Build a Lasting Dynasty
Kyle is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
“My friends, you bow to no one!” This line, taken from The Lord of the Rings: The Return of the King (2003), is one that each of us, as investors, would love to hear. To throw away our time cards, fire our bosses, and enjoy a life of financial freedom where we bow to no man! Oh, what a life that would be. The good thing for you and I is that this phrase can apply to us easily enough, assuming we follow the rules which were epitomized by Shelby Cullom Davis and his family.
The Davis Dynasty, by John Rothchild, outlines the life of Shelby Davis and the critical investing lessons he learned. Davis, who was able to turn $50,000 into $900 million, passed these same lessons on to his children, who in turn passed them on to their children. The two most important aspects were, and still are, the rule of compounding interest and the importance of time. It was on these two pillars that Davis built his investment philosophy, which, as you can see below, yielded great success.
Graphic source: http://davisfunds.com/funds/nyventure_fund
With this investment philosophy in hand, the Davis family went about finding companies which fit certain criteria. First, the family sought companies which had earnings growth, but a price/earnings multiple that did not reflect it. A rule of thumb was to have a P/E multiple that was lower than the earnings growth rate. Second, they were not tempted with the next superstar company. It was much preferred to purchase a company growing at 12% for 10 times earnings than it was to buy a company growing at 40% for 30 times earnings. The reasoning behind this was the real possibility of multiple contraction if the growth rate of 40% slowed. Finally, the Davis family believed in letting their winners ride. By doing this, an investor is able to keep transaction costs low, as well as avoid large capital gains taxes. Now, let’s find a couple blocks on which to build our dynasty.
To start, let’s take a look at the world’s largest company in terms of market capitalization, Apple (NASDAQ: AAPL). This company has been on a tear recently, climbing from around $100 per share 5 years ago, to $569.18 as of the close of market today. Apple has been riding a tidal wave of great products over the last few years, with the iPod, iPhone, and the iPad selling like hotcakes around the world. Because of its innovative products, Apple has seen its profits rise 52% for fiscal year 2011, 116% in Q1 2012, and 92% in Q2 2012. Typically, this would be the type of stock avoided by the Davis family because a company growing at rates this high would hold a multiple of 30 or 40. In this instance, the company sports a multiple of just under 14. Although the high growth rate does not jive with the concept of slower growth companies, I think the low multiple more than compensates.
Next, let’s check out a potentially explosive stock, Exelon (NYSE: EXC). This company operates in the field of energy generation, particularly in the nuclear and natural gas arenas. Unfortunately, earnings decreased 27% in Q1 2012. The two main contributors to this decline were unusually mild weather and unnaturally depressed natural gas prices. Due to the most recent declines in earnings, the stock currently trades at a multiple to earnings of just under 13. That being said, I think this company will really take off as natural gas prices start to rise. When this happens, not only will earnings increase, the multiple to earnings should also increase; a so called “Davis Double-Play!” To top it off, investors receive a 5.5% dividend while they wait for this thesis to play out.
Now that we have a strong foundation, we can return to our two pillars of compounding and time. By combining the two, we allow our companies to compound our earnings, tax free, over a long period of time. By using this investment philosophy, we come one step closer to attaining our financial freedom by following in the furry footsteps of the two heroic Hobbits and eventually we, too, will bow to no one.
Fool blogger Kyle Campbell owns shares of Exelon. The Motley Fool owns shares of Apple. Motley Fool newsletter services recommend Apple and Exelon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.