Challenging Times

Dear Partner 👋

I hope you are doing well.

Let’s face reality: times are currently very challenging for Quality Investors.

In this article we’ll dive into some facts and give you an update.

Challenging Times

You don’t believe me that times are challenging?

Let’s give a few examples.

1. Chuck Akre

Chuck Akre is a very famous quality investor who owns some of the best companies in the world.

Here are his top 10 positions:

Source: Fiscal.ai

Chuck Akre has built a very strong reputation and track record for himself over the past few decades.

But lately, he has been underperforming the market.

As a result he’s now even slightly underperforming the S&P 500 since inception:

2. Terry Smith

Another famous quality investor is Terry Smith.

I had dinner with Team Fundsmith at Gorrat’s in Omaha in 2024.

The least I can say is that these people are incredibly smart.

Terry Smith’s investment strategy is simple, but beautiful:

His top 3 positions are:

1. Stryker ($SYK)

2. Marriott ($MAR)

3. L’Oréal ($OR)

He managed to report very attractive returns using this strategy.

But recently, Terry Smith is struggling. He underperformed over the past few years:

3. Compounding Quality

The same is true for Compounding Quality.

The goal is (and remains) to outperform the market by 3% per year on average.

Partners of Compounding Quality can see the Portfolio, all transactions, and the CAGR of the Portfolio 24/7 with full transparency here.

While some companies are doing well:

• Games Workshop ($GAW.L): +100.8%

• Medpace ($MEDP): +80.6%

Others are struggling:

• Evolution AB ($EVO): -26.9%

• Novo Nordisk ($NOVO-B): -39.5%

The above also shows you the importance of position sizing.

A few big winners (or losers) can make or break your return.

As Peter Lynch said:

Should we start worrying?

In the Community, I notice some people are becoming a bit nervous.

Here’s a great example:

I feel you.

Emotionally it’s not easy to handle periods like this.

But if I read things like this, it also makes me think the turning point is near.

It’s very similar to this statement regarding Novo Nordisk:

When your barber starts to give you investment advice, it’s time to run away.

When people are becoming desperate, it’s usually a great time to buy more.

As J.P. Morgan once said:

So let’s face reality: times are challenging for quality investors right now.

Very challenging.

But as Napoleon said: "A genius is the man who can do the average in when everyone else around him is losing his mind."

Here are two questions we should answer for ourselves:

• Does the strategy not work anymore?

• Or are we in a very strange market environment today?

I think it’s the latter.

To make my point, let’s look at the yearly returns of Warren Buffett, the best investor in the world.

Warren Buffett compounded by almost 20% (!) per year since 1962.

If you invested $10.000 in 1962:

• S&P 500: $6 million

• Berkshire Hathaway: $3.6 billion

The difference is ridiculous… $6 million versus $3.6 billion.

You could take away 99% of Berkshire Hathaway’s return and you’d still have outperformed the index.

That’s the power of compounding over very long periods of time.

But does this mean Warren Buffett outperformed every single year?

Not at all.

Just look at 1999 in the table below.

In 1999, Berkshire Hathaway was down 19.9% while the S&P 500 increased by 21%.

That year, Warren Buffett lacked the index by 40% (!).

You saw headlines like this popping up in 1999:

We all know what happened just after 1999: the burst of the Dot-com bubble.

I truly think we are in strange time in the market right now.

Even though Quality is facing a very hard time, I sincerely believe we are on the right path.

My role? Try to be your guide on a wonderful hike that leads to beautiful views.

But right now, it’s raining and very slippery.

So what do you do now?

Do you blame me?
Do you return to the beginning of the hike?
Or do you leave me and find your own way, even when the road ahead is uncertain?

The best thing you can do during challenging times, is to stick to the plan.

The plan we already outlined in Our Owner’s Manual in 2023.

Because when you get to the top of the mountain, the view will mean so much more.

Top of the world - Malta

Dollar-Cost Averaging versus Fully Invested

Compounding Quality is read by over 500.000 people.

Every situation is unique.

You might be in a completely different phase of life than someone else who is reading this article.

• Some people are still in their ‘wealth accumulation’ phase and add to their Portfolio every single month

• Other people are fully invested already

Adding every single month (Dollar-Cost Averaging)

Life is easy when you can add to your stock portfolio every single month:

1. If the stock market goes up, you make money

2. If the market goes down, you can add to your portfolio at cheaper prices

At Compounding Quality, we add $50.000 to our existing Portfolio every single month.

Currently, Our Portfolio is worth $1.38 million.

I want to keep investing for as long as I can.

Warren Buffett is 95 years old. Me? I’m 29 years old.

If I could keep investing for the next 66 years at a return of 12% per year, Our Portfolio would be worth:

• Without adding to the Portfolio: $3.8 billion

• With monthly additions: $17.5 billion

Once again, that’s the magic of compounding put to work.

Fully invested

But what if you’re fully invested already?

When you’re facing tough times, it’s definitely harder when you’re fully invested already.

On the other hand, there is no reason to worry. In the long term, stocks always go up.

Let’s teach you why you should feel comfortable today…

Why you should feel comfortable

Even tough times on the stock market are challenging for Quality, I feel very comfortable with our current positioning.

This too shall pass.

There are three things you should care about as an investor:

1. Portfolio Fundamentals

2. The evolution of the Owner’s Earnings

3. The evolution of Free Cash Flow

1. Portfolio Fundamentals

Every month, we compare the Portfolio Fundamentals with the S&P 500.

Here’s what things look like today:

It’s crazy to see that we own fundamentally way better companies while they are trading at a discount compared to the market:

• Forward P/E Portfolio: 17.1x

• Forward P/E S&P 500: 22.0x

Terry Smith uses a very interesting rule of thumb to calculate your expected yearly return as an investor:

Expected return = EPS Growth + Earnings Yield
Wherein Earnings Yield = 100/ Forward P/E

Expected return = 7.6% + (100/17.1x) = 7.6% + 5.8% = 13.4%

The expected return for Our Portfolio currently equals 13.4% based on this rule of thumb.

And the S&P 500? According to J.P. Morgan you could expect a return of 0-5%:

2. Owner’s Earnings

You know that in the long term, stock prices always follow the evolution of the Owner’s Earnings.

Source: Clearnomics

It’s very easy to calculate this metric:

Owner’s Earnings (Change in %) = EPS Growth + Dividend Yield

Here’s what the evolution looks like for Our Portfolio:

In the next 3 years, Our Portfolio's Owner's Earnings should increase by 13% annually.

If this would be correct, the return of Our Portfolio should follow.

3. Free Cash Flow

Just hear me out for a second…

… You are the owner of a company and you want to keep running it for the next 50 years.

You never want to sell.
You want to build something that lasts.

In that case…

Should you care whether someone wants to buy your business for 3 times revenue or 5 times revenue today?

No. It doesn’t matter.
The only thing that matters is the Free Cash Flow it generates for you.

You should think exactly the same about your stocks.

Here’s what the evolution of the Free Cash Flow for Our Portfolio looks like:

In other words, year after year Our Portfolio is making more and more money for us.

That’s the only thing that matters.

The stock prices will follow, eventually.

Conclusion

Here are the key takeaways from today’s article:

• Quality is currently facing a tough time. Short-term pain is the price of long-term gain.

• There are only three things you should care about as an investor:

  1. Portfolio Fundamentals

  2. The evolution of the Owner’s Earnings

  3. The evolution of Free Cash Flow

• Stick to the plan. You should let the magic of compounding work for you. Invest in great companies that keep growing their intrinsic value over time.

Last but not least, I’m very curious to hear your feedback.

It would mean the world to me as it helps to take Compounding Quality to the next level.

Everything in life compounds
Team Compounding Quality
PS You are not a Partner of Compounding Quality yet? Discover everything you need to know here.

Book

• Order your copy of The Art of Quality Investing here

Used sources

• Interactive Brokers: Portfolio data and executing all transactions

• Fiscal.ai: Financial data

Disclaimer

As a reader of Compounding Quality, you agree with our disclaimer. You can read the full disclaimer here.