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 one or two 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 other investment, the stock market can yield good and bad averages, 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 the positive returns one can achieve vis-a-vis an ‘enduringly profitable’ private 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. Many of these businesses have never turned a profit. However, 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. Their ability to fly beneath the radar and not attract too much attention (or competition), is what we believe makes these businesses so valuable (or as we call them, hidden gems).
There are many reasons why buying (partially or outright) an ‘enduringly profitable’ business is a much better investment than buying stocks on the stock market. Here are a few:
- 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, a method in which you divide 72 by the rate of return to see how long it will take your investment to double, 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 an ‘enduringly profitable’ business can lead to your money doubling in under three years.
- 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 any business: competition, government policies, etc. All of 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, it is common to hear such events up to 90 days after they have occured- in the company’s quarterly filings.
- Tax treatment: While it remains to be seen exactly how this will play out with the new tax act, indications are that corporations as well as dividends will be taxed at a lower rate due to the reduction in personal income tax rates. While these tax cuts will affect both public and private markets, it is the privately held businesses that have the advantage in terms of timing and frequency of distribution events. Whereas, the individual investor has no say in the public markets as to when or how often profits will be distributed.
- 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 a 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.
- 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 in which their main attraction is their dividend- ex: utility companies. A private business can give you both a steady cash flow while you own it and the ability to build equity (value) to sell at a later date for a nice, long term capital gain.
We are not suggesting that your investments in private companies should replace investments in public stocks, but rather, they should act as a complement. Generally speaking, small-to-medium sized businesses tend to move independently of 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 pool. 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.