A “Flywheel” Approach to Investing

By John Reese —

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Teacher and leadership coach Jim Collins has authored and co-authored six books that delve into the inner workings of corporations and what makes them succeed or fail. One of the many concepts he features in his books, articles and lectures is that of the flywheel:

“No matter how dramatic the end result, good-to-great transformations never happen in one fell swoop. In building a great company or social sector enterprise, there is no single defining action, no grand program, no one killer innovation, no solitary lucky break, no miracle moment. Rather, the process resembles relentlessly pushing a giant, heavy flywheel, turn upon turn, building momentum until a point of breakthrough, and beyond.”

The relevance to investing may seem painfully obvious—find a company with a flywheel that’s rolling along with promise, reflecting characteristics and underlying operations able to sustain the roll, and you’ve got yourself a promising stock. But the relevance is both nuanced and layered. While the flywheel metaphor is valuable when evaluating a company’s strength from a potential buyer’s point of view, it also offers a meaningful comparison to the act of investing itself.

Imagine the initial purchase of a stock as the first push of an investor portfolio’s flywheel. The company, and therefore the stock, performs well, sustaining the wheel’s momentum. Upon rebalancing of the portfolio, gains are reinvested into other stocks with good prospects or even the overall market in general if you are believer in passive investing. Over time and in this way, the flywheel precept can be thought of as representing the compounding of returns from buying stocks, a concept that Warren Buffett, (one of several market gurus that inspired the stock screening models I created for Validea) refers to as the “Eighth Wonder of the World.” In a documentary on Buffett’s life that aired earlier this year, he described compounding as a “simple concept but, over time, accomplishes extraordinary things.” Billionaire investor Seth Klarman puts it this way: “The effects of compounding even moderate returns over many years are compelling, if not downright mind boggling.”

You don’t have to look further than the 2016 Berkshire Hathaway annual report to see a shining, if not the very best, example of the effects of compounding. A chart on the second page outlines Berkshire’s performance versus the S&P 500 since Buffett purchased the textile company back in 1965. Over that 52-year period, Buffett has averaged a 20.8% annualized gain on Berkshire Hathaway stock—a mind boggling return—but over the entire period, he’s earned nearly a 2 million percentage return on his investors’ money. A Motley Fool article from this past March explains that a $10,000 investment in Berkshire Hathaway in 1965 – which, it points out, is enough to buy a “nice car but nothing ridiculously fancy,”–would have been transformed into a staggering $88 million. While the S&P 500 has returned a hefty 12,700% over the same period, it’s doesn’t compare to the whopping 2 million percentage points that the compounding of Berkshire stock returns has created.

“Flywheel” Investing: A Two-Pronged Approach

This approach incorporates identifying companies that can outperform over time—a tack consistent with Buffett’s philosophy of finding strong companies with solid management and promising prospects—as well as taking a long-term approach to compounding investment returns.

Strong Performance— The stock screening models I created for Validea are all inspired by legendary investors that targeted companies with the potential to outperform. These approaches include those of Buffett as well as deep value techniques espoused by Benjamin Graham and John Neff, growth-at-reasonable price methods popularized by Peter Lynch and growth-focused strategies developed by both Martin Zweig and The Motley Fool’s Gardner brothers. The potential for strong returns exists whether you use one of these proven methods or develop your own stock-selection approach.

Compounding–The second part of the flywheel approach includes allowing your money to work over the long term. Getting the Buffett-like returns mentioned above is virtually impossible, but tracking the returns of the larger market (and perhaps then some), is possible if you choose the right strategy. An article by popular financial blogger Ben Carlson uses market return data to illustrate the potential for long-term wealth creation by investing in the stock market and the power of compounding.

On his website, Jim Collins’ expands on his flywheel concept to offer a parallel to long-term investing:

“Once you fully grasp how to create flywheel momentum in your particular circumstance, and apply that understanding with creative intensity and relentless discipline, you get the power of strategic compounding. Never underestimate the power of momentum, especially when it compounds over a very long time.”

Photo: Copyright: blueringmedia / 123RF Stock Photo

John Reese is founder and CEO of Validea.com and Validea Capital Management, LLC. Validea is a quantitative investment research firm and Validea Capital, a separate company from Validea.com, which maintains this blog, is a asset management firm offering private account management, ETFs and a robo advisor, Validea Legends and Validea Legends Income. John is a graduate of MIT and Harvard Business school, holder of two US patents and author of the book, “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”.