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The Power of Compounding: A Tale of Two Investors

Compound interest, often humorously dubbed “the eighth wonder of the world,” may not have a historical quote to back its grand title, but the principle behind the jest is no laughing matter. In this article, we explore the transformative power of compound interest through the lens of two investors with differing outcomes. This concept, though not officially recorded in the annals of history as a quote from a famed historical figure, captures the essence of its staggering potential in a way that resonates with many.

Picture compound interest as a snowball cascading down a slope: the higher its starting point, the more time it has to accumulate mass and momentum. In the realm of Investment Management, professionals strive to harness this compounding effect for their clients by overseeing asset portfolios and enacting strategies aligned with each client’s time frame and risk appetite.

‘Superinvestors’ are those exceptional investment managers who have showcased superior capital allocation skills by consistently delivering above-average returns over significant periods. Often, these investors have steered investment partnerships to impressive double-digit gains for decades—an extraordinary feat. As assets under management swell, it’s generally understood that the potential for future returns diminishes due to a shrinking pool of attractive investment opportunities. Nevertheless, a few have managed to compound their capital at remarkable rates, which is even more noteworthy considering they’ve achieved this while managing their partners’ funds.

We will engage in a hypothetical thought experiment to compare the long-term impacts of two contrasting investment trajectories. The first involves an investor who unfailingly earns an above-average 20% return throughout their entire career. The second describes an investor who has a varying rate of return.

Both scenarios offer rich insight into the mechanics of compounding and investment strategy, shedding light on how exceptional the discipline of investment management truly is when practiced at the highest levels.

Experiment One: Setting the Scene

Let’s introduce our two investors, Investor A, and Investor B. Each embarks on their investment journey with the same starting capital of $1 and a remarkable 50-year investment horizon.

Investor A follows a consistent approach, achieving a steady compounding interest rate of 20% throughout the entire 50 years. This strategy exemplifies the power of constant growth over a long period.

Investor B, in contrast, adopts a strategy with variable compounding rates: an aggressive 50% for the first decade, a solid 20% for the subsequent two decades, and a more conservative 10% for the final two decades. This approach leverages higher early gains that taper off as the investment manager matures, which can potentially lead to a larger final sum despite the reduced rates in the later years.

The growth of each investor’s portfolio can be estimated using the Future Value formula:

FV=PV×(1+r)n

where:

– FV represents the future value of the investment,

– PV is the present value or initial amount,

–  r is the annual interest rate (expressed as a decimal),

–  n is the number of years the money is invested or compounded.

  • Investor A (Steady 20% Rate)
    • First 10 Years: 20% annual growth, FV ~$6.19
    • Next 20 Years: Continues at 20%, FV ~$383.38
    • Final 20 Years: Remains at 20%, FV ~$9,100.44
  • Investor B (Variable Rates)
    • First 10 Years: High growth of 50%, FV ~$57.67
    • Next 20 Years: Slows to 20%, FV ~$2,210.93
    • Final 20 Years: Further slows to 10%, FV ~$14,874.03

Summary:

Investor A ends up with approximately $9,100.44 after 50 years with a steady compounding rate of 20%. Investor B, with a variable compounding strategy of 50% for the first 10 years, 20% for the next 20 years, and 10% for the final 20 years, ends up with approximately $14,874.03. Investor B’s strategy results in a higher final amount due to the aggressive growth in the initial years, which created a significant base that continued to grow at a decent rate.

The findings suggest that an investor who is able to implement a higher-returning strategy during the early years of compounding stands to benefit greatly from the increased initial capital. This allows for a slower compounding rate as the portfolio matures without significantly affecting the overall growth of the investment.

It is also worth noting the impact of asset growth in this scenario. While in an experimental setup where the initial investment is just $1, the effects might not be as clear, they become much more pronounced when we consider a more substantial initial sum, such as $1,000,000. With such an initial investment, the eventual outcomes for the hypothetical investors are striking approximately $9.1 billion for investor A, and around $14.9 billion for investor B. These figures are indeed remarkable, considering they originate from a starting point of one million dollars without additional contributions.

However, the experiment also illustrates that maintaining a consistent 20% return throughout the lifespan of a growing portfolio is an extremely challenging task. As the assets increase in value, the market inefficiencies that once could be exploited to generate significant returns diminish. Such inefficiencies become too small to have a meaningful impact on a large portfolio. Consequently, investors may need to assume greater risks to achieve the same rates of return that were obtainable with much less risk when the investment pool was smaller.

Therefore, it seems more practical to maximize returns by exploiting market inefficiencies while they are still impactful and transition towards a less risky strategy as the portfolio expands. This approach balances the need for growth with the realities of changing market dynamics as asset size increases.

 Experiment Two: Inversion

In our second experiment, we’ll explore the implications if Investor B’s variable return rates were reversed. Investor A will continue to generate a consistent 20% return over their 50-year investment period. On the other hand, Investor B will exhibit a 10% return for the first 20 years, a 20% return for the next 20 years, and a 50% return for the final 10-year period. Let’s examine the potential outcomes of this scenario.

  • Investor A (Steady 20% Rate)
    • First 10 Years: 20% annual growth, FV ~$6.19
    • Next 20 Years: Continues at 20%, FV ~$383.38
    • Final 20 Years: Remains at 20%, FV ~$9,100.44
  • Investor B (Variable Rates)
    • First 20 Years: Slow growth of 10%, FV ~$6.73
    • Next 20 Years: Higher growth of 20%, FV ~$258.01
    • Final 10 Years: High growth of 50%, FV ~$14,878.16

Summary:

Investor A ends with a value of approximately $9,100.44, while Investor B reaches $14,878.16. Similarly, scaling up the initial sum to one million dollars, the end values would be approximately $9.1 billion for Investor A and $14.9 billion for Investor B. This implies that periods of substantial outperformance within a portfolio allow for flexibility during periods of lower performance, regardless of the sequence of returns.

The data suggests that higher return periods significantly enhance the absolute return of an investor’s portfolio over their investment career. This can be seen as an investor adopting a conservative approach early on to mitigate the risk of poor early performance that could halt investment activities. As their career progresses and their intellectual and investment capital grow, they may increase their investment activities.

As an investor’s assets under management grow, so does their market influence. It’s plausible that as an investment manager’s assets under management increase, they also become more experienced and knowledgeable in the investment space. They gain a broader network of resources and can exert more control over their investments by acquiring significant amounts and holding substantial voting interests. In this scenario, it’s conceivable for an investment manager to improve their portfolio’s return rate while also expanding their assets under management. It is crucial to discern whether this is due to greater influence, which leads to better decision-making, or if it is the result of a high-risk strategy that could incur significant losses.

Economic conditions are another reasonable consideration. It is well-known that economic cycles can cause investment strategies to fluctuate in popularity. This leaves windows during which strategies can be effectively employed to generate increased returns. As investors recognize these opportunities or as economic conditions shift, these windows may close. There may be long intervals before these specific strategies become viable again. This understanding offers comfort to investment managers starting firms during costly markets or periods of low performance. Moderate returns at the outset can swiftly improve as time passes and economic conditions evolve, presenting more opportunities and boosting returns.

In a 50-year investment career, numerous economic scenarios can influence the ability to achieve exceptional returns at different times. If market conditions enable consistent performance over time, an investment manager can still enjoy a successful career by remaining committed and capitalizing on high-performing strategies when opportunities arise.

Results:

The results of these experiments are intriguing. They indicate that investment managers can afford periods of lower returns if they can demonstrate a higher rate of return, whether early or later in their career, and still outperform on an absolute basis. However, consistently producing above-average returns is challenging in all scenarios. This study suggests that it may be more effective to generate highly attractive returns intermittently, accompanied by periods of lower performance, rather than maintaining consistently high returns throughout one’s career. These higher-than-average returns can be achieved early in a career by exploiting market inefficiencies and seizing opportunities, then reducing the aggressive strategy as assets under management increase. Conversely, a conservative approach implemented early on can yield average returns, with the potential for performance to improve over time based on enhanced skills, influence, and favorable economic conditions.

The results highlight the practical incentives of generating higher returns early in a financial career, emphasizing that smaller assets under management can contribute significantly to achieving higher returns. As assets under management  grows, the potential for above-average returns tends to diminish exponentially. This phenomenon is evident in the career trajectories of many “super investors,” who often start with exceptionally high returns that taper off after decades of outperformance and asset growth. These investors may need to return money to partners or clients to sustain the high returns compatible with the levels of risk they are comfortable with. This aspect, not included in the experiment due to its complexity, can be thought of as a form of variable returns—not just from the portfolio that consistently performs well but also from the performance of funds reallocated or returned to investors.

The returns of the original proceeds that stay in the high-performing investment vehicle, and those of the subsequently returned proceeds invested elsewhere or held in risk-free alternatives, are difficult to quantify due to varying individual decisions. The fee structure of investment partnerships, such as carried interest, adds further complexity to these calculations. While the outcome—whether an investment manager consistently produces high returns and returns money or experiences variable returns—is partly circumstantial and mostly beyond control, understanding the limitations of assets under management growth is crucial.

An inverted variable rate scenario, where returns compound slowly initially and then accelerate, is unlikely. However, it serves to illustrate that periods of underperformance can be counterbalanced by periods of over performance. This is encouraging for investment firms that may start with challenges, such as entering overvalued markets or making miscalculated investments.

The mathematical implications of variable compounding rates are significant. For example, compounding $1,000,000 at 3% for the first 40 years and then at 50% for the last 10 years yields a final sum of $188,105,536.58. Conversely, compounding at 50% for the first 10 years and then at 3% for the remaining 40 years results in $188,105,536.69, differing by only eleven cents. These calculations demonstrate that high compounding rates significantly enhance the attractiveness of variable returns over an investment career. In comparison, compounding $1,000,000 at a constant rate of 10% over 50 years yields $117,390,852.88, less than the variable rate examples, even considering a lengthy period of underperformance.

The results suggest that periods of exponential compounding offer investors leeway for lower returns either in the past or future while still achieving a high absolute return. By generating exceptional returns when possible, an investor can afford periods of lower returns without eroding the overall portfolio performance throughout their career.

It is crucial to acknowledge the limitations of this experiment and recognize that both hypothetical investors, A and B, would be considered extreme outliers and “superinvestors” if they were able to produce such returns. This thought experiment was conducted solely to explore the dynamics of consistent versus variable rates of return.

These are, of course, theoretical amounts, not taking into account taxes, fees, investment risks, and other real-world factors that could affect investment growth. Please note that the calculations provided for the future values of investments for Investor A and Investor B were performed using mathematical approximations. The results may vary slightly due to rounding during the compounding process and the precision of the calculations. When applying these methods to actual investment scenarios, it is important to consider additional factors such as transaction fees, taxes, market volatility, and other economic factors that could affect the final outcome. The figures presented should be used as a general guide and not as exact predictions of future investment returns.

Key Takeaways:

  1. Timing of High Returns Is Flexible: The study suggests that the timing of when an investment manager realizes higher rates of return—whether early or later in their career—does not necessarily impact the end result significantly. Whether high returns are achieved through initial aggressive strategies or developed capabilities over time, both approaches can even out and result in impressive long-term wealth accumulation.
  2. The Power of Compounding Over Varied Periods: The compounding effect benefits both early and later high returns, but the approach can be adapted depending on the investment manager’s circumstances and market conditions. The advantage lies in the ability to compound at a high rate, regardless of when this occurs in the career span.
  3. Adaptability in Investment Strategy: Consistency in high performance is challenging to maintain. This experiment illustrates that adaptability in investment strategies—capitalizing on market inefficiencies early on or enhancing skills and influence to boost returns later—can be as important as the actual returns themselves. An investor’s ability to adjust their strategy in response to changing economic conditions and personal growth within their career can lead to overall outperformance.

This experiment implies that it’s not just about when you achieve your returns but also how you adapt and change your strategy throughout your investment career to maximize the periods when you can earn above-average returns.

In conclusion, the experiment’s findings challenge the conventional emphasis on consistently high returns throughout an investment manager’s career. Instead, it presents a compelling case for the strategic timing of when these returns are realized, whether early or later in one’s professional journey. The study illustrates that both approaches — capitalizing on early market opportunities or growing capabilities to achieve higher returns later — can be equally effective due to the enduring power of compounding.

The adaptability of an investment strategy in response to evolving market conditions and the manager’s own professional development is highlighted as a crucial factor in long-term investment success. The key takeaway is that while it is difficult to maintain above-average returns consistently, investment managers who can navigate the dynamic financial landscape and optimize their performance periods — regardless of their career stage — stand to accumulate significant wealth over time.

Therefore, this thought experiment underscores the importance of a flexible, adaptive investment approach over the rigidity of seeking consistent outperformance, reaffirming the notion that there are multiple paths to achieving exceptional long-term investment results.

The information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity.  The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies.  This is for information purposes and should not be construed as an investment recommendation.  Past performance is no guarantee of future performance. 

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Coffee Cans and Cigar Butts: The Ins and Outs of Long and Short Duration Investments

There are various strategies and approaches that investors can adopt to achieve their financial goals. Two such strategies are the “coffee can” portfolio and the concept of “cigar butts.” Understanding these terms and their characteristics can help investors make informed decisions when it comes to long and short duration equity investments.

In this article, we will discuss the differences between a coffee can portfolio and a cigar butt portfolio. We will also explore the similarities in the analysis process for each of these distinct investment styles. Understanding the nuances of each strategy enables investors to benefit from pattern recognition, helping them identify whether a potential investment aligns with a short-duration or long-duration strategy.

The Coffee Can Portfolio

The term “coffee can portfolio” was coined by Robert Kirby, a renowned investment advisor. It refers to a long-term investment strategy where investors buy shares of high-quality companies and hold onto them for an extended period, often decades. The name originates from the idea that once the shares are purchased, they can be metaphorically put into a coffee can and forgotten about.

Investments suitable for a coffee can portfolio are distinctively characterized by their constant growth, significant free cash flow generation, and longevity.

Constant growth is a vital attribute, as the strategy favors companies showing a consistent upward trajectory in their performance. These firms typically have a robust competitive edge and a resilient business model, enabling them to deliver continuous growth and maintain their market position over time.

The importance of free cash flow generation cannot be overstated in this context. Companies that generate substantial free cash flows are particularly attractive for long-term investment, as this indicates their ability to sustain operations, invest in growth opportunities, and weather economic fluctuations without relying heavily on external financing.

Additionally, longevity is crucial; the ideal candidates for a coffee can portfolio are those that have proven their capacity to adapt effectively to changing market conditions and have a strategic, long-term vision for expansion. This combination of attributes ensures that the investments remain strong and potentially profitable over a long horizon, in line with the long-term holding principle of the coffee can investment approach.

Furthermore, companies fitting the coffee can portfolio criteria must demonstrate strong corporate governance. The core concept of a coffee can portfolio is to “set it and forget it,” making it crucial to evaluate management’s past decisions, compensation, and their vision for the company’s future.

Analyzing the board members is also vital. Insider ownership plays a key role in assessing the ownership mindset of the company’s leadership. When management and board members own significant portions of the company, it aligns the interests of shareholders with those responsible for the company’s operations. This alignment ensures that both groups are incentivized to benefit from the long-term appreciation of the stock.

When assessing the potential attractiveness of long-duration stock investments, industry and market analysis play crucial roles. These analyses help in understanding the broader context in which a company operates and its position relative to industry trends and economic cycles.

Innovation and the ability to adapt in various economic conditions are key factors in selecting long-duration investments suitable for a coffee can portfolio. Companies that consistently innovate and pivot according to market demands are more likely to sustain growth over long periods.

However, it’s also important to recognize that industries undergoing rapid change, such as the information technology sector, require extra caution in evaluating the attractiveness of their stocks. The dynamism of these sectors can often lead to significant uncertainties and volatility.

When analyzing a company within a highly competitive and transformative industry, it’s vital to avoid being overly influenced by potential growth narratives. Such narratives may be easily eroded by fierce competition, or they may rely so heavily on future technology that the potential implications become too uncertain to accurately assess. Therefore, a balanced and thorough analysis is essential to discern genuine long-term potential from mere speculative opportunities.

Durability might be the most important factor when analyzing a stock that could fit into the coffee can portfolio. The Lindy Effect, a concept often used in the context of technology and ideas, can also be applied to the stock analysis process. It refers to the idea that the future life expectancy of certain non-perishable things is proportional to their current age. This translates to the notion that companies with a longer past are more likely to have a longer future. Although this isn’t always the case, as numerous instances show new technology displacing incumbent participants who have held substantial market share in a specific industry for a long time, it remains an important exercise when analyzing a company’s ability to survive over the long term.

One approach to assess the potential of the Lindy Effect is to examine companies that are decades old, sometimes even over a hundred years. This process allows you to study the various industries that have risen and fallen throughout history, understand how companies have adapted and survived during hardships, and observe how management has made changes or implemented new forms of technology to stay relevant in the evolving business landscape.

Incorporating the Lindy Effect into stock analysis is crucial because it forces the analyst to focus on companies that have proven their ability to remain in business for extended periods. This historical perspective is invaluable in evaluating a company’s durability and its potential to be a successful long-term investment.

One-way companies experience extended lifecycles is by exercising dominance in the niche they operate in. A key form of this dominance can be a local competitive advantage. This relates to a company’s strong foothold in a specific geographic region, often due to a deep understanding of local consumer preferences, regulatory environments, or logistical advantages. Industries that typically exhibit strong local competitive advantages include agriculture in regions with unique climates, tourism in areas with distinct natural or cultural attractions, resource extraction in resource-rich locations, financial services in global financial hubs, tech and innovation in specialized clusters, specialized manufacturing in areas with historic expertise, creative industries in cultural capitals, and renewable energy in regions with abundant natural resources.

Another form of niche dominance is supply chain control. This can be related to importers and exporters of important raw materials used in manufacturing, as well as the ability to transport goods from the supplier to the manufacturer. By being an essential actor in the manufacturing and raw materials industries, these companies have the ability to maintain consistent pricing power and can exercise control over the supply and demand of the products or services in which they operate.

Industries that have competitive advantages through supply chain control include oil and gas, with their hold on reserves and refining; mining and metals, controlling key resources; automotive manufacturers, managing everything from raw materials to parts production; electronics and semiconductor firms, dominating essential component production; pharmaceuticals, leveraging drug manufacturing processes; agricultural companies, influencing the seed and fertilizer markets; chemical producers, who are pivotal in basic materials; textile and apparel businesses, overseeing the journey from material to garment creation; aerospace and defense firms, controlling critical technology production; and consumer goods and retail giants, managing end-to-end product supply chains.

Additionally, brand recognition and customer loyalty can be the strongest niche factors that keep a customer engaged with a business for extended periods of time. While brand recognition and customer loyalty are intangible in nature, if properly realized, they should lead to tangible value generation. Being a recognized brand allows a company to benefit greatly from meaningful advertisement, fostering an emotional response in customers who are satisfied with the operations.

Similarly, continuously providing a good value proposition for the customer fosters customer loyalty, either through membership programs or high switching costs associated with changing providers. High switching costs tend to be a powerful form of niche dominance due to locking in customers for recurring revenue. However, an even more powerful form of niche dominance is when customers voluntarily return for services or products because of their previous satisfactory experiences, creating a combination of customer loyalty and brand recognition.

Industries that typically benefit from competitive advantages like brand recognition, customer loyalty, and high switching costs include luxury goods where brand prestige drives sales; technology and software firms where customer familiarity and ecosystem integration create loyalty; financial services where trust and complexity discourage switching; telecommunications with long-term contracts and network reliance; the automotive industry where brand loyalty influences repeat purchases; consumer electronics where brand ecosystems create high switching costs; pharmaceuticals where trusted brands dominate; retail and fast food chains with strong brand identities; and airlines where frequent flyer programs foster loyalty. These sectors leverage their established reputations and customer habits to maintain market dominance and deter switching to competitors.

By analyzing companies with a long-term time horizon, analysts can disregard temporary price fluctuations and focus on the underlying economics of the company. Evaluating the management, understanding the operational aspects of the business, and having reasonable expectations about the future enable shareholders to benefit from the success of the business operations over a complete business cycle. Additionally, the tax efficiency of this low turnover strategy, along with the implications of meaningful dividend increases or other sound capital allocation decisions, compound benefits for the shareholders. This approach becomes logical when one recognizes the benefits of investing in businesses that conduct their operations with ease. The discipline becomes evident once an analyst realizes the challenge in discerning what constitutes a good business and determining the right price for that business.

The coffee can portfolio strategy is based on the belief that by holding onto high-quality stocks for an extended period, investors can benefit from the compounding effect of long-term returns. This approach requires patience and discipline, as it involves resisting the temptation to constantly buy and sell stocks based on short-term market fluctuations.

Cigar Butts

On the other end of the spectrum, the concept of “cigar butts” refers to a short-term investment strategy where investors seek out undervalued stocks that have the potential to provide quick profits. The term was popularized by Warren Buffett, who described these investments as companies that are “so cheap that they are selling for less than the value of their assets minus their liabilities.”

Cigar butt investments are characterized by their undervaluation in the market, offering investors the chance to buy these stocks at a bargain price. The primary objective of this investment strategy is to capitalize on short-term price movements, with investors aiming for a ‘value realization event’—the point at which the stock reaches its fair value and is then sold to secure the gains. Unlike the coffee can portfolio strategy, cigar butt investments entail a more significant level of risk. This risk, however, is often mitigated by a quantifiable margin of safety. The undervaluation of these stocks may stem from temporary market conditions, and there’s always the risk that the market may not fully recognize the stock’s true value.

A quantifiable margin of safety is often paramount in cigar butt investing, as the companies fitting this strategy are usually considered inferior. Their business performance can be mundane or even negative, often leaving previous shareholders dissatisfied and further diminishing the appeal of the shares. It’s crucial to understand the psychological differences between this strategy and the coffee can approach.

In the coffee can strategy, considerable time is spent comprehending the future of the business. Confidence in this analysis often stems from examining the long-term profit history, analyzing various earnings metrics from EBIT (Earnings Before Interest and Taxes) and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) to net income and free cash flow, and making predictions about future earnings based on current capital allocation decisions. However, this approach is not suitable for analyzing cigar butts. Deep analysis to make predictions based on earnings is a mistake for these companies.

The cigar butt strategy focuses on asset analysis, whereas the coffee can strategy is more earnings-based. The goal in cigar butt investing is to purchase a company at a discount to its worth, hypothetically in a liquidation scenario where assets are liquidated, and liabilities paid off. The remaining value is what is due to the shareholder, serving as the analyst’s margin of safety. The desired outcome is to buy these shares at a price significantly lower than this calculated value.

Once becoming a shareholder, the objective is to either have the market recognize the value of the shares, have the company purchased by a larger entity at a fairer price, or see the excess capital returned to shareholders through dividends or full liquidations.

Another distinction between the cigar butt and coffee can strategies lies in the active involvement required in cigar butt investing. Shareholders of companies trading at a discount often have more concerns about operations than those invested in fairly valued companies. In such cases, it can be beneficial for shareholders to voice these concerns to management and board members, particularly if they possess unique insights or expertise on the relevant issues.

Frequently, the accounting procedures of certain companies can be problematic, whether due to ignorance or intent. Unprofitable business lines may continue to operate, draining value from the organization, or there might be insufficient capital allocation for future operations. These issues can prompt shareholders to express their concerns to management, with the hope that the management will listen and take necessary actions. The ultimate goal of these interventions is to aid in achieving the fabled value realization event, where the true worth of the company is recognized in the market.

Reality often deviates from the simplistic notion of a letter to management causing a significant change in the organization’s top executives. In most cases, management is already aware of operational problems, either having unsuccessfully attempted to resolve them or lacking the necessary incentive alignment to make the required changes. An astute investor must either persistently assert to management that changes are needed or exhibit patience, holding shares of the discounted firm until an unforeseen event leads to a fairer value assessment or a liquidation that returns excess capital.

Patience is crucial in this strategy as these situations take time to unfold. However, it can also be risky; the longer an investor holds a discounted asset, the less impactful the realization event becomes. Worse still, if the company’s capital allocation decisions are poor, they might erode the firm’s value, further diminishing the impact of a value realization event.

Active management is vital in the cigar butt strategy. It’s essential to assess the capabilities and intentions of management, the value within the company, and the potential for realization in the market. If the situation doesn’t seem favorable, it’s logical to cut losses and move on to a more attractive opportunity. Staying locked into an unsuccessful investment increases opportunity costs. Therefore, an investor using the cigar butt strategy must be diligent in searching for opportunities, always weighing options, and ready to sell one position to invest in another. This active approach does result in higher share turnover, incurring more taxes and requiring more time spent on idea generation.

The question then arises: why would anyone choose the cigar butt strategy over the coffee can strategy? The answer lies in the potential returns. Properly implemented, the cigar butt strategy offers compelling returns, making it an excellent way to generate outsized returns early in one’s career. Moving from one successful value realization event to another has a compounding effect, similar to that seen in the coffee can strategy, but with the investor actively directing capital flow to the most attractive opportunities. In contrast, the coffee can portfolio relies entirely on the continuing operations of selected firms. Both strategies can yield outsized returns if properly executed, but generally, the successful cigar butt investor is compensated for the strategy’s active nature.

While the coffee can portfolio focuses on long-term wealth accumulation, cigar butt investing aims to generate quick profits. It requires a keen eye for undervalued opportunities and the ability to make timely investment decisions.

Benefiting from Both Strategies

Investors can benefit from incorporating elements of both the coffee can portfolio and cigar butt strategies into their investment approach. By diversifying their portfolio with a mix of long and short duration investments, investors can potentially achieve a balance between steady long-term growth and short-term gains.

By assessing each opportunity individually, an investor can benefit from both the coffee can and cigar butt strategies. Understanding that both approaches have their benefits and faults is crucial for long-term investment success. Recognizing patterns indicative of a situation likely to succeed under either the coffee can, or cigar butt strategy allows an investor to tailor their analysis accordingly. This helps in determining whether an opportunity is attractive.

Both strategies can produce winners and losers based on similar analyses. It’s the investor’s responsibility to identify which opportunities are most likely to succeed within each strategy and to weigh the most attractive options at any given time. This discerning approach is key to navigating the complex landscape of investment strategies effectively.

It’s interesting to note that some characteristics are universally important in both the coffee can and cigar butt strategies. For example, share dilution is viewed negatively in both approaches. Conversely, share buybacks are favorable as they help increase the earnings per share value for consistent earners and also enhance the value per share of discounted assets.

Furthermore, returns on capital are positive indicators in both strategies. While the coffee can approach favors consistent returns on capital with a potential for growth, even modestly positive returns can significantly enhance the appeal of discounted assets in the cigar butt strategy.

Price discipline is a cornerstone of proper execution in both strategies, as is consistent idea generation and successful position sizing. These factors are essential regardless of the strategy being employed when assessing potential opportunities available.

It is important to note that the success of any investment strategy depends on thorough research, analysis, and understanding of the individual investor’s risk tolerance and financial goals. It’s worth mentioning that psychological aversions can sometimes hinder investors from effectively implementing one of the strategies due to various reasons.

In conclusion, the coffee can portfolio and cigar butt strategies offer investors different approaches to long and short duration investments. While the coffee can portfolio emphasizes stability, longevity, and long-term wealth accumulation, cigar butt investing focuses on undervalued opportunities and short-term profits. By incorporating elements of both strategies, investors can tailor their investment approach to suit their individual goals and risk appetite.

Information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity.  The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies.  This is for information purposes and should not be construed as an investment recommendation.  Past performance is no guarantee of future performance.