discussion on Thomas Phelps’s book and Akre Capital’s articles, there is mention of a resource called the TIP Mastermind community. Launched in April 2023, it has garnered significant interest from audience members seeking to connect with like-minded investors and share ideas. The community hosts weekly Zoom calls with roundtable discussions, Q&A sessions featuring investors like Stig Brodersen and Gotham, and a forum for members to share links, articles, and questions.

[01:01:35] Clay Finck: Furthermore, plans are underway to organize an in-person meetup for TIP Mastermind community members in New York City from October 6th to October 8th, 2023. The itinerary is being finalized, and the anticipation for this trip is high. Currently, there are around 35 paid members in the Mastermind community, and while new membership is temporarily closed, they plan to open it up to another cohort in June or July.

[01:02:02] Clay Finck: If you’d like to be notified when we open up the new cohort, you can join our waitlist by visiting theinvestorspodcast.com/mastermind. That is theinvestorspodcast.com/mastermind to check out the community and join our waitlist. Also, Stig and I discussed the Mastermind community further in his mastermind episode, which will be released on Saturday, June 3rd.

[01:02:24] Clay Finck: If you want to learn more about the community, you can skip to the very end of that episode where we delve into more details about the Mastermind community. Alright, that’s all I have for today’s episode. I’ve truly enjoyed putting this one together, as always. To the audience, thank you so much for tuning in, and I hope to see you again next week.

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