This post was originally published on January 14, 2016.
Great businesses and investments do not require an “exit strategy.” Great businesses generate significant amounts of cash flow relative to the amount of capital invested in them. This cash flow alone should be justification enough for owning a business without requiring someone else to buy the business from you. Meanwhile, the very notion of selling an investment at any point in the future is an inherently speculative assumption that necessitates exceptional caution. Moreover, the tax implications of selling a business or investment are significant and warrant careful consideration.
Invest like an owner
Great businesses generate cash flows that are proportionately large in comparison to the amount of capital invested in them. As a hypothetical thought exercise, say your friend Danny decides to open a hamburger stand. He takes $100k of his savings to buy the equipment and materials necessary get off the ground. The stand is a hit and people line up around the block for his hamburgers. It is so successful that in the first year of operation, the stand generates $20k in profit. This is an outstanding return on investment of 20% ($20k in cash flow divided by the $100k invested).
The $20k of cash flow gives Danny choices on what to do going forward. He could just elect to pay himself the $20k as trouble for his work. He could also save up the cash and after a few years use the capital to open a second hamburger stand. Assuming the second stand is just as profitable as the first, he thereafter would enjoy $40k in annual earnings. This ability to take earnings from a high return investment and reinvest at the same rate is a wonderful virtuous circle that can lead to exceptional compounded returns over time.
The only significant concerns Danny should worry about are: (a) are the earnings from his hamburger stands sustainable into the indefinite future and (b) can he continue to open more stands at the same rates of profitability? So long as Danny can answer these two questions affirmatively, he should be perfectly happy to invest every dollar of profit back into the business and not have to worry at all about if he can sell his business. If (b) no longer proves to be the case, it would likely be best to dividend to himself the earnings of the business. If (a) no longer proves to be the case, it may indeed be a good time to consider selling or shuttering the business.
This logic can be applied to investing in publicly traded securities. If a security generates $15 in reliable and repeatable cash flow and we buy it for $100, we can reasonably expect that our return on the investment will be 15% for as long as that $15 is sustainable. The obvious caveat is that the earnings must be sustainable which is why businesses which have “wide moats” (e.g., market share advantages, brand recognition, intellectual property, etc.) are considerably more desirable than those that do not. Businesses that can grow through reinvestment of cash flow are all the more attractive due to the ability to further compound earnings by way of this growth, thereby increasing our rate of return. If we can invest in a business that can sustain and grow earnings, our ability to earn acceptable rates of return are predicated only on the sustainability of the business’s earnings from year-to-year and depends not at all on our ability to sell the business at any given price or point in the future. Good investments make money because the business itself makes money, not because someone else will offer us a price dearer than that we paid.
“The best place to find a helping hand is at the end of your own arm.”
In the professional investment business, one often hears the words “exit strategy” thrown about in conversation. In the Venture Capital and Private Equity industries, exit strategy can refer to a variety of outcomes:
- selling shares in the company by way of an IPO
- selling to a “strategic buyer” (e.g., Zappos selling to Amazon)
- selling to another “financial buyer” (e.g., another VC or PE firm)
In the world of publicly traded securities, the notion of exit strategy is also pervasive, although not usually described with those words. Investors will often talk about target prices or target multiples at which they would ideally sell their investment. While this is not as complex a procedure as an IPO, or strategic sale, the point is, even in public investing, an exit strategy presumes that there will be a willing buyer of your investment at some point in the future. In other words, one is counting on the idea that someone else will be there to pay you what you want for what you own.
The problem with assumed target prices or multiples is precisely the fact that they are assumptions. Even if they are supported by analysis of trading multiples of “comparable” businesses, they are nonetheless speculative assumptions. What happens if the multiples of the comparable companies contract? What happens if the IPO market closes or credit markets freeze rendering acquisition financing unavailable to strategic or financial buyers? This is not to say one cannot make money through successful “exits.” Certainly many a great fortune has been made in this way. However, one should recognize that making assumptions about exits is an inherently risky exercise.
“Can a people tax themselves into prosperity? Can a man stand in a bucket and lift himself up by the handle?” —Winston Churchill
Another significant problem which arises from exiting investments is the tax payable upon sale. Capital gains tax is a significant headwind for any investor and significantly raises the hurdle rate for any investment which requires capital from the liquidation of an existing investment. Consider the value of three hypothetical investment scenarios which are illustrated in the chart below. The blue line illustrates the growth of a $100 investment over twenty years if one buys and holds an investment that compounds at a 15% annual rate of return over that horizon. Since the investment is never sold, the investor never pays any taxes on the capital appreciation. The green and orange lines also assume that the $100 investment grows at 15% over the twenty years. However, the green line presumes that the investor pays a capital gains tax of 20% once a year as his or her portfolio turns over once each year just after the requisite 12-month holding period required for such tax treatment. The orange line illustrates what happens if the investor has to pay short-term capital gains taxes of 40% as the result of selling after holding investments for less than 12 months.
Over the course of 20 years, even the orange line yields a fairly attractive result: the $100 investment grows to $560, a nice multiple of the original principal amount. The green line fares better, growing to $965. However, the blue line representing the “Buy and Hold” strategy blows both the others away, growing to over $1,600. This resultant sum is almost three times that of the short-term seller and nearly twice that of the long-term seller. To put it in further perspective, in order to earn a equivalent after tax return as the “Buy and Hold” strategy, one would need to earn 19% or 25% rates of return depending on if one is paying long-term or short-term capital gains taxes, respectively. In other words, if one is going to sell a perfectly good 15% return investment, one must be reasonably confident that the next investment can earn a 4% to 10% better return in order to make the switch worthwhile!
“Our favorite holding period is forever.” —Warren Buffett
We need look no further than to the Oracle of Omaha himself to see evidence of how one can achieve great results in investing without ever thinking about exit strategy. Over the many decades of his career Warren Buffett has consistently stressed the value of buying a business for its cash flows. He has bought numerous companies in industries ranging from auto insurance to chocolate confections that he has held for decades and never intends to sell. He has applied the same principal to his public investments in companies such as Coca-Cola and American Express, equities he has owned for decades and never sold. As a further testament to his discipline, look at the Berkshire Hathaway balance sheet and one will find that it features a deferred tax liability in excess of $60 billion! This amount of taxes not (and perhaps never to be) paid is quite substantial in the absolute sense but also in relation to Berkshire’s total investment portfolio of approximately $160 billion. Had Buffett been pursuing exit strategies, Berkshire’s incredible investment portfolio might be smaller by one-third than it is in actuality today.