So You Want to Compound Capital… But Can You Avoid “Torpedoes”?

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As investors, we all seek it and want to benefit from it: the power of compounding. Albert Einstein is said to have called the power of compound interest the most powerful force in the universe. But what is the essential prerequisite for compound interest? No, it is not having the highest investment returns. Above all, it is the avoidance of large losses.

We all like to sing the praises of compound interest. Yet as many asset prices continue to climb new highs, more and more investors seem to be disregarding what it takes to actually stay on the path of compounding: looking down first, before looking up. The latter, more optimistic mindset seems to be ruling the day again: back in vogue are valuations based on leveraged buyout multiples, activist proposals and the like. While most fund managers are out fundraising again, what should be a clue is Seth Klarman doing the opposite at Baupost!

Another great value investor that truly grasps the power of compounding is Jeffrey Auxier, President and Chief Executive Officer of Auxier Asset Management. In the excerpt below, Jeff explains how he thinks about the challenge of compounding capital, or in his words, how to look for “double-plays” while avoiding “torpedoes.” The full video of my conversation with Jeffrey Auxier is available to attendees of Best Ideas 2014 here.

Jeff Auxier on How to Look for “Double-Plays” and Avoid “Torpedoes” in Investing

Jeff Auxier (transcript): “We’re always looking for the double-play. That’s a low valuation business. In other words, one that the investment community is down on, sells at a very low multiple of earnings, a low multiple of cash flow, but has a strong balance sheet…So we like to buy where the prices are at bargains and then to compound we want the double-play. Like in 1983, we bought Waste Management (WM) at 9x earnings. It had all kinds of clouds over it. Their earnings more than doubled over the next six years. The stock went from 9x to 40x, so we made 9x our money. So you need to get the double- and triple play to have the margin of safety.

The opposite is a “torpedo,” a highly-valued, popular business that everybody loves. It’s a magnet for new capital that comes in, and they miss, and you torpedo. So the key to compounding is you can’t take big hits…you’re always on the lookout of how can I get hurt. So, we’re just constantly looking at the portfolio to make sure it is compelling: compellingly priced, compelling fundamentals, there’s a turn up in the fundamentals. We’re trying to catch that turn when the market is down on something but we see there’s a turn.

A good example a couple of years ago is Weight Watchers (WTW). It dropped down to $26. It was 8x earnings. The market was down on it, forecasted flat numbers for several years, but they were doing a lot of energetic things as a management team with online initiatives and celebrity endorsements and, sure enough, their sales went up double-digits. The stock went from $26 to ultimately $80. [Editor’s note: Weight Watchers has again lost favor with investors as its share price has declined from more than $80 in March 2012 to about $30 recently. The equity may deserve another look at recent prices].

So, that’s where you’re just constantly grinding, looking for the turn because there is always something turning up, and on the flipside, turning down. You’ve got to be on those fundamentals. It gets back to that rigorous daily research because you got to catch the turn, but you got to make sure that price is compelling as well. You can have a great company – Coke was 50x earnings in 1998 at $80…so you can have a great company, but it doesn’t mean you will make money in the stock.”

 Jeff Auxier is one of the instructors at Best Ideas 2014, the fully online investment conference taking place live on January 7-8, 2014.