Thank you James for this text, it includes some interesting thoughts. For example: “He pointed out that had it been a private unlisted company, he would never have considered selling it” I never thought about that from this angle.
On the other hand take Costco. They have an EV/EBIT of 47, inverted that is a yield of 2.1%. I do not want to own a business like this.
I guess in the end it is a subjective question everybody has to answer for himself.
Costco’s valuation only matters if you're thinking about buying today. At its current price, the earnings yield might not hit the threshold of what an intelligent investor would consider acceptable.
But what if you bought Costco years ago, back when it was trading at a more reasonable valuation? Should you sell now just because the market says it’s overvalued? That’s like Phil Fisher’s Motorola situation (as I explained in the article).
I used to think of investing like this: buying a stock is choosing between owning it or keeping the cash for something else. Then I applied that logic to selling: if I didn’t sell, it meant I thought the stock was worth more than cash. So, holding a stock was like “re-buying” it every day.
Turns out, that mindset isn’t quite right. Let’s break it down with some math.
When you and I buy a stock, we pay the market price — often way above the company’s book value. But when a company reinvests its retained earnings, it does so at book value.
This leads to two key points:
1./ The company reinvests its earnings at a much better “price” than shareholders could ever get, and that’s what drives huge returns over time.
2./ If you paid a high price to start with but held on for the long run, then that premium is being diluted by the growth in the value of your investment that comes from the reinvestment of earnings at no premium at all.
So, a top-notch company like Costco — with its massive competitive moat, strong cash flow, and room to grow — isn’t something you should sell just because the market is offering a premium. That premium is simply a reflection of existing shareholders saying, “This goldmine isn’t for sale unless you’re willing to pay up.”
That said, even the best investors can get it wrong. Take Buffett, for example. He sold his Costco shares in 2020 because the valuation seemed high. He bought them back in 1999 for $32 million and sold for $1.5 billion — not a bad return! But here’s the kicker: those shares would be worth over $3 billion today. In the last four years, he could’ve made as much as he did in the previous 20.
This just goes to prove, as I state in this Substack post, the biggest gains come at the end of a long compounding period.
Charlie Munger once said “The first rule of compounding is to never interrupt it unnecessarily.” If you can find a high-quality business that can compound its earnings over time, the best holding period is “forever”.
Your statement "But when a company reinvests its retained earnings, it does so at book value" sounds logical , but to fully grasp it, could you please put it in a mathematical way, a formula?
Do you mean the "Avg Yearly Equity Growth", or "Avg Yearly new retained earnings / Equity", or something else?
If a company retains earnings, it may hold it as cash or invest in assets. Every $1 retained is reflected as $1 on the balance sheet. As such, the book value (another name for the net asset value or equity of the company) increases by exactly $1. So the ratio is 1:1. This is why retained earnings are reinvested in the company at book value.
Contrast that to the situation if you buy shares in the stock market which may be trading at 4x book value. $1 of your investment buys 25 cents of book value, so the ratio is 4:1. Ergo, if you buy into a company at 4x book, your earnings yield will be one quarter of the return on equity generated by the company.
However, if the company subsequently reinvests earnings into growing the business and doubles in size, half of your holding was acquired at 4x book, but the other half has grown organically at book value. So you are now averaging 2.5x book on your investment. As the company grows over time, the premium that you paid is more and more diluted, tending towards parity.
But this benefit only accrues to long-term buy and hold investors.
What strategies can investors employ to mitigate the effects of cognitive biases like overconfidence and recency bias, ensuring more rational and long-term investment decisions?
Steve Jobs once said people are always on the hunt for the next big thing that will revolutionize life. But when it comes to investing, the real question to ask is: "what’s not going to change?"
The key to long-term investing is sticking with businesses in stable industries. That’s why Warren Buffett’s best investments—Coca-Cola, Gillette, and American Express—make so much sense. People have loved Coke for over 150 years, and they’ll probably love it for another 150. Everyone needs to shave, so Gillette isn’t going anywhere. And spending money? That’s not stopping, so American Express will always be relevant.
Here’s the takeaway: don’t get sucked into flashy ideas or hyped-up stories. Focus on solid fundamentals. For example, Bitcoin might look exciting because of recent price surges, but that’s just recency bias. If you doubled your money on Bitcoin, you might feel overconfident (confirmation bias), but the reality is there’s no solid foundation to back it up. Now, compare that to Coca-Cola—a company with real profits, real cash flow, and a proven track record. That’s not subjective; it’s objective value.
The bottom line? Stick with what’s real. Invest in companies you can confidently forget about for a decade, knowing they’ll still be strong when you check back. If you’re constantly glued to price charts because the value of your investment depends on human psychology or unpredictable trends, you’re in the wrong game. Aim for stability, not speculation.
I have found myself at times being pulled in recency bias - certainly with cryptocurrency, I have had fear of missing out on 'memecoins/ altcoins' which has shrouded my judgement in what I am actually investing in. I'm curious what your thoughts are on investing in blockchain/ AI?
Also, I’ve been going through your book 'The Fabric of Success' and I have a question that I would love to ask, would it be alright if I messaged you on LinkedIn to discuss it further?
Blockchain and AI are valuable additions to our tech stack. We can use them productively. I have no issue with either. Finding the best way to invest in either is a different question entirely. Sometimes it is best to invest indirectly in those that derive benefit from the technology. I recently wrote about this in a series of posts: https://rockandturner.substack.com/p/dominos-and-kroger-retail-robotics
Thank you James for this text, it includes some interesting thoughts. For example: “He pointed out that had it been a private unlisted company, he would never have considered selling it” I never thought about that from this angle.
On the other hand take Costco. They have an EV/EBIT of 47, inverted that is a yield of 2.1%. I do not want to own a business like this.
I guess in the end it is a subjective question everybody has to answer for himself.
Costco’s valuation only matters if you're thinking about buying today. At its current price, the earnings yield might not hit the threshold of what an intelligent investor would consider acceptable.
But what if you bought Costco years ago, back when it was trading at a more reasonable valuation? Should you sell now just because the market says it’s overvalued? That’s like Phil Fisher’s Motorola situation (as I explained in the article).
I used to think of investing like this: buying a stock is choosing between owning it or keeping the cash for something else. Then I applied that logic to selling: if I didn’t sell, it meant I thought the stock was worth more than cash. So, holding a stock was like “re-buying” it every day.
Turns out, that mindset isn’t quite right. Let’s break it down with some math.
When you and I buy a stock, we pay the market price — often way above the company’s book value. But when a company reinvests its retained earnings, it does so at book value.
This leads to two key points:
1./ The company reinvests its earnings at a much better “price” than shareholders could ever get, and that’s what drives huge returns over time.
2./ If you paid a high price to start with but held on for the long run, then that premium is being diluted by the growth in the value of your investment that comes from the reinvestment of earnings at no premium at all.
So, a top-notch company like Costco — with its massive competitive moat, strong cash flow, and room to grow — isn’t something you should sell just because the market is offering a premium. That premium is simply a reflection of existing shareholders saying, “This goldmine isn’t for sale unless you’re willing to pay up.”
That said, even the best investors can get it wrong. Take Buffett, for example. He sold his Costco shares in 2020 because the valuation seemed high. He bought them back in 1999 for $32 million and sold for $1.5 billion — not a bad return! But here’s the kicker: those shares would be worth over $3 billion today. In the last four years, he could’ve made as much as he did in the previous 20.
This just goes to prove, as I state in this Substack post, the biggest gains come at the end of a long compounding period.
Charlie Munger once said “The first rule of compounding is to never interrupt it unnecessarily.” If you can find a high-quality business that can compound its earnings over time, the best holding period is “forever”.
Thanks for your comprehensive answer.
Your statement "But when a company reinvests its retained earnings, it does so at book value" sounds logical , but to fully grasp it, could you please put it in a mathematical way, a formula?
Do you mean the "Avg Yearly Equity Growth", or "Avg Yearly new retained earnings / Equity", or something else?
If a company retains earnings, it may hold it as cash or invest in assets. Every $1 retained is reflected as $1 on the balance sheet. As such, the book value (another name for the net asset value or equity of the company) increases by exactly $1. So the ratio is 1:1. This is why retained earnings are reinvested in the company at book value.
Contrast that to the situation if you buy shares in the stock market which may be trading at 4x book value. $1 of your investment buys 25 cents of book value, so the ratio is 4:1. Ergo, if you buy into a company at 4x book, your earnings yield will be one quarter of the return on equity generated by the company.
However, if the company subsequently reinvests earnings into growing the business and doubles in size, half of your holding was acquired at 4x book, but the other half has grown organically at book value. So you are now averaging 2.5x book on your investment. As the company grows over time, the premium that you paid is more and more diluted, tending towards parity.
But this benefit only accrues to long-term buy and hold investors.
Thanks James, got you :)
Hi James,
thanks for the article - many great points.
What strategies can investors employ to mitigate the effects of cognitive biases like overconfidence and recency bias, ensuring more rational and long-term investment decisions?
Steve Jobs once said people are always on the hunt for the next big thing that will revolutionize life. But when it comes to investing, the real question to ask is: "what’s not going to change?"
The key to long-term investing is sticking with businesses in stable industries. That’s why Warren Buffett’s best investments—Coca-Cola, Gillette, and American Express—make so much sense. People have loved Coke for over 150 years, and they’ll probably love it for another 150. Everyone needs to shave, so Gillette isn’t going anywhere. And spending money? That’s not stopping, so American Express will always be relevant.
Here’s the takeaway: don’t get sucked into flashy ideas or hyped-up stories. Focus on solid fundamentals. For example, Bitcoin might look exciting because of recent price surges, but that’s just recency bias. If you doubled your money on Bitcoin, you might feel overconfident (confirmation bias), but the reality is there’s no solid foundation to back it up. Now, compare that to Coca-Cola—a company with real profits, real cash flow, and a proven track record. That’s not subjective; it’s objective value.
The bottom line? Stick with what’s real. Invest in companies you can confidently forget about for a decade, knowing they’ll still be strong when you check back. If you’re constantly glued to price charts because the value of your investment depends on human psychology or unpredictable trends, you’re in the wrong game. Aim for stability, not speculation.
Thanks for the reply,
I have found myself at times being pulled in recency bias - certainly with cryptocurrency, I have had fear of missing out on 'memecoins/ altcoins' which has shrouded my judgement in what I am actually investing in. I'm curious what your thoughts are on investing in blockchain/ AI?
Also, I’ve been going through your book 'The Fabric of Success' and I have a question that I would love to ask, would it be alright if I messaged you on LinkedIn to discuss it further?
Blockchain and AI are valuable additions to our tech stack. We can use them productively. I have no issue with either. Finding the best way to invest in either is a different question entirely. Sometimes it is best to invest indirectly in those that derive benefit from the technology. I recently wrote about this in a series of posts: https://rockandturner.substack.com/p/dominos-and-kroger-retail-robotics
In order to chat more generally, why not use Substack chat: https://substack.com/chat/1252790