High returns won’t make you rich, BIG bets will
We had an interesting email exchange with one of our customers. He raised an interesting question and made us think hard. His question goes like this:
Can you suggest business/stocks growing more than 25% CAGR? I want compound my portfolio above 25% CAGR over long term.
Edited answer: There is no way to find in advance which stock may yield 25% CAGR. As stock essentially follows earnings growth, we are sceptical whether there would be many businesses growing above 25% CAGR over long periods. In past quite a few business grew at stellar rates as inflation was 10-12% and GDP growth was 8% (Market returns approx ~ GDP growth + inflation). Penetration was low and higher inflation made it easy to pass on the prices, earnings grew faster than volume growth.
Currently, inflation levels are at ~5-6% and GDP growth rate is likely to be 5-6% over 5-7 years (Market CAGR approx. 12-13% est.). In such situation, for a company to grow at 25% CAGR, almost double of market growth rate, seems quite impossible. Over 2-4 years a company may grow at higher growth rates, but we certainly doubt if it can grow beyond that, profitably. Hence, we do not wish to chase every high growth company.
We prefer sticking to quality companies which may come to a price such that we may earn 15-18% from our buy price. Since an average company in the market may grow at 13%, we may spot few companies earning 15%+ returns on equity. Some of our holdings will yield 15-18%, a few lower than that or even negative. However, we still stand a good chance to earn 15%+ returns provided we concentrate on high conviction and low downside ideas; keeping portfolio reasonably diversified in 10-15 stocks.
We cannot know in advance if a company can compound at 25% CAGR consistently. Also, no promoter or analyst or investor can be certain that a company would grow 25% CAGR. There will be few. Even if we do find one or two, can we bet our significant networth on just a few? Seems risky! Afterall, 25% CAGR is just a ‘hope’ and not a certainty! At the same time, it makes no sense in taking chances with 2-3% of portfolio on every other company which could be a multibagger. We may load up 25-30 companies and end up becoming the market, yielding average results. We instead bet heavily in a quality company even its just 13-15% CAGR with lower downside risk. Returns can be enhanced by building more stake. We think this is prudent and sound strategy.
Aiming for 25% CAGR, we may result paying up for a high growth company and thereby making our holdings susceptible to loss of capital. High growth companies react very negatively on slightest of disappointment in growth numbers as they trade at high multiples.
We advise not to aim for 20%+ portfolio returns to start with. One may earn once in a while or over short period, but over long term it’s difficult without taking high risk. Your financial goal should be to beat inflation to maintain our lifestyle and add 6-7% returns over it so as to generate wealth over long term (or retirement corpus). This means you need to earn bare minimum 11-13% returns. Any return beyond this benchmark is icing on the cake.
We have seen may of you betting just 3-5-10% of their net-worth in equity market and expect 20%+ CAGR. Let’s assume you end up earning 30%+ CAGR, it won’t help you getting wealthy or financially free as you bet just small % networth in great opportunity. It won’t significantly improve your lifestyle.
You rather earn 12-13% (conservatively) and bet entire networth in equity (Exclude residence). This will certainly make you wealthy over long term; and entire wealth being liquid it will be at your beck and call. Most Indians have illiquid Real Estate as 90% of networth (sometimes even leveraged), which earn nothing beyond 2-3% rental yield post maintenance costs. Capital appreciation can’t get much ahead of inflation rate over long term unless one is an expert distress property purchases. Since property is illiquid, you can’t think of selling it in hurry or can’t sell a part of it in case of emergency.
We think if you invest 40-60-70% of networth in equity (even index fund) at 13% CAGR, you can get UBER RICH over long term!