DKAM-final newsletter5-a

3 3 2 ROE REPORTER | DKAM What we need to do is pick the most efficient capital allocators and let them compound the values of their businesses. The market will eventually reward the most efficient companies. Compound growth can only be ignored for so long. We’re able to sleep well at night knowing each year, quarter, and even day, our businesses are growing the underlying values of their companies. 88 MPH Marty McFly had to reach a speed of 88 mph in order to travel through time. For us, the critical threshold for a company to outperform the market, is to have an ROE over 20%. The market average ROE sits around 10%, so in order to outperform the market, you would want to own stocks with ROEs above 10%. But why stop there? The ROE threshold of 20% allows for a concentrated yet diversified portfolio of roughly 10-20 stocks, while still optimizing compound growth and eliminating less valuable companies. As Buffett’s assets have grown in size, he has had to lower his hurdle rate, as his size has forced him into larger capitalization stocks. The average market cap of Berkshire Hathaway’s stock investments is now $109 billion. Staying small and nimble has allowed us to remain disciplined with our targets and continue to invest only in very high ROE companies. When Lightning Strikes If you research investing techniques, you’ll find the most common topics refer to Value versus Growth investing. We are over-simplifying, but there is a certain practical usefulness in thinking of it this way. We’ve established why we and Buffett think growth investing based on Return on Equity is optimal. However, it is still helpful to review the alternative, and to understand the psychology of investing based on searching for bargains. We refer to a lot of value stocks as being Hotel Californias, paying homage to the iconic Eagles song with the verse “You can check out any time you like, But you can never leave.” This is the main issue with value investing: the unknown variable of time or – in other words – the value trap.