Thursday, August 25, 2016

My observations on wealth building

My journey to try and accumulate wealth has been an interesting one. I’ve learned many interesting lessons over this period of time.

Dollar cost average into a stable index

Steady accumulation into a low-cost index is a great way to build up consistent wealth. Over time, the value of a broad-based index steadily increases as the underlying companies within that index improve their performance.
Dollar cost averaging ensures that you take advantages of market volatility and downturns in pricing. Also the beauty of an index that it will respond to structural changes in the economy and discard those companies that are poor performers or become irrelevant.

Stick with businesses that have sustainable competitive advantages

I have a personal preference for businesses that have strong differentiation I want businesses that can stand the test of time. That’s important to me because these businesses typically not only have superior returns but it also means that I don’t need to be chopping and changing and finding new businesses on a constant basis.
I tend to have a preference for businesses that have some element of switching cost or that have natural monopolies. Marketplace businesses tend to be ones that particularly interest me. While you don’t think of Visa and MasterCard as marketplaces per se, the reason that their business is so strong is they have to build up a two-sided marketplace both with consumers and also with businesses from an acceptance point of view.
Switching costs are also another great moat, particularly in the medical devices area. The implantation of heart pumps of the type that Abiomed uses tends to require significant surgical training resulting in switching costs for surgeons in implanting a new device

Be prepared to hold for years

I’ve learned over time that high-quality businesses that significantly outperform tend to be few and far between. A company’s investment return typically follows a bell curve where the best of the best are in a significant minority, all on their own at the top of this distribution.
That makes sense when you think of venture capital. It’s the outliers that account for the high returns of the fund as opposed to the ability to hit constant singles and doubles. Finding one of these extraordinary businesses is difficult enough but exiting such a business prematurely is a sure way to insure that your returns quickly deviate back to the mean.
The only way to put yourself in a position to take advantage of finding such quality is to be prepared to hold these businesses forever and to let them grow and compound indefinitely. Frankly there’s also nothing better than to endlessly differ tax on unrealized capital gains and let that tax-free loan from the government also compounding value over time.

Go with high returns on assets

I have an inherent preference for those businesses to generate high returns on assets and high returns on equity.
Based on my own observations it appears that there is a strong correlation between the rates of return on equity and the long-term performance of businesses.
Provided that you can find a business that has good growth prospects and which is running high returns on equity that is likely to lead to strong long-term outperformance.
Typically this combination of growth drivers plus high returns on equity means that retained earnings can be favorably reinvested in high returning prospects which make the compounding of wealth all the more accelerated. Getting these businesses at a fair price can then put you in the driver seat to generate fantastic returns for many years to come

Stick with cash rich businesses

I’ve learnt to place more of my investment capital in businesses that are in control of their own destiny.
That typically means looking at businesses that have relatively low long-term debt and high cash generation. Being in control of their own destiny can help mean the ability to more readily ride out inevitable economic downturns and cyclical fluctuations in a given business. I also prefer companies that have a relatively low need for ongoing capex to sustain profitability.
This can create a long-term drag on business prospects. Capex remains a fixed cost expenditure that generally needs to be incurred to run operations on a regular basis.
I’ve learned over time that a strategy of being a long-time partner in a great business seems to work best for me in being able to generate above normal returns on my investment. Of course there are likely to be many other ways to build sustainable wealth over a long time.

This article was written by Financially Integrated. If you enjoyed this article, please consider subscribing to my feed.

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