The difference between stock market

investment and speculation.

Using the “Rule of 72” to achieve

pension investment success.

Christopher M. Quigley B.Sc. (Maj. Accounting), M.I.I. (Grad.), M.A.

The issue of successful stock market investment affects us all. Even if we are not directly

engaged in the industry, all of us will need some form of pension to fund our retirement.

Whether we like it or not most of our retirement funds will find their way into the financial

markets. For this very reason, the issue of pensions has moved politically centre stage; in

particular the investment strategies used to direct pension funds. Due to mismanagement,

mainly over the last decade, many retirement portfolios have become under-funded at best,

or, at worst, totally bust. This situation is a direct result of the managed funds having been

speculated rather than invested. Many cynics will say that the whole investment

environment today has more of the characteristics of a casino than of a professional market

of equities and, therefore, they doubt that one can ever achieve a faithful and fair return on

capital. However, this view is erroneous. This essay sets out to explain how to achieve

superior pension investment returns through a simple yet powerful investment rule: “the

rule of 72. This rule is based on investment and not speculation yet if you faithfully apply it

your returns, over time, will be spectacular. Many believe that such degree of return is only

possible through “speculative activity”. They are wrong and I will explain.

Benjamin Graham, the father of security analysis, and mentor of Warren Buffett, long

believed in the stock market as a means to achieve financial freedom. The wealth he

accumulated and the school of successful investment gurus he educated are testament to his

insight and genius. The key to his formula has always been one simple concept: VALUE.

His central message never changed and in a financial community which bores easily, his

conservative investment style became "classical" and then "old fashioned". Graham

ultimately derided the fads and trends that engulfed Wall Street and he eventually gave up

trading and managing funds. However, his "baton" of value was spectacularly taken up by

his acolyte, Warren Buffett, who went on to become the most successful investor of all time.

Buffett, like Graham, believes the policy of investing does not require high qualities of

insight or forethought, as long as some simple rules are applied. In essence these simple

rules are:

1. Safety of Capital

2. Adequacy of Return

An operation that does not seek both of the above is not an investment but a speculation.

Now in today's complex, volatile, media-driven and fast-moving market environment how

does one actually apply these simple rules? The essential thing to realise is that when you

buy an equity, you are purchasing part of a business. Investment is most intelligent when it

is most business like. For my part, the best way to achieve this business-like goal is to focus

on price, and through systematic analysis of this factor, the grail of value will be

discovered.

Investment Filters At Wealthbuilder for the last decade, for pension purposes, we have been educating clients

on how to review equities critically and focus on value. Using a number of filters, prospects

are identified and compiled into watch lists. Then, through the use of basic technical

analysis, appropriate buy-in and sell-out points are pinpointed. The main criteria that are

used to filter these stocks are:

1. Price/Earnings Ratio

2. Financial Strength

3. Earnings Growth

4. Dividend Yield

5. Dividend Growth

6. Business Model Strength & Sustainability

7. Return On Capital

Of these seven elements (after price/earnings ratio and financial strength), earnings growth

and dividend yield are the most important. Why?

The big driver of investment returns over time is not figuring out which sector is going to

do best, or which country will surpass the rest, or what investment style will be in vogue, or

which consumer group will prevail. No, the biggest driver is: EARNINGS GROWTH AND

INVESTMENT INCOME RECEIVED AND RE-INVESTED because the fundamental

axiom of financial dogma is: “where earning go, share price will eventually follow”.

Thus it is crucial to your investment success that you find those great companies that give

great yet sustainable returns over the long term. The profile of such profit generating

institutions can only come from companies in large markets with proven products or

services such areas as: financial services, consumer staples, healthcare, energy and

insurance.

What are our growth targets? Earnings growth in the 12% per annum range is our ideal goal. Add to this a dividend

yield of 2% and you get our combined investment objective of 14% growth per annum. In

summary our investment formula is as follows:

Financially Strong Businesses + Fair Valuations + Large Growing Sustainable

Markets + Growing Earnings + Good Dividend Yield + Good Dividend Growth =

Superior Value

The rule of 72. Why do we look for 14% growth? Well to understand this let me now introduce to the rule

of 72. The 'Rule of 72' is a simplified way to determine how many years an investment will

take to double, given a fixed annual rate of interest. Thus by dividing 72 by the annual rate

of return, investors can get a rough estimate of how long it will take for the initial

investment to “double” itself.

For example, the rule of 72 states that $1 invested at 10% would take 7.2 years (72/10) =

7.2) to turn into $2.

Thus our target annual rate of return of 14% requires 5 years for “doublings” to take

effect. (Example using approximations):

Year 1. 1000 X 1.14 = 1140

Year 2. 1140 X 1.14 = 1300

Year 3. 1300 X 1.14 = 1482

Year 4. 1482 X 1.14 = 1689

Year 5. 1689 X 1.14 = 1926

The average “pension investment” cycle is 20 years, therefore if you focus on the annual

investment target of 14% you can get 4 “doublings” of your initial investment over the 20

year period. Thus through the “magic” of compounding a 100,000.00 dollar investment

grows into a handsome pension fund of 1.6 million dollars after 4 such “doublings”.

Year 1-5. 100,000.00 X 2 = 200,000.00

Year 6-10. 200,000.00 X 2 = 400,000.00

Year 11-15. 400,000.00 X 2 = 800,000.00

Year 16-20. 800,000.00 X 2 = 1,600,000.00

We believe such returns are necessary because over the next 20 years, according, to John

Williams of ShadowStats.Com, inflation will not be a benign 1-2% (see CPI rate) but 7-9%

(see SGS rate) due to the ongoing Quantitative Easing policies being executed in the USA,

Latin America, Canada, Japan, Britain and the EU. See chart below for current and

historical inflation rates:

Unless investors have an aggressive strategy to find and stay invested in superior

companies giving annual growth rates in our target range their “life-styles” are going to be

significantly altered by inflation going forward. Using the ShadowStats above, when we

apply the rule of 72 to an annual 7% inflation rate we can reasonably estimate that over

the next 20 years there will be two doublings of general price levels (72 divided by 7 is

approximately 10. 20 years divided by 10 is 2). This will have a cathartic effect on future

society. To be fore-warned is to be fore-armed. It is our opinion that the best way to protect

yourself against this monetary crisis is to become a smart investor. Time is of the essence.

Conclusion Despite appearing to be a complex matter, the path to investment success is quite simple, as

pointed out by Graham all those years ago. The financial achievements of his students:

Warren Buffett, Charlie Munger, Ed Anderson, Bill Ryane, Rick Guerin and Stan

Perlmeter, are testament to the enduring power of his investment philosophy. By applying

our earnings growth and dividend investment policy the average investor, using discipline

and patience, has within his or her grasp the power formula to earn superior returns in the

stock market and thereby win for themselves and their families financial freedom and

independence.

Charts courtesy of ShadowStats.Com.

© Christopher M. Quigley 14th

. February 2014.

www.Wealthbuilder.ie