are you smarter than a 7th grader (notes)

8/9/2019 Are You Smarter Than a 7th Grader (Notes)

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As a kid, I dreamed of becoming an architect. I had my own drafting table

by middle school and took drafting classes through high school.

After high school graduation, I was one of 30 or so students selected into

Penn State’s architecture program our of the 70-80K students on campus.

I think what was so appealing to me about architecture was the

combination of creativity and problem solving it required, in conjunction

with a good understanding of math.

Luckily for me, this combination of skills has applications outside of

architecture as well. Successful investing requires a child-like curiosity. Itrequires creativity in problem solving and independent thinking. And it

requires a firm grasp of basic math to put it all to work.

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Lucky for me, Lego still allows me to express my inner architect.

But today, I spend most of my time building a different kind of model.

I’ll spend the next thirty minutes or so explaining what I mean.

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I’m going to do my best to keep things simple today.

Students have so many distractions thrown at them constantly. So do we.

So we do our best to focus on only what matters. Because if we don’t,

this can happen.

Video: https://www.youtube.com/watch?v=6MpfVD-c-QI

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Mrs. Pitts told me that you are learning about rates of return in class this

year. In my job as an investor, this is all we think about.

Our job is to grow – or compound – our client’s money at the highest rate

that is safely possible.

Let me show you why Einstein called compound interest the most

powerful force in the universe.

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There's a famous legend about the origin of chess that goes like this.When the inventor of the game showed it to the emperor, he was soimpressed by the new game, that he let the man name his own reward!

Think about that for a second. What would you have asked for? Anythingis fair game.

He did better than that. He “only” asked for one grain of rice on the firstsquare of the chessboard, followed by two grains on the next square,four on the next, eight on the next and so on for all 64 squares on theboard. So each square would have double the number of grains as thesquare before. Got it?

Seems like a pretty simple request right? The emperor probably thoughthe got off easy and wondered why the man had asked for such a smallreward. But after a week, he realized how wrong he was! Watch this:https://www.youtube.com/watch?v=t3d0Y-JpRRg

Anyone care to guess how much rice the emperor would have put on theboard?

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Here’s the math behind it. That’s a lot of rice!

Not too shabby considering we started with a single grain.

That’s the power of compounding.

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Everybody’s with me so far right?

Good. So here is your first test:

A lake has water lilies growing on it.

On the first day, there is one water lily.

Each day, the number of water lilies doubles.

After 30 days, the water lilies cover half the lake.

How long before they cover the other half of the lake?

The answer will seem obvious after you hear it.

The lilies that took 30 days to cover half the lake take only one more day

to cover the other half.

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Unfortunately, it is impossible to double your money every day.

But you can double it pretty quickly at even lower rates of return.

The Rule of 72 is a quick trick for estimating how fast your money will

double.

Just divide 72 by your rate of return to estimate how quickly you’ll

double your money.

So for example, if you just put your money in a bank earning 2% per year,

you’d have to wait 36 years to double your investment!

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We’re not going to wait that long.

For example, if we earned just 6% each year, our money would double

every 12 years: (72/6)

Better yet, if we are able to earn 12% per year, we would double our

money every six years: (72/12)

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So the most important lesson for today:

Perseverance at even modest rates of return is of the utmost

importance in compounding your net worth.

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When Mrs. Pavese and I first met, she thought my job was just doing this.

She told people I “did math” for work.

Truth be told, I do “do math” a lot. Investing requires a good grasp on

basic math skills.

But I actually spend most of my time doing this.

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Anyone want to guess what I’m reading about all the time? No Mrs. Pavese. It’s not

lemonade stands. But I do spend most of my time reading about businesses and

asking questions. If you are curious by nature, this might be the perfect place for you.

How many of you had a lemonade stand as a kid?

Let’s think about that lemonade stand we had as kids for a minute or two. What

might we want to know about it? Maybe things like:

• What’s their recipe? Is there a secret sauce? Is it better/sweeter than other

lemonade?

• Where do they get their lemons? How much do they cost? How many drinks can

we make from one lemon?

• What’s stopping someone else from making the same drinks? Are there lots of

other kids on the block selling lemonade?

• Is their lemonade better? Are their glasses bigger? Are they selling it cheaper?

Maybe we should consider partnering with them?

• Why should be people buy our lemonade instead of others? Where should we put

our stand? Is there a lot of traffic on the street?

These are some of the things we ask ourselves when researching a company. There

are many more, but it’s always helpful to keep things very simple. Let’s take a look at

another simple business model.

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Mrs. Pavese tells me that you guys aren’t allowed to chew gum in school.

Is that right?

Okay . . . So maybe this wasn’t the best example I could have chosen, but

stick with me here, and please don’t try this at Jacob’s Fork!

Question: Ever notice that when you open a pack of gum in class, how

quickly everyone becomes your friend?

Assuming gum was permitted in school, this would be a great business,

right?

So let’s take a look at our imaginary gum business.

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It’s a simple business, but it works. Jason buys four or five packs of gum

each day for 25 cents each.

Once he gets to school, he sells each stick of gum to his friends for 25

cents.

That’s five sticks at 25 cents so Jason rakes in $1.25 on each pack.

That means he is making $1 of pure profit on every pack!

At four or five packs a day, that’s a lot of money!

Let’s think about this for a second.

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How much do you think Jason can make by the end of high school?

If he sell’s four packs a day, that’s $4 times five days a week, so $20 per

week.

Let’s say there’s 36 weeks of school in a year. I know. Depressing, but

that’s $720 a year. Not bad.

If he started in 7th grade, he has six years left until graduation, so $720

per year for six years turns into over $4,000!

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Now, what if I told you that our friend, The Bubble King, wanted to sell

you half of his gum business. How much would you pay him for it?

In other words, he’ll share half his profits with you until he graduates,

but he wants you to give him the money today.

How much would you give him?

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Let’s think about this together. He’s selling 4-5 packs a day now, right?

But what if Jason doesn’t sell that many every day? What if he just sells 3

packs?

That’s still $3 a day or $15 per week. That’s over $500 per year ($15 x 36

weeks).

With six more years of school, we still make $3,000 ($500 x 6 years) by

graduation.

So you would you give him half that today - $1500 - for half the profits?Is that a good deal?

Let’s weigh the pros and cons.

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Jason has a good business.

But you never know what he might do over the next six years.

It’s a long way until graduation.

He might decide to start experimenting with new flavors. Weird flavors.

That’s a risk. So $1,500 is probably too much to pay him today.

Don’t you think? What about $1?

How many would buy it for $1?

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You guys are smart so about now you’re probably asking why someone might sell us

something for less than it’s worth? That’s a very good question. I’m glad you asked.

It turns out that the stock market is a very emotional place. Let’s imagine that one of our partners in the gum business, named Mr. Market, offers to buy our business or

sell us his half of it every single day. Most of the time his numbers are in the right ball

park. But occasionally he’s in a great mood and offers us way too much money. And if

he wanted to pay us $5K for our half of the gum business, we’d have no problem

selling it to him, because we know it’s worth somewhere b/t $1 and $1500 right?

So some days Mr. Market is skipping around Wall Street, but other days he can be

very depressed or really nervous about how much gum we’re going to sell. Maybe

someone found a needle in some Halloween gum or something. Do Mom’s still even

say that by the way? Whatever the reason, he occasionally get’s scared, panics and is

in a rush to sell his half of the gum business back to us at any price. This is when we

hope to buy it for $1 right? Because we know that’s a great price!

People act differently in a crowd than when they are by themselves. You probably see

it all the time in school. We see it in the stock market too. Here’s your last test of

the day. Tell me which of these lines on the right is the same length as the one on

the left. How many think 1? 2? 3? Would you still have said 2 if everyone around

you answered 3?

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Are you sure about that?

Independent thinking is very rare.

It is even more rare as part of a group.

I want to show you something which might be hard to believe.

This was an experiment in the 1950s that showed how our opinions are

influenced by a group. It’s pretty crazy.

Video: https://www.youtube.com/watch?v=qA-gbpt7Ts8

What did we learn? About 3 out of 4 people gave a wrong answer to at

least one question. Wow.

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Anyone every heard of Candid Camera?

I didn’t think so. It was old even when Mrs. Pavese was your age.

But this is still pretty good. Watch this one with our last experiment in

mind.

Video: https://www.youtube.com/watch?v=i24MDkEzXHk

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Okay. This is the home stretch.

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A better solution is to keep things as simple as possible, which is where we started

this morning. You don’t have to know everything. Focus on what interests you. On

what you can understand. And whenever you can, on what you are passionate about.

Ted Williams is one of the greatest hitters in baseball history. He finished his career

with the highest batting average of any baseball player and the highest on-base

percentage of all time. Do you know how he did this? He only swung at pitches in his

sweet spot. It didn’t even matter if they were strikes. He split the strike zone into

dozens of smaller areas and studied where he hit the ball best. Then he waited for

the perfect pitch and let anything else go by him.

We think about the stock market in much the same fashion. We look at hundreds of

companies. Maybe thousands. It’s impossible to understand every one of them. We

don’t. But the nice thing about investing is that you don’t have to have an opinion on

everything. We can focus on a few businesses we know really well. On the people we

trust. And we can spend all our energy deepening our understanding of these

businesses, so that when Mr. Market offers us a great price, we are ready to buy it!

I still learn something new every day. But most of the time, I’m pretty much just

sitting back reading. Just ask Mrs. Pavese.

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How many of you have been to Carowinds? Pretty cool right. We actually own stock

in the company. They have amusement parks all over the country.

It’s a business we can understand. It’s a good business, because no matter how goodor bad things are, people can usually afford to take their kids to the local amusement

park. And kids spend a good bit of money on stuff while they are there.

We also own SeaWorld, which is a very similar business. The nice thing about

amusement parks is we know they’ll probably always be around. You might see a

scary headline in the news about some of them from time to time but these things

pass and people eventually come back to the parks. Remember what I told you about

Mr. Market. Occasionally he gets spooked by parks closing or by killer whales and

that gives us a chance to buy a good company at a great price.

That’s a good rule of thumb when investing. When I buy stock for our son Lucca, I

want to make sure that he owns something that will be around when he’s my age so

that it can compound over all those years.

Just keep in mind how quickly all that rice piled up.

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Not all businesses live forever.

Do you guys remember Blockbuster?

Not a good investment.

How about these guys?

Video: https://www.youtube.com/watch?v=3FCioWz7aps

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are you smarter than a 7th grader (notes)

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