The Power of Power Laws
Since 1776, American GDP per capita has risen 38-fold, net of inflation.
A 38x increase sounds impressive until you do the math. A 38-fold gain in 244 years only requires a 1.5% growth rate.
Yet that 1.5% growth rate turned out to be world-class. Compounded for 244 years, it has made Americans among the wealthiest in the world. Only four small countries (Luxembourg, Switzerland, Ireland, and Norway) have a higher GDP per capita. Today, Americans make up 8% of the world’s population but own 30% of the world’s wealth.
There are three morals of this story:
Humans underestimate exponential growth;
Small inputs can produce massive outputs; and
Small minorities can produce disproportionate results.
Humans think linearly but live in a world dominated by exponentials. Power Laws drive the most powerful forces around us. Understanding them is key to harnessing them.
What Are Power Laws?
Power Laws are exponential functions, like Y=X^2. The exponent means that a change in X will produce a disproportionate change in Y. For example, doubling a square’s length quadruples its area.
Most power laws have a fixed exponent and variable base, like the relationship between a square’s length and area. Only one power law has a variable exponent. It’s the compound growth formula:
Future Value = Present Value x (1 + Interest Rate) ^ Years
Power laws produce a wide range of possible outcomes.
A power law governs wealth. Lots of women are worth $70,000. And plenty are worth $700k or $7 million. The richest woman in the world, Francoise Bettencourt Meyers, heir to the L’Oreal fortune, is worth $72 billion.
By contrast, power laws do not govern height and weight. That’s why they tend to cluster in a narrow range around an average. Lots of men are five or six feet tall. No men are fifty or sixty feet tall.
Power laws produce unequal outcomes.
In 1906 a professional economist and amateur gardener named Vilfredo Pareto observed that 20% of his peapods produced 80% of his peas. Likewise, he noticed that 20% of Italians owned 80% of Italy’s wealth.
This phenomenon is called the Pareto Principle or the 80-20 Rule. Peter Thiel gave more examples in Zero To One:
The most destructive earthquakes are many times more powerful than all smaller earthquakes combined.
The biggest cities dwarf all mere towns put together.
Monopoly businesses capture more value than millions of undifferentiated competitors.
When power laws are at play, a few individuals or events generate most of the results.
Power Laws In Action
Humans aren’t wired to understand exponential growth. So, let's walk through an example.
Say you’d like to be a millionaire. How much do you need to invest today to achieve this goal? We’ll assume you earn a 9% annual rate of return, the market’s long-term average.
Now, when would you like your million dollars? The longer you can wait, the less you’ll need to invest today. Below is a table of possibilities.
Source: Author
If you need $1 million in ten years, you’ll need to invest $422 thousand. That’s about the price of a house. If you can wait 80 years, you’ll only need to invest $1 thousand. That’s about the price of an iPhone.
For the price of an iPhone, investors who average a 9% annual return can leave behind a life-changing sum of money to their heirs or charity of choice. Higher returns make the math even more compelling. The present value of $1 billion in 80 years, assuming 15% annual returns, is just $14,000 today!
The compound interest formula can turn small amounts of money today into huge sums in the future, even at average rates of return.
Power Laws In The Stock Market
The market’s long-term 9% average annual return is a deceiving statistic.
It’s not as if half of the stocks produced an 8% return and a half produced a 10% return, and they averaged out to 9%. Instead, just 4% of stocks produced all of the market’s gain since 1926. That’s according to a 2017 research paper by Arizona State’s Hendrik Bessembinder. It’s not so much the 80-20 rule as the 96-4 rule in the stock market.
Stock returns are like wealth, not height or weight. Returns cover several orders of magnitude, and a few stocks produce most of the gains.
Berkshire Hathaway was one of the best-performing stocks of the last fifty years, mainly due to Buffett and Munger’s stock picks. But even their portfolio fell prey to the Pareto Principle. Munger once said, “If you took our top fifteen decisions out, we’d have a pretty average record.”
Ben Graham, Buffett’s mentor, had an even more extreme experience. Graham’s sought to buy stocks for 50% of their liquidation value and sell as they approached 100%. He relied on rising price-to-book ratios rather than growing earnings. These amounted to relatively safe and predictable base hits.
Graham departed from this strategy just once. In 1948 he used 25% of his partner’s capital to buy 50% of GEICO for $712,000. Then, he held. Over the ensuing 25 years, the value of that stake rose 500 fold. Graham’s GEICO investment made him more money than all of his others combined — a home run.
How To Harness The Power of Power Laws
Investors who want compound interest on their side should keep these points in mind.
1. Time in the market matters more than timing the market.
Time is an investor’s best friend. Even a low rate of return sustained long enough produces spectacular results. 1.5% annual growth is all it took to transform America in 1776 to America as we know it.
There are two corollaries:
Start investing as young as possible.
Stay invested as long as possible.
We generally prefer to remain fully invested so long as we own securities with adequate estimated forward returns. We don’t think we can time the market, nor do we believe we must to succeed.
When the market is hot, like it is now, we naturally prefer to own “defensive growth” businesses with solid balance sheets and non-cyclical earnings. When the fear takes over, as it did in March 2020, we aim to “upgrade” our portfolio into higher growth secular compounders. Market prices and our forward return estimates inform how defensive or aggressive we get.
This strategy allows us to remain invested and earn compound interest without the need to time markets.
2. Don’t interrupt compounding unnecessarily.
In the early ‘70s, Buffett and Munger had a third partner named Rick Guerin. Buffett and Munger always knew they’d become incredibly wealthy and weren’t in a rush. But Guerin was in a hurry. While Buffett and Munger paid cash for their investments, Guerin used debt.
For a while, debt turbo-charged Guerin’s results. Then the 1974 bear market struck. During the downturn, margin calls forced Guerin to sell his Berkshire Hathaway shares to Buffett at $40. Each is now worth $357,000, a 22% annual return.
Anything times zero is zero. A single margin call can wipe out decades of prior compounding. It’s not worth interrupting compounding for higher investment returns. If you’re smart, you don’t need leverage. If you’re not smart, you have no business using leverage.
Eagle Point doesn’t use leverage or short stocks. No bank, broker, or Reddit thread can force us to sell if we don’t want to.
3. Don’t trim the flowers and water the weeds.
According to the Pareto Principle, 20% of your investments will produce 80% of your gains. If this is true, then selling winners to reinvest in losers will truncate a portfolio’s growth.
Can you imagine if Graham had sold GEICO when it first doubled? He’d have left a 250x return on the table and turned a home run into a base hit. Where would Jeff Bezos, Bill Gates, and Warren Buffett be if they’d sold their shares as their price appreciated? Not atop the Fortune 400.
We generally don’t trim positions. We do, however, sell positions. The idea is to either exit entirely or not at all, based on our perceived opportunity costs.
4. Focus on slugging percentage, not batting average.
It doesn’t matter how often you are right or wrong in investing. It matters how much you make when you’re right and how much you lose when you’re wrong.
Graham’s GEICO investment showed that a single home-run is more valuable than hundreds of base hits. It’s better to buy and hold a compounder than to flip lots of cheap non-compounders.
Businesses with low marginal costs and high incremental returns are our favorite to own because of their potential to compound at high rates.
5. Concentrate on your best ideas.
No one gets rich off their 15th or 20th-best idea. Yet most investors own tens, if not hundreds, of securities. Statistically, most of these will be duds.
Good investments are hard to come by. It’s rare to find a compounder you understand for a fair price, let alone a bargain price. When that happens, it's best to swing big and buy a meaningful amount.
Eagle Point operates with a 10x10 portfolio — ten stocks, with a cost basis of 10% each. As long as we can find ten good ideas, we think this strikes an optimal balance between risk and reward.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.