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CHAPTER 11

THE KEY TO SUCCESS IN LIFE IS DELAYED GRATIFICATION

Someone’s sitting in the shade today because someone planted a tree a long time ago.

—Warren Buffett

If you’re glued together and honorable and get up every morning and keep learning every day and you’re willing to go in for a lot of deferred gratification all your life, you’re going to succeed.

—Charlie Munger

People who arbitrage time will almost always outperform. The first order thought of instant gratification is a crowded path, ensuring mediocre results at best. Delayed gratification, which requires second order thinking, is less crowded and more likely to get results.

—Shane Parrish

In the 1960s, Walter Mischel, an American psychologist specializing in personality theory and social psychology, conducted a famous experiment at Stanford University’s nursery school. In the experiment, now widely known as the Stanford marshmallow experiment, four- and five-year-olds were presented with a difficult choice. They could eat one treat—a marshmallow—immediately, or they could wait fifteen minutes more and be rewarded with two marshmallows.

Over the next forty years, the children were included in follow-up studies. It was found that the children who were willing to delay gratification and waited to receive the second marshmallow ended up having higher SAT scores, lower levels of substance abuse, lower likelihood of obesity, better responses to stress, better social skills as reported by their parents, and better scores on a range of other life measures.

In other words, the experiment demonstrated the virtues of delayed gratification—doing what is hard now rather than doing what is easy. Over time, this builds up the muscle of discipline, strengthens one’s skills and capabilities, and compounds into a much greater level of success and satisfaction than taking the easier path.

Charlie Munger has always been a big proponent of delayed gratification. He has emphasized the importance of patience and being prepared to act at scale when great opportunities arise. These are rare and fleeting, so we need to be patient, prepared, and decisive to seize them. Munger has shared an inspiring example. He had been reading Barron’s magazine for more than fifty years and found only one actionable idea in it. It was a cheaply valued auto parts company (the name is widely speculated to be Tenneco), which he bought at $1 per share and sold a few years later at $15 per share, earning him $80 million in profits. Munger then gave Li Lu the $80 million and Lu turned this into $400 million. Through just two investments, Munger turned a few million into $400 million. This example illustrates the significance of extreme patience, deferred gratification, and displaying strong decisiveness at the right moment. It is why Munger has said, “It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities [emphasis added].”¹

The only way to win is to work, work, work, work, and hope to have a few insights.

—Charlie Munger

How much insight does one need in a lifetime to be a successful investor? Not much, as Warren Buffett explains:

I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.²

Munger repeatedly brought up the topic of deferred gratification during the 2017 Daily Journal Corporation meeting. He talked about how most investors are looking for a quick buck, but the best investors defer their gratification for much larger gains that come later, in the distant future.

Long-term investors look for management teams that are willing to defer gratification. These teams are focused on building a durable economic franchise. They are focused on the longevity of the business. They are willing to forgo near-term earnings to increase long-term value. Let’s look at the compound interest formula and view it in a way that helps us think about building long-term value:

where a = accumulated future value, p = principal or present value, r = rate of return in percentage terms, and n = number of compounding periods.

All too often, management teams focus on the r variable in this equation. They seek instant gratification, with high profit margins and high growth in reported earnings per share (EPS) in the near term, as opposed to initiatives that would lead to a much more valuable business many years down the line. This causes many management teams to pass on investments that would create long-term value but would cause “accounting numbers” to look bad in the short term. Pressure from analysts can inadvertently incentivize companies to make as much money as possible off their present customers to report good quarterly numbers, instead of offering a fair price that creates enduring goodwill and a long-term win–win relationship for all stakeholders. The businesses that buy commodities and sell brands and have strong pricing power (typically depicted by high gross margins) should always remember that possessing pricing power is like having access to a large amount of credit. You may have it in abundance, but you must use it sparingly. Having pricing power doesn’t mean you exercise it right away. Consumer surplus is a great strategy, especially for subscription-based business models in which management should primarily focus on habit formation and making renewals a no-brainer. Most businesses fail to appreciate this delicate trade-off between high short-term profitability and the longevity accorded to the business through disciplined pricing and offering great customer value. The few businesses that do understand this trade-off always display “pain today, gain tomorrow” thinking in their daily decisions.

Let’s look at two contrasting examples. On one hand, we have Valeant Pharmaceuticals, which buys lifesaving drugs for rare diseases from innovative companies but then resorts to predatory pricing. The financial metrics might appear attractive, but a parasitic relationship of extracting value from customers (rather than adding value to them) usually ends up destroying shareholder value at some point in the future. On the other, we have companies like Amazon, led by Jeff Bezos, who says, “We’ve done price elasticity studies, and the answer is always that we should raise prices. We don’t do that, because we believe—and we have to take this as an article of faith—that by keeping our prices very, very low, we earn trust with customers over time, and that that actually does maximize free cash flow over the long term [emphasis added].”³

Some companies are willing to look past maximizing short-run focused r and instead focus on maximizing long-term focused n to create maximum long-term stakeholder value and happy customers. Amazon, Nebraska Furniture Mart, Costco, and GEICO are prominent examples. As they have grown larger over time and have achieved economies of scale, they have continued to share those benefits with customers in the form of lower prices and to provide more value for their customers. This not only makes for delighted customers, who then spend more money with those companies, but also makes those businesses harder to compete with over time, because they have the rare ability to defer gratification in lieu of long-term benefits. Consider the following quotes from Bezos that reflect the culture of long-term thinking at Amazon:

A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it’s durable in time—with the potential to endure for decades [emphasis added]. When you find one of these, don’t just swipe right, get married.⁴

Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that [emphasis added]. So if you could take the free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins.⁵

[Selling at low prices creates] a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com [emphasis added].⁶

When forced to choose between optimizing the appearance of our GAAP [generally accepted accounting principles] accounting and maximizing the present value of future cash flows [emphasis added], we’ll take the cash flows.⁷

Some of the best insight on the virtues of delayed gratification in creating long-term intrinsic value comes from studying Buffett’s comments on GEICO’s customer acquisition costs over the years:

In 1999, we will again increase our marketing budget, spending at least $190 million. In fact, there is no limit to what Berkshire is willing to invest in GEICO’s new-business activity, as long as we can concurrently build the infrastructure the company needs to properly serve its policyholders.

Because of the first-year costs, companies that are concerned about quarterly or annual earnings would shy from similar investments, no matter how intelligent these might be in terms of building long-term value. Our calculus is different: We simply measure whether we are creating more than a dollar of value per dollar spent—and if that calculation is favorable, the more dollars we spend the happier I am [emphasis added].⁸

At GEICO, for example, we enthusiastically spent $900 million last year on advertising to obtain policyholders who deliver us no immediate profits. If we could spend twice that amount productively, we would happily do so though short-term results would be further penalized [emphasis added].⁹

Buffett views these expenditures, which put pressure on reported earnings in the short term, as long-term value creating investments. In owner-related business principle number 6 of the Berkshire owner’s manual, he states, “Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable.”¹⁰

Noted value investor Thomas Russo has often talked about companies that have “the capacity to suffer,” or the capacity to reinvest to build long-term competitive advantage at the cost of depressed short-term reported earnings. Usually, these companies have an ownership structure that keeps activist investors at bay. Usually, some individual or entity has enough control to adhere to a strategic path and build a long-term economic franchise without bothering too much about short-term profitability. Growing a business in a new market requires high upfront costs. These higher costs depress current earnings, which negatively affect the stock price in a shortsighted market. Most early upfront costs beyond production and distribution are put toward converting people into lifetime consumers as their income grows. Significant advertising and promotion is needed initially to maintain early market presence before a company sees growth in market share or profits. That process takes time and requires a lot of patience, which most management teams do not have. That nagging itch from shareholders, employees with stock options, and the management’s net worth measurements cause companies to make a little compromise here, hold back on some needed investment there, to feed the earnings machine, pacify Wall Street, and prop up the stock price. Just scratch that itch a little bit. It will feel so much better.

But once scratched, does the itch ever go away? This is doubtful. Companies end up getting entangled in the endless game of managing analyst expectations. By bowing to these expectations, they become complicit, and then it is hard to exit. They begin playing the earnings management game to avoid the short-term hit that’s likely to follow. Or they think it could threaten their tenuous hold on strategic control. Or they fear they may lose their jobs if Wall Street declares that the earnings are in a secular decline. Management teams that are influenced easily by short-term-oriented shareholders, like an activist, tend to focus on activities that drive short-term results at the expense of long-term success.

In the most recent edition of the book Valuation: Measuring and Managing the Value of Companies, the authors write, “We’ve found, empirically, that long-term revenue growth—particularly organic revenue growth—is the most important driver of shareholder returns for companies with high returns on capital. We’ve also found that investments in research and development (R&D) correlate powerfully with positive long-term total returns to shareholders.” At the same time, the book also notes that “in a survey of 400 chief financial officers, two Duke University professors found that fully 80 percent of the CFOs said they would reduce discretionary spending on potentially value-creating activities such as marketing and R&D in order to meet their short-term earnings targets.”¹¹

Most managers are not willing to suffer upfront pain. So they focus on short-term results, which contributes to underinvestment in brand building, R&D, and other long-term growth initiatives, which in turn eventually leads to long-term pain. They cut current costs to prop up current earnings, rather than spend more now to gain much more later. Consequently, they hurt their chances of long-term success.

It is important to align your personal values with that of your investment. Buffett and Munger are masters of practicing delayed gratification, and unless you, as a partner in Berkshire Hathaway, are equally willing to delay gratification, you will end up as a frustrated shareholder.

Buffett is happy to forgo current profits for GEICO to acquire additional policyholders, but he is also willing to increase expenditures and their concurrent charges against earnings if warranted, because he always focuses on total lifetime value of every customer. When a business has a high ratio of lifetime value to customer acquisition costs, it’s rational to invest as much as possible in acquiring new customers. That is how Buffett thinks about advertising dollars spent on profitable customer acquisition by GEICO: in net present value terms.

In the insurance business, Berkshire Hathaway not only will happily forgo business and market share in the absence of profitable underwriting opportunities but also, in specific instances, will incur underwriting losses that hit the bottom line in the current year. In exchange, they acquire float that will produce income for many years in the future. What could be worse? All of the expenses are currently recognized, and all of the income will be recognized only in future years as the float produces investment earnings. This is delayed gratification in the extreme.

The question in all of these cases is this: Are you, as a shareholder, willing to give the same commitment to delayed gratification that Buffett and Munger practice? If not, you may want to revisit your participation in this security and in other securities with similar long-term-minded management teams. Keep in mind that only by resisting the marshmallows today will you receive the whole box of See’s truffles tomorrow.

Investors generally overlook businesses that are doing things that will create significant incremental earnings one to two years from now because they don’t want to wait that far out. Investors often shun businesses that are investing for the future and currently are suffering from low initial margins in those new initiatives (because capacity gets utilized only over time) because the earnings growth is back-ended. Even if they execute well, they will see little “reported” earnings growth for the next four to eight quarters and may even see a decline resulting from incremental depreciation and poor initial margins (because of low capacity utilization). Even if they are expected to experience an exponential jump in earnings growth after that, the stock markets generally do not initially increase the market value of these businesses. They do re-rate them, however, around the time when the earnings growth is clearly visible.

As investors, we get an edge over competition if we pick these companies and have the patience and conviction to hold them. Although these businesses are clearly undervalued on a longer-term basis, it is psychologically challenging to invest in them and even more so to hold on to them. These difficulties result in a lack of investors and the subsequent mispricing of these stocks, because the price discovery is weak when investors’ attention on these stocks is low.

Capitalizing on businesses that operate on a long-term timeline of value creation is possible only if we operate with a long-term view as well. When you focus on long-term outcomes, expect to be frequently misunderstood in the short term. This is true not only in business and investing but in life and relationships as well. To invest in companies with “the capacity to suffer,” we must be willing to suffer along with them. In other words, we need a high tolerance for short-term pain.

You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

—Seth Klarman

A money manager must have the resilience to suffer through periodic bouts of underperformance. During 1999, Russo was invested in high-quality businesses like Nestlé, Heineken, and Unilever, among others. They were terribly out of favor relative to the speculative forces that were driving the market at the time. Russo’s fund was down 2 percent for the year and the Dow was up 27 percent. During the early part of the following year, he was down 15 percent and the market was up by 30 percent. Russo was able to stay the course because he had the capacity to suffer. The same can be said of his investors at the time. This is why the success of an investment manager is as much about his or her ability to vet prospective clients as it is to say no to the wrong type of investment idea.

Equity investing is like growing a Chinese bamboo tree. We should have passion for the journey as well as patience and deep conviction after planting the seeds. The Chinese bamboo tree takes more than five years to start growing, but once it starts, it grows rapidly to eighty feet in less than six weeks. As prominent blogger Anshul Khare once aptly remarked, “In the initial years…compounding tests your patience and in later years, your bewilderment.”¹²

Peter Lynch’s investing experiences share a symbolic resemblance to the inspiring bamboo tree story: “The stocks that have been most rewarding to me have made their greatest gains in the third or fourth year I owned them.”¹³ Stocks can stay cheap for longer than we expect and then may be repriced much more quickly than we expect.

We should judge our businesses based on their operating results, not on the volatility of their stock prices. The stock market is focused on the latter, but investing success is based on the former. If the management team executes, the stock eventually follows. In fact, not getting immediate returns on our existing high-quality growth stocks builds antifragility. Patience plays a critical role during such times. For instance, Berkshire Hathaway’s stock has delivered a CAGR of ~21% over the past 42 years (as of October 2019). But if you bought it in 1997, you would have had to wait five years before you saw any positive return on the stock. Similarly, investors in Adobe (which, as of October 2019, has delivered a CAGR of ~24% since its IPO in August 1986) had to undergo a period of thirteen years (2000–2013) during which they made nil return on its stock. Investing is hard. Very hard.

It pays to have a long-term view. But a long-term investment horizon must be married with an investment process willing to continually question the core investment thesis. Investors should exercise active patience, that is, diligently verifying their original investment thesis and doing nothing until something materially adverse or negative emerges. All too often, when a stock doesn’t work out as planned, we call it a “long-term investment.” When we spend a lot of time getting to know a business and its management team before investing, as we investors often do, it becomes difficult to change our mind. Investors don’t want to feel like all that time was wasted learning things that they didn’t act upon. We gain an advantage over time by staying intellectually honest while studying new ideas and existing holdings, and only investing in the few in which we think the odds are significantly in our favor. Investors tend to become complacent and stop questioning their existing holdings when their stock prices are going up. They resume analyzing in detail only when the prices start falling. Don’t analyze your holdings only when they fall. Just because the stock price of an existing holding is going up doesn’t necessarily mean that nothing negative is happening in its business.

An Investor’s Biggest Edge

If you want to make money in Wall Street you must have the proper psychological attitude. No one expresses it better than Spinoza the philosopher…Spinoza said you must look at things in the aspect of eternity.

—Benjamin Graham

To make money in stocks, you need to have vision to see them, courage to buy them and patience to hold them. Patience is the rarest of the three.

—Thomas Phelps

An investor who can hold on in the face of all of the advice and temptations to ensure a profit by selling an existing position demonstrates a quality of mind quite out of the ordinary.