100 Ways to Beat the Market #26: Buy stocks that will double in five years.

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.

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7 thoughts on “100 Ways to Beat the Market #26: Buy stocks that will double in five years.

  1. tony b

    I have an even simpler idea . . . why not just buy stocks that are going to go up and short stocks that are going to go down? That is about as helpful as the advice presented in this article. If you could accurately predict a company’s earnings growth for the next 5 years why wouldn’t you also be able to directly predict its stock price too?

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  2. Greg Speicher Post author

    Tony, thanks for the comment. I do not believe it is the same. It is important that an investor has a clear idea of what they are looking for. This broad framework can help investors home in on what is important. Knowing the framework doesn’t enable you to “accurately predict a company’s earnings growth for the next 5 years”, but knowing that this is what you should be TRYING to do allows you to pass on all the businesses where this is not possible. You only need a handful of businesses to make this work and that is where you should focus. Again, you don’t need to value every business – nobody can – just a few. Knowing this distinction can make all the difference.

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  3. Aly

    This is really a great post Greg. And, great response to tony.

    It gets me to think about investing an entirely different way and one that is probably healthier for my portfolio.

    Thank you for the generous tips and please keep them coming!

    Reply
  4. Satyajeet Mishra

    True, Buffett has been looking at a 15% earning power in most if his investments most of the time. But as you mention, there is another important factor – the valuation gap. When Buffett was starting out – with less capital and under a very heavy influence of Ben Graham – he used to use the valuation factor more than the earning power factor. A study of Buffett’s early investments and examples in Ben Graham’s Security Analysis seems to suggest so. What do you think?

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    1. Greg Speicher Post author

      Sanyajeet, I tend to agree with you. Given Berkshire’s large amount of capital, their universe of prospective investments is much smaller and they tend to be much larger themselves. It is not generally practical to flip in and out of these companies. Moreover, they tend not to be available at the massive valuation gaps that show up more often in smaller, more obscure securities.

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    2. Oli

      In the early days of Buffett he used Grahams strategy (= buy cheap) – eg. net-nets (= stock price under book value). I hope I remember correctly, in the late 60’s as the net-nets became rarer and the “bad” expierence with Berkshire Hathaway, where the textile business economics worked against Berksire (he brough Berksihre under book value, liquidated the textile business over time and produced a loss). He conclude that he musst change his buy cheap strategy in buy good quality cheap. Now he is at the stage buy high quality at fair price.

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  5. Oli

    Hi Tony,
    in my opinion, over longterm the stock price will follow the earnings. I concluded, that you can not predict with any accuracy when the stock price will return from its depressed price to its fair price – only that it will. As I realized that I lost any interests in stock prices. For me the stock price is only an indicator when to get in or out of a stock – its not my wealth producer. In my investment philosophy it does not matter how long the timespan is between buy and sell because I am only interested in earnings of the business – they produce my wealth (and as long as earnings are kept in the business and I do not sell the stock, I do not pay taxes on them – its a “little” snowball effect besides the compounding retained earnings ;).
    For me I switched my focus from business valuation (when is the stock cheap?) to the working economics behind the business (What earnings can I expect? What are the critical factors to the business model / competitive advantages?). I think a rough, conservative valuation is enough to decide which price is an attractive investment.
    I think with that combination of both knowledges I can discover businesses which having sustainable competitive advantages at an absolute cheap or fair price, which leads to compounding wealth.

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