Editor's Note: The following exclusive excerpt is from the book, Build Wealth With Common Stocks: Market-Beating Strategies for the Individual Investor by David J. Waldron. The hardcover, paperback, and ebook editions are available worldwide. Reprinted with the permission of the author.

As an active, noninstitutional investor, be aware of the risks of investing in the stocks and bonds of publicly traded companies. Keep on guard against sudden market exuberance for candidates—Bitcoin and tech stocks were the latest flavors of choice—queued to take down an entire market. Unpredictable macroeconomic events such as the COVID-19 coronavirus pandemic are the exception.

Remember junk bonds in the 1980s, dot-coms in the 1990s, and mortgage-backed securities in the 2000s?

Image Source: Pixabay

Between bubbles, irrational investor sentiment from the daily news cycle and quarterly earnings releases provoke gyrations within the US domestic stock market. The volatility keeps your holdings on a roller coaster ride in the short term as you wait for the compounded capital and income growth of your portfolio in the long term. Mitigate those risks by employing a value-based, long-view common stock portfolio strategy. Hold the shares for as long as the business remains terrific, as demonstrated by growing revenues and earnings, and, most importantly, by generating free cash flow and capital allocations that produce compounding annual returns for you, the shareholder.

Just as crucial as compounding is having wide margins of safety built into the common stocks of your chosen publicly traded companies.

The Magic of Compounding

Compounding is the financial process when an investor reinvests the owners' earnings, such as capital gains, interest payments, or dividend payouts back into the asset or portfolio with the intent of spawning additional profits from the holdings over time. This magical principle of mathematics is the primary generator of real returns from equity and fixed-income investing.

An Apple a Day

Apple (AAPL) went public on December 12, 1980, at $22 per share. The stock had split five times since the initial public offering (IPO), splitting on a two-for-one basis on June 16, 1987, June 21, 2000, and February 28, 2005. The stock split on a seven-for-one basis on June 9, 2014, and on a four-for-one basis on August 31, 2020.¹ A stock split occurs when a company divides its existing ordinary shares into multiples, adjusting the traded price by the same division. For example, if one share trading at $40 splits two for one, the result is two shares trading at $20.

On a split-adjusted basis, Apple's IPO share price was a mere ten cents after adjusting the cost from the original $22. As a bonus, the company paid quarterly dividends from April 1987 to October 1995 and again from July 2012. The result was a $1,000 investment during the IPO in December 1980, adjusted for stock splits and dividends, was worth about $3.5 million—accounting for inflation in 2020 dollars—as of the date of this calculation when the stock was trading at $113 a share.

Apple's captivating story of the power of compounded buy-and-hold investing reminds the retail-level investor to forge a commitment to total return from capital appreciation and dividend payments. And, as of this writing, Apple was the largest reported holding in Warren Buffett's Berkshire Hathaway portfolio.

It's the Real Thing for Real Investors

Upon its IPO on September 5, 1919, one common share of Coca-Cola (KO) traded at $40 a share—not adjusted for inflation—about the same price range during the research and writing of this book. Nevertheless, as of the split in July 2012, the estate of an original buy-and-hold purchaser has enjoyed eleven varied stock splits yielding 9,216 shares from the lone original share.² At the time of this calculation, the total value of the original single share equates to $5.5 million—accounting for inflation in 2020 dollars—net of dividends.

Thus, based on the share price of $50 as of this writing, a $200 investment in KO in 1919 was worth about $34.5 million—accounting for inflation in 2020 dollars—as of this calculation, net of dividends. The storied history of Coke is another prime example of why the retail investor cherishes the power of annual compounding from buying and holding the shares of wonderful companies that enjoy enduring competitive advantages from in-demand products or services.

“The ideal business is one that earns very high returns on capital, and that keeps using lots of capital at those high returns. That becomes a compounding machine”.³

—WARREN BUFFETT

In his answer to a shareholder question, Buffett—the eminent investor of our time—rendered wisdom in advocating the buying and holding of common shares of quality companies with the history and continued likelihood of generating high capital returns to grow the business. In turn, compounding total return from capital gains and dividends rewards the shareholder. Coca-Cola—a favorite long-term holding of Buffett's Berkshire Hathaway (BRK-B)—has been a compounding machine for a century.

There are investors, and there are speculators. Each seeks to profit, the former in the long term and the latter in the short term. The long view investor seems to prevail thanks to the magic of compounding.

Protected By a Wide Margin of Safety

Compounding capital gains and dividends are the best friends of the common stock investor. Buffett's mentor Benjamin Graham, in his classic book The Intelligent Investor,⁴ speaks of limiting stock purchases to shares trading with a margin of safety.

Margin of Safety in Practice

The margin of safety in a stock is the difference between the estimated intrinsic value of the security and its actual market price. In general, an investor has two options to calculate the margin of safety in a company and its common shares. The conventional approach attempts to predict an exact intrinsic value of the equity and then subtracts the estimate from the actual price. The second, more practical method uncovers whether the stock represents a quality, enduring company trading at what appears to be a reasonable price. The former requires high intelligence and plenty of assumptions; the latter presents mere thought and discipline in a review of the facts.

Some well-intentioned investors prefer to calculate the margin of safety with discounted future free cash flow projections and other future-focused or assumptive estimates of precision price targets cast within specific time frames. Wall Street analysts enable the behavior on Main Street by publishing complex financial models that lack consistency. These sophisticated margin of safety or intrinsic value estimates are what justifies the high fee structure of Wall Street. Be suspect of the projections within these formulas. Hasn't an investor who starts predicting future cash flows, interest rates, and capital expenditures become more of a speculator?

Nearsighted predictions are more or less crapshoots, yet Wall Street makes a living off of them, a paradox of epic proportions.

Margin of Safety by Proxy

Interpret the useful measure of the intrinsic worth of a company and its stock based on current and trailing indices as opposed to assumptive discounted future cash flows and other cross-your-fingers projections. Attempt a modest, albeit realistic, approach to estimating inherent value by measuring the margin of safety in a broader sense.

Part II: Strategies offers conservative models to screen for the bargain-priced shares of companies with strong value propositions, favorable earnings and free cash flow yields—as compared to the Ten-Year Treasury rate—adequate returns on equity and invested capital; attractive prices to sales, operating cash flow, and enterprise value to operating earnings; and controllable long- and short-term debt coverage.

When a company and its common shares present as superior in each margin of safety indicator, a higher potential for market-beating performance exists. Quantify the performance of the operation in more objective than subjective terms. No-brainers are better bets than possiblys or maybes.

Instead of chasing the dragon, own common shares to savor the benefit of partnering with a company supporting its customers with in-demand, useful products or services, rewarding employees with sustainable career opportunities, and compensating shareholders with positive returns protected by world-class internal financial controls.

The thoughtful, do-it-yourself investor avoids attempts at predicting specific future movements in the shares, whether by price target or percentage gains and losses, leaving nonsensical games of chance to market speculators. Nonetheless, the historical capital gains in the common shares spawn from the occasional, sometimes generous, upticks in the stock price of a high-quality business adding up over time. It is the patient investor who experiences this alpha or the excess return of an investment relative to the performance of a benchmark index.

Any ongoing dividend yields are the stock market equivalent of receiving interest payments on the outstanding principal of a loan or the equivalent of the initial capital investment to purchase the shares of the stock.

On Becoming Warren Buffett

My investment objective enthusiastically follows the rational wisdom of the Oracle of Omaha. As presented in the excellent HBO documentary Becoming Warren Buffett,⁵ Buffett bought cheap companies earlier in his career, regardless of quality, and unlocked value through corporate events by dumping the stock when the price increased to a predetermined level. He then transitioned to buying and holding quality companies at sensible prices and taking advantage of the magic of compounding protected by a wide margin of safety.

Buffett acknowledges that it was under the tutelage of his partner, Charlie Munger when he made this career makeover from a stock trader to a company investor. He learned from Munger that "it is far better to buy a wonderful business at a fair price than a fair business at a wonderful price."

If modeling Buffett's earlier career, the cautious advice reminds the stock trader to sell a fair company at a fantastic price or live with the consequences. On the contrary, if influenced by the Buffett/Munger partnership that resolved to buy and hold terrific companies at fair prices, the independent investor is better served staying for the long haul, as this was the holding period when Buffett's fortune began to compound into the billions. Nevertheless, his valuable lesson and the basis of the documentary — what a successful investor does with a portfolio windfall is far more important than the act of making money. Buffett is giving a bulk of his wealth back to society through charities such as the Bill and Melinda Gates Foundation.

The HBO documentary presents a profound juxtaposition of Buffett's eccentric accumulation of enormous wealth against his ultimate decision to divest a majority of his investable assets to philanthropic causes, including those presided by his children. My takeaways were: you cannot go wrong, financially, by modeling his greedy, albeit compassed ways; intellectually, from his mountains of wisdom; and spiritually, by giving it back when the scoreboard reads Game Over. Hence, a stark reminder that one cannot take a lifelong accumulation of tangible assets to any Promised Land or afterlife.

Capital notwithstanding, the thoughtful investor who follows Buffett's time-tested paradigm of taking advantage of the magic of compounding protected by a wide margin of safety increases the likelihood of success over a long-term holding period.

Build and Maintain Wealth with Common Stocks

During the research and writing of this book, the overextended post-Great Recession bull market, including the unpredictable gyrations forced by the irrational sentiment of traders and speculators, was another reminder to stay invested in the common shares of quality companies. By doing so, you take advantage of the compounding capital gains and dividends protected by wide margins of safety.

As it went, the exuberance reversed in a heartbeat from the coronavirus pandemic.

When searching for bargains to add to your portfolio during a bull market and finding that new opportunities are nonexistent at the moment, you are better off just staying put. Remember, the good ideas already sitting in your portfolio are often the best opportunities to allocate dry powder—investable cash insured by the Federal Deposit Insurance Corporation or FDIC—as opposed to investing in speculative or desperate new ideas. Believing the historic post-Great Recession business cycle was somehow different, investors were chasing visions of fast money from waves on technical charts and other speculative fads of the moment. The penchant of the herd for irrational behavior was in full gear. And then COVID-19 became the number one story with a bullet.

The pursuit of alpha equates to a portfolio of dividend-paying common stocks of quality companies outperforming the corresponding benchmark over time, plus exceeding any other expectations of the disciplined, long-view investor. Notwithstanding any attractive buying or profit-taking opportunities, current market cycles—whether bull, bear, or range-bound*—are irrelevant in the scheme of buy-and-hold investing.

Within the perpetual uncertainty of economic cycles, it is crucial to evaluate downside risk and other measurements of the margin of safety of the stock in the near view to take advantage of the compounding of the capital gains and dividends in the longer view.

*Bull: an economy that is growing and the broader market is on the rise. Bear: an economy that is receding and most stocks are declining in value. Range-bound: prices are constrained and lie between certain upper and lower limits.

Chapter Summary

On Compounding with a Margin of Safety

• Buy and hold the stocks of quality companies with the history—and continued likelihood—of compounding total return from capital gains and dividends across every market cycle.
• Since volatile markets are perpetual, it is crucial to evaluate the downside risk and other measurements of the margin of safety in a stock price, a concept originated by the father of value investing, Benjamin Graham.
• In the spirit of the shared wisdom of Warren Buffet and Charlie Munger, the thoughtful retail investor buys slices of terrific companies at fair prices as opposed to fair companies at terrific prices.
• What a successful investor does with a portfolio windfall is far more important than the act of making that money.
• Live well within your means.

Notes:

1. Yahoo Finance, "AAPL, Historical Data, Prices, Stock Splits, Dividends" accessed September 8, 2020, https://finance.yahoo.com/quote/AAPL.

2. The Coca-Cola Company, "Historical Data," accessed July 2, 2020, https://investors.coca-colacompany.com/stock-information/historical-data.

3. Warren E. Buffett, 2003 Berkshire Hathaway, Inc. annual shareholder meeting (answer to audience question #41),  https://buffett.cnbc.com/video/2003/05/03/businesses-with-idealfinancial-traits-are-hard-to-come-by.html. Material is copyrighted and used with the permission of the author.

4. Benjamin Graham, The Intelligent Investor (New York: Harper-Collins, 1949). 

5. Becoming Warren Buffett, directed by Peter Kunhardt (New York: Kunhardt Films, HBO Documentary Films, 2017).