Published: January 17, 2025
Greetings and Happy New Year from Middleburg.
2024 was a good year for stocks, just not as good as the headlines would have us believe. Consider the disparity between the 25.02% performance of the market capitalization-weighted S&P 500 Index, and the 13.01% performance by the equal-weighted S&P 500. The disparity of returns continues to be driven by the outperformance of the largest market-capitalization companies, a technology-oriented group renowned as the “Magnificent 7”. According to an article from Inc. Magazine, the aggregate weighting of the Magnificent 7 in the S&P 500 has increased from 20% at the beginning of 2023 to around 33% today—growth, which has significantly distorted the index return.
According to Goldman Sachs, the S&P 493 returned 13.76% in 2023 and 15.92% in 2024, which amounted to a cumulative total return of 31.87% over the past 2 two calendar years. In absolute terms and under normal market conditions, this would be considered strong performance. However, the Mag 7 collectively returned 76.27% in 2023 and 48.41% in 2024, which amounted to a 161.60% cumulative return over the past two calendar years and accounted for over half of the S&P 500’s cumulative 57.59% total return over this period.
Year-End Thoughts on Our Favorite Subject: Compounding
“Compounding” is a word often used among investors to describe what they hope to achieve for their capital. Compounding is invoked so frequently that one would think it was the standard aim and practice among investors. Aim? Perhaps. Practice? We are less sure. The uncertainty stems from our long-held view that compounding capital is a distinct discipline with distinguishing characteristics rarely found in practice.
Compounding’s basic ingredients are well known. Time, of course, is the most important. We appreciate the Buffett/Munger analogy of a snowball rolling down a hill; the key to compounding being a very long hill! Rate of return is another key ingredient for compounding but is still fundamentally attached to time. A snowball rolling faster (analogous to a higher rate of return) down a short hill will not compound in size nearly as much as a snowball rolling more slowly down a long hill.
The importance of time to compounding is widely known, but routinely undermined in practice. One reason is that investors are often more tantalized by rapid growth than by durability. Rapid growth rates are easily observable and easily extrapolated and thus tend to be overweighted in importance; whereas, the length of the proverbial “hill” is harder to discern. We believe endurance (that of investors and investments) and setting proper expectations are critical to a compounding investment practice. Environmental factors are also making it increasingly difficult for investors to harness the power of time and so compound. We lump these environmental factors under the term abstraction. Abstraction, endurance, and expectations all mix and mingle somewhat, but are all crucial to identifying and sticking to the compounding path.
Abstraction
Benjamin Graham wrote, “Investing is most intelligent when it is most businesslike.” To us, that means never losing sight of the fact that owning a stock is to own a stake in an operating business with all its attendant complexity, including the nature and durability of any competitive advantage, the quality of the people and culture, and the reinvestment opportunity and acumen. Our “three-legged stool” approach centers on these dynamics: Business, People, Reinvestment. It is the encapsulation of our investment process and is expressly and intentionally “most businesslike” in its focus. This process demands that distinctions be made between a business and the movements of its share price, or said differently, to being served, rather than instructed, by the stock market. For investors, understanding the businesses they own protects against emotional reactions to share price movements. Hasty decisions tend to rob investors of time, the most critical element of compounding.
Unfortunately, financial innovation continues to bury that fundamental connection between investor and business beneath increasing layers of abstraction. Since the turn of the century, equity investing has increasingly become less about owning specific businesses and more about managing generic “exposures”. Investment professionals are often more concerned with exposures (or lack thereof) relative to a benchmark rather than with the individual businesses owned. Financial innovation has aided and abetted this seismic shift. Investors of all stripes can now, with a single security, own virtually every publicly traded company on earth and any subset thereof. Want exposure to the hottest theme/sector/country/crypto? Buy this sector ETF. Want that exposure leveraged 2x or 5x? There are products for that, too. Have at it! You can always change course as soon as you have a bad day, typically without even a trading fee to serve as a speed bump.
The insidious effect of this mounting abstraction is the shrinking of investment holding periods. In the 1950s, according to an April 2022 study by Reuters, the average holding period for NYSE-listed stocks was 8 years. According to our own analysis using Bloomberg, the average holding period for NYSE-listed stocks fell to 18 months in 1997 and eight months in 2023.
The average holding period for individual stocks has become short, but the “abstractions” are far worse offenders. Representing the abstractions are passive exchange-traded funds (ETFs). Passive ETFs, via a single security, offer generic exposure to whole industries, sectors, and market indices. According to our analysis, the average holding period for ETFs (both passive and active) traded on the NYSE ARCA exchange was one month in 1997 and two months in 2023. The average holding period for “SPY”, the largest ETF replicating the S&P 500 index, was 16 days in 1997 and 17 days in 2023.
Clearly, renting generic exposures doesn’t encourage the same steadfastness as owning specific businesses.
Abstraction to the generic makes it easier to disconnect from the subject at hand. On the other hand, specificity demands thought, awareness, connection, and thus friction. This concept was expressed brilliantly by none other than Homer Simpson during a family dinner in response to objections raised by his daughter, a budding vegetarian: “Lisa, get a hold of yourself. This is lamb, not a lamb.” In a similar vein: this is stock, not a stock.
Innovations like passive ETFs and the fee compression that accompanies them would seem like positives for investors. But the focus on fees ignores much larger costs. When the investment process shifts from owning great businesses to managing abstract exposures, investors—unconnected to what they own—find it easier than ever to change course, reduce their holding period, and so cheat themselves of time. Compounding simply cannot occur over 8 months, 2 months, or 17 days. Tellingly, while the average holding period for stocks has reduced over time, the average holding period for the abstractions has always been much lower. This is by design, if not intent. Abstraction is the enemy of holding period and therefore compounding.
So is human behavior.
Endurance
Whatever the rate at which an investment compounds, its investors categorically compound at something less. This stems from the very human tendency to buy after the price has risen substantially and/or sell after the price has dropped substantially, or (more insidiously) “underperformed.” Morningstar publishes an annual report titled “Mind the Gap” that quantifies the extent that investors underperform their mutual fund and ETF investments over rolling 10-year periods. The latest report for the 10-year period ended December 31, 2023, shows that mutual funds and ETFs overall returned 7.3% annualized net of fees but that investors earned 6.3%–a full 15% less than their investments. Poorly timed buying and selling cost investors 15% of the annual return they would have earned had they simply bought and held, and that before the impact of taxes. To make matters worse, that 15% haircut was just the annual average. Compounding only increases the cost of this behavior when stretched over decades.
Investors need endurance to compound in accordance with their investments. Endurance is also required of the investments themselves. The goal of our investment process is to identify businesses capable of compounding capital at above-average rates for very long periods of time. Accordingly, we are more “hill-focused” than “speed-focused”, though, to be clear, we want to own businesses growing at attractive rates. Few businesses meet our criteria and valuations are rarely opportune. This is what informs our concentration (high) and our portfolio turnover (low). But when the stars align and we finally buy, it is our “businesslike” investment approach that enables us to hold on and benefit from the compounding taking place at the per-share level of the business. Whether it’s enduring as an investor or identifying enduring investments, both sides of the endurance “coin” are served by knowing the businesses owned rather than formulating an opinion based on breathless hype and recent share price movements.
Expectations
We wrote in last year’s annual letter about the stock market’s 100-year compound annual total return of approximately 10% and the fallacy of believing that return was every investor’s birthright. That “market return” accrued only to those who held on for those hundred years through recessions, depressions, world wars, high interest rates, pandemics, Fed tightening cycles, etc. As illustrated above, the tendency to buy and sell at inopportune times means that investors have earned some fraction of the “market return”. This gets to the importance of setting proper expectations.
We wish it was otherwise, but compounding capital at an attractive rate cannot always be smooth sailing. Real boats rock. It is as unrealistic to think that one can dance between every raindrop as it is self-defeating from a compounding standpoint. Simply expecting recessions, interest rate fluctuations, geopolitical tensions, high and low valuations, outperformance and underperformance over the course of a long holding period can be very empowering. For example, we expect the exceptional businesses we own to have high valuations much of the time. We also expect that the businesses we own or want to own will periodically have low valuations due to market conditions and/or particular concerns that arise. The first expectation keeps us compounding in exceptional businesses already purchased well. The second expectation helps us stay patient with shareholder cash and explains why we will often go years between adding to existing positions or establishing new ones. We believe such rational expectations are crucial to compounding.
We endeavor to compound capital over decades at an above-average rate of return while incurring a below-average level of risk. Our investment process is designed to be “most businesslike”, avoid abstraction, and promote the endurance and expectations that we believe support this goal. We wish you a wonderful winter and thank you for your continued support.
John Neff
The investment examples included herein have been selected based on objective, non-performance selection criteria, solely to provide general examples of the research and investment processes of Akre Capital Management. The investment examples should not be construed as an indicator of future performance. The information presented above should not be considered a recommendation to purchase or sell any particular security. There can be no assurance that any securities discussed herein will be a part of any portfolio or, if sold, will not be repurchased.
