By David Kaufman
Two dominant themes inevitably present themselves when discussing the purpose of investing: capital preservation and capital growth.
Many investors would be happy to preserve their capital over time, producing enough income to live on and enough growth to keep up with inflation (i.e., keep the spending power of the capital constant). Others are more intent on growing the capital substantially over time, worrying less about deriving income in real time and more about impressive long-term growth that results from the power of compounding double-digit returns.
Which camp you’re in depends on how old you are, how much employment income you generate, and how large your investment portfolio already is. If you’re retired and have saved ‘just enough’ to live on, you are much more focused on protecting your capital than growing it. Conversely, if you are relatively young, have a secure job and keep your costs under control, you can focus on growing your portfolio.
There are a variety of methods to derive income from your investments, such as investing in bonds, mortgage funds, REITs and dividend-paying equities, but there is only one way to achieve growth over the long run that exceeds inflation: equities. Equity investments come in many forms.
First, there are public equities — common stock of companies listed on exchanges such as the TSX or S&P 500. These range from large companies with long track records and consistent dividends to tiny companies with no earnings but a good story to tell.
Then there is private equity, which also comes in many shapes and sizes. Entrepreneurs who own their businesses are private-equity investors, as are those who eschew the public markets in favour of buying private businesses, either for cash flow or with an eye to value-added activity, especially when those businesses are in distress.
If you were to spend some time reading the biographies of the wealthiest people on the planet, virtually every one of them (leaving aside those who simply inherited their wealth) made their fortune in private equity.
For example, Bill Gates started Microsoft at the age of 20 and built it into one of the world’s largest companies, while Warren Buffett is generally considered the savviest investor of the 20th century.
Although Buffett was an early disciple of famed value investor Benjamin Graham, who wrote a number of seminal pieces on how to make money investing in the stock market, the vast majority of his wealth has come through purchasing companies outright and reaping huge rewards by applying sound and disciplined management.
If you look further down the list of the wealthiest people, the trend continues: Larry Ellison (Oracle Corp.), the Walton family (Wal-Mart Stores Inc.), Michael Bloomberg (Bloomberg LP), Jeff Bezos (Amazon.com Inc.) and Mark Zuckerberg (Facebook Inc.).
No matter how far down the list you go, you won’t find anyone whose fortune was primarily the result of stock trading, unless you include some of the largest hedge-fund managers, whose actual fortunes resulted not from trading in stocks, but from collecting enormous performance fees from their clients.
What can the average investor learn from this? First, unless you have a truly innovative idea at the right place and the right time, you probably won’t end up on the wealthiest list. And, second, if you want to really grow your investments, you must either invest in private equity or take a private-equity approach to investing in the public markets.
In the case of investing in private equity, you can either bet on yourself by starting a business, or on someone else by investing in a private-equity fund (in which case, you must really believe in them because you will be tying up your money for a very long time).
Taking a private-equity approach to public equity, meanwhile, means making very concentrated bets on companies that you understand, know intimately and believe can survive difficult economic conditions.You must have strong convictions if you take this approach, since the market will at times disagree with your assessment, and you will have to either ignore what the market is saying or not care.
There is no third choice.
It’s true that diversified equity investors might be fortunate in certain cycles, potentially doubling their money in five years or less during bull markets.
But anyone who wants to move the needle in a meaningful way better have a good idea or be willing to make a long-term bet on someone else who does.