For many years, Warren Buffett’s stated goal was to increase the intrinsic value of Berkshire Hathaway by 15% per annum. By doing this, investors could expect Berkshire’s value – and, with time, its stock price – to double every five years. (In the Berkshire Owner’s Manual, Buffett candidly states that this is the upper limit of what investors should expect today given Berkshire’s massive amount of capital and the difficulty for any large business to compound intrinsic value at 15%.) Prem Watsa’s stated goal at Fairfax Financial is to increase book value by 15% per year.
Finding stocks that will double in five years is, I believe, an aggressive but realistic objective for an active individual investor who develops the requisite skills and works hard at it. If you achieve this goal over the long term – regardless of whether your annual returns are lumpy along the way – you can expect to soundly beat the S&P 500. Your much smaller capital base is a distinct advantage vis-à-vis large investors such as Buffett or Watsa who need to deploy billions of dollars.
What you are essentially trying to do is to figure out what a business’s shares will be worth in five years and then to look to buy them at half of that today. How you get there will be some combination of growth in intrinsic value and buying shares at a discount to intrinsic value. One example is to find a company that can grow earnings at 15% for the next five to ten years and then buy it at fair value. You then sit tight as the stock price rises in tandem with earnings growth. Another approach is to find a stable, high quality business and buy it for 50% of its intrinsic value with the expectation that, over the subsequent five years, the market will re-price the security to reflect its intrinsic value. If it happens sooner, your rate of return is even higher. Finally, there is the combination approach where your double comes not only from growth in intrinsic value, but also the closing of a valuation gap.
One more thing: however you get to your double, you should always include a consideration of certainty. One way to think of it is that your outcome will be a function of your expected return and the certainty with which you will obtain it. Ideally you want investments where the expected mathematical annual return is 15% and the certainty with which you will obtain it is near 100%. You may want to consider changes in your portfolio if you can exchange your current holdings – after consideration of taxes, if any – for ones that offer a higher expected return or a higher certainty of obtaining generally the same return as an existing holding.
There are other frameworks for beating the market, but this is a good one. It is both conceptually simple and within reach. It goes without saying that compounding at this rate over long periods can generate real wealth.