Want a Better Return Than the Stock Market? Buy a Business

What is the Average Percentage of a Stock Market Return?

Depending on the source, the approximate average return of the stock market after inflation (i.e. real return) for the past 75 years has been around 7%. If you focused on a particularly healthy index you could maybe squeeze out another few percentage points in your favor. These are very solid returns when you think about it; especially if you play for the long term and reinvested your returns to achieve compounding effects. Like any investment, the stock market can yield good and bad returns, depending on the year. Therefore, keep in mind that the previously mentioned 7% value represents an average over the long term.

Financial planners generally insist that the stock market is the very best place to get the best return on your money and that, depending on your age, these allocations should be coupled with bonds and other ‘guaranteed’ investment vehicles.

While that may be true, many people fail to recognize a better return than the stock market one can achieve vis-a-vis an enduringly profitable private business.

What is an 'Enduringly Profitable' Business?

The term enduringly profitable originally coined by Harvard Business School professors Richard S. Ruback and Royce Yudkoff, is used to describe a well-established business that is profitable and exists in a low-competition environment. In their book, HBR Guide to Buying a Small Business, the two professors use the word ‘dull’ to describe these businesses. They use it in the sense that these companies have the same customers year after year and experience slow, steady growth (aka low risk). Although these entities are described as ‘dull’, their returns are anything but.

We often hear stories about high-growth businesses and startups with flashy billion-dollar valuations. However, the reality is, many of these businesses have never turned a profit. On the other hand, we rarely hear about the established, small-to-medium, private businesses that have been around for years and consistently post solid profits for their shareholders. These companies have the ability to fly beneath the radar and not attract too much attention (or competition)- this is what we believe makes these businesses so valuable (or as we call them, hidden gems).

Why Buy an 'Enduringly Profitable' Business?

There are many reasons why buying an enduringly profitable business (partially or outright) can be a much better investment and bring better returns than the stock market. Here are a few of those reasons:

1. Return

There are many businesses for sale today that have stood the test of time, delivering consistent returns for their shareholders - quite often a return on investment in excess of 25% per annum. Using the rule of 72, we can see that if you invest in the stock market, it will take over a decade to double your money. On the other hand, an investment in a select, ‘enduringly profitable’ business can lead to your money doubling in under three years.

2. Control

If you buy into a private business you have the ability to personally impact the outcome. Sure, there are outside factors that can impact the business: competition, government policies, etc; however, this is true for any business. These outside factors affect the public markets as well, with the exception that you don’t get any say in the decision-making. Not only are the decision-making events entirely out of your control, but it is also common to catch wind of major events 90 days after they have occurred- in the company’s quarterly filings.

3. Tax treatment

There are many tax benefits to being a private business owner. One of the many examples includes the fact that dividends have traditionally been taxed at a lower rate than personal income. Another is the fact that there are several items that private business investors can personally benefit from by way of business write-offs (i.e. pre-tax money).

4. Growth

Here is where the ability to personally impact the outcome of a given company can really pay off. Often a new set of eyes and/or introducing new technology can drastically improve an existing business. Many of these ‘enduringly profitable' businesses have been plugging along successfully for years and have not felt any particular need to improve. New owners tend to see things from a different perspective and look for ways to improve with the intention of increasing growth, and as a by-product, their investments.

5. Cashflow

Unless you have a portfolio of stocks that regularly pay dividends, chances are you haven’t seen your money since you invested it. There is nothing wrong with that since it is growing in value; however, buying into a private business can give you the best of both worlds - value and cash. The stable growth of the value of the business coupled with cash flow in the form of wages and/or dividends can be a phenomenal combination. Public companies that pay dividends tend to be very slow growth entities. A private business can give you a steady cash flow while you continue to increase the value of your equity stake to sell at a later date.

In Summary

We are not suggesting that your investments in private companies should replace investments in public stocks, but rather, they should complement them. Generally speaking, small-to-medium-sized businesses tend to move on a different wavelength compared to large-cap public stocks. Meaning, diversifying your portfolio to include ‘enduringly profitable' businesses can help reduce your exposure to risk.

One common misconception is that investing in private companies means you’re putting your money into a smaller pocket. That is simply not always the case. In fact, small businesses employ as many people in the U.S. as public companies. So, put some money in the public markets, keep some cash, but don’t forget about this great (yet often overlooked) asset class - ‘enduringly profitable’ private businesses.

Whether you want to buy and run a private business or participate passively as an investor, the opportunities are plentiful and the returns can be spectacular.