Consistency is Superior
If you’ve never played Catan - I’d highly recommend it.
In the game, a board is created using five different kinds of hexagon-shaped pieces and each piece is assigned a number. If I choose to occupy a given hexagon, I receive the resource associated with that piece each time its assigned number is rolled on dice. Resources that you receive from successful dice rolls can then be used to expand and build on additional hexagonal pieces. The first player to expand their kingdom to a pre-determined size wins the game.
The game exhibits many ideas that we examine in finance such as return on investment, examining reinvestment opportunities, supply and demand, and even building relationships. But even those who aren’t interested in finance will find that the breakdown between strategy and luck always provides an entertaining game that honors the thoughtful player…and it adds just enough of a random element to leave some players feeling cheated by the randomness of the dice!
After playing the game many times over the last decade, I noticed some reoccurring results from the players who most often felt ‘cheated’ by the dice.
Inevitably, there is at least one player in every game who can’t help but take the position of betting big on just a couple of numbers. They do this with the thought that the magnitude of their gains for their successful rolls would make up for the extended streaks where the dice doesn’t roll their way. In my experience, this type of player seldom wins. In fact, it is usually the player that takes the opposite approach: sacrificing large gains in exchange for consistent gains that wins.
I wondered if the mechanics driving victory in Catan could also be applied to investing, so I took to Microsoft Excel to examine the numbers in more depth.
I examined two hypothetical players, one pursuing a strategy of consistency, while the other pursues a strategy of large but inconsistent gains. Each player (or in investment language, investor) achieved a 10% average return – the consistent player achieved 10% every period, while the large gains player achieved an alternating combination of the 10% return plus and minus the level of volatility.
By varying the number of periods and the level of volatility experienced by the ‘large gains’ strategy, the following data table was generated showing the excess return of the consistency strategy over the big gains strategy:
While the difference doesn’t look like much if the variance and the number of periods remain small, as the variance and periods increase the excess return of the consistency strategy rises confidently.
The average game of Catan lasts roughly 50 dice rolls (or periods). The player that adheres to a strategy of consistency will handily beat the ‘large gains’ player. Using 10% volatility and 50 periods, the consistent player is nearly 25% better off than the large gains player, despite the fact that, on average, their return was the same. By adjusting the time between gains for the ‘large gains’ strategy, the difference between the two outcomes becomes even more pronounced. If the large gains investor instead receives a 30% return in one out of every three periods, and a 0% return in the other two (still averaging the same 10% per year), the excess return of the consistency strategy rises to over 75% after 50 periods.
At RPM Capital, we pride ourselves on attempting to be consistent, long-term investors. Our private company holding period is forever, and our equity is permanent. We seek to build equity for generations to come, through period 100 and beyond!
We do not seek to buy companies that will generate huge yields in some years in order to sell them for a profit. Instead, we seek to deploy our permanent, patient, and focused capital in private companies that earn consistent profits. We do this by targeting companies with a high percentage of recurring revenue. Recurring revenue is generated by businesses whose customers are forced by the immutable laws of nature, government, or otherwise to repeatedly purchase the product or service regardless of the current stage of the economic cycle. These companies earn a consistent return that can be reinvested and, over the long run, generate much more value than comparable companies with lumpier revenue streams.
If you own or know someone who owns a business with this characteristic, please let us know. We’d love to meet them. RPM Capital seeks to rationally compound capital for decades to come - and when the investment horizon is measured in decades, consistency is superior.