Bookworm: An investing lesson from the world’s second richest man

Welcome to the next edition of Bookworm, my weekly column that seeks helpful insights from investing books and shareholder letters.

Today’s insight

As the creator of one of the world’s biggest and most widely known companies, Jeff Bezos needs little introduction.

His letters to shareholders during his tenure as Amazon CEO hold plenty of lessons for investors, as well as those (perhaps a bit optimistically) hoping to emulate his business success.

Bezos’ shareholder letters through the years centred on a small number of recurring themes, which included:

An obsession with the customer and delivering more value to them.
Never letting malaise set in.
The importance of having a long-term focus.

One aspect of long-term thinking that Bezos highlighted quite early on, in his 2003 letter, is the difference between acting like a business owner and simply trading in and out of stocks. He illustrated this through a story:

As Bezos suggests, owning an asset rather than merely taking possession of it for a while can completely change your mindset regarding the asset, be it a house or a common stock holding. Here are four ways I think this change in mindset can change the game for equity investors.

It changes your likely source of return

Short-term changes in the price of a company’s shares are likely going to be dictated by a mix of 1) shifts in investor sentiment towards the company, its sector or the broader stock market and 2) how the company’s short-term results and outlook match up to the market’s previous expectations.

The longer your holding period, the more your return as a shareholder will mirror changes in the company’s intrinsic value and earnings power. As Ben Graham’s most quoted quip goes, the stock market is a “voting machine” in the short term and a “weighing machine” in the long-term.

Many investment commentators, from Howard Marks to our own Lochlan Halloway, have written about how hard it is to make profitable bets on short-term events. In addition to nobody having a crystal ball in regard to the event itself, it is just as hard to predict how markets will react to that event.

By contrast, the medium-term direction of some (but definitely not all) businesses can be a lot easier to make a confident bet on. Companies, for example, that have an incredibly strong competitive position in a market that clearly has favourable long-term prospects. If you agree with Ben Graham’s assertion that markets will eventually get the value of companies roughly correct, doesn’t taking a longer-term approach seem a lot easier?

It changes the questions you ask

Taking this kind of approach shifts your focus and attention from short-term issues – what will earnings be in the next quarter, how might the stock perform over the next year, et cetera – to a very different set of questions. You will likely be more interested in things like:

What the business might look like in ten years.
How big its main markets will be
What market share and competitive position the company is likely to have
What sales growth might look like, and what profit margins it might be able to make
What opportunities will it have to reinvest profitably in its business

The famous investing duo Nick Sleep and Qais Zakaria spoke a lot about “destination analysis”. Above anything else, they wanted to be almost certain that the firm’s value and competitive strength being considerably higher many years from now.

The primary way that Sleep and Zakaria did this was by identifying superior business models that become more and more competitively advantaged as the business grows. You can read more about their “scale economies shared” framework and other key takeaways from their investment letters here.

It changes your assessment of “how things are going”

Ask a stock renter how things are going with their investments, and they will probably tell you the returns they have achieved over the past quarter, six months, or year. Perhaps versus a benchmark like the ASX200 or the S&P500 index.

Thinking like a long-term business owner rather than a trader entails thinking differently about this too. If the business wasn’t publicly quoted, for example, how would you, its owner reply to the same questions?

You’d probably look at metrics like revenue growth, profitability, returns on equity and market share. Or at other things like how the company’s research and development efforts are translating into better products and services.

In the Warren Buffett Way, Hagstrom writes that Buffett looks at the “look through earnings” of his investment portfolio – the collective improvement in underlying profits – rather than using the far more capricious market prices as his scorecard. Taking a similar approach can help you stay focused on the right things and ignore market noise.

It should make you more picky

If you start viewing every investment as a long-term commitment rather than a short-term trade, the bar you set for hitting the ‘buy’ button in your brokerage will rise too. Going back to Bezos’ example of renting versus owning a property, you might accept certain trade-offs in a short-term rental that you wouldn’t be able to put up with in your ‘forever home’.

Knowing that there probably aren’t that many companies suitable for a long-term buy and hold approach should also make you more loathe to sell. You will need to find somewhere else to put the money, and there is a severe risk that the new business won’t be as good as the business you are leaving behind.

Because it allows to the magic of compounding to take place uninterrupted, owning a great company for this long (as long as it really does have the qualities required to keep growing in value over such a long timeframe) opens you up to the possibility – not the guarantee! – of achieving the kind of returns that are essentially impossible to achieve otherwise.

This is why Bezos advocates that if you find such a jewel, you should probably hold on to it.

You can learn more about the virtues of buy and hold investing in this article by my colleague Mark Lamonica.