What is the best kind of stock to buy?

The ones internet gurus pitch?

Surely not; why would anyone with a good idea be willing to give it away for free? Or are they technology companies, which always seem to go higher?

The Answer

The answer is rather simple: you want to invest in things that can have limitless returns, which means you never really have to sell. Tax advantages, simplicity, compounding; all benefits of a forever hold strategy. But what has to be true to be considered a forever hold?

Scenario One

Take two scenarios: in one, you invest in a firm that manufactures widgets. Can this be held for the long run? Well, let’s say you invest when the firm has 5% market share for widgets, and over time that grows until you reach 30%. After that, for structural reasons, you are unable to grow, and more investment in the business will do no good, according to the law of diminishing returns.

What can a business do now? Is your dollar invested as productively as it can be? Probably not.

The firm could expand through consolidation, but at some saturation point growth will slow, and resulting equity returns will as well. This is a great outcome scenario for an investment, but it can very well be worse; regardless, maybe this entire process takes 30 years- what after? Then you must find another great business, sell the current firm, etc. Hard work indeed; it can work, and it has, although it is not optimal. Can there be an optimal investment?

Scenario Two

Well, what about a structure where you can have limitless returns? Where you can have a core business, such as insurance, which is the source of free cash flow from the business, which you allocate into other assets to seek greater returns, either through acquiring other businesses or stakes in businesses. Conglomerates have a structure where you can allocate capital into areas repeatedly and continue to seek greater returns.

There are direct holding companies, where you’re really investing in great allocators, and conglomerates, which leverage “synergies” and general benefits of owning several assets under one house, as seen in Japan. There are also conglomerates that get messy and end up being broken up, or sold for parts. Each one has extreme value; the direct holding companies often compound forever, the Japanese trading company model is very resilient, and also is built on an insurance foundation. And the messy conglomerates often have a crown jewel at heart, which, when spun off, can be a great business to own in itself.

Conglomerates also have this uniqueness since there are always places to invest; you see great companies incubated as tiny projects within conglomerates that end up as major profit centers for firms. AWS and the PlayStation are prime examples.

The strategy of being a conglomerate is that you monetize a core competency through a different business, essentially out-pricing your competition and gaining dominant market share. Disney is a good example of this, leveraging content, which they can spend more on than a studio-only firm, and monetizing through parks & cruises.

The Risks

The risks are certain, though; many, if not most, conglomerates tend to have the conglomerate discount, unless the firm has a reputation for allocating capital at returns greater than the market.

Finding great allocators is a difficult and rare task; most allocators are not Will Thorndike’s “Outsider CEO’s”, but if you can even find one, that is all you really need.

Cheers,

Cade and Taikhoom