Fast(er) to FIRE via Investment Companies?!

Can you reach FIRE (Financial Independence Retire Early) faster by investing in Investment Companies?

That might actually be the case and maybe even faster after the current market crash we have seen over the last month (-30%)! In this post I intend to go through what an investment company is, what they do and why I believe that these types of companies over time should generate better returns than the average stock market. Now, let’s fire away!

“Traditional” way of investing for a FIRE aspirant

Let’s start from the beginning. Reaching Financial Independence is a dream for many and over the last few year, the acronym FIRE (Financial Independence Retire Early) has gained massively in popularity. Why? Seems like most people are not completely happy with how they spend their time (by selling hours to an employer). Unsatisfied with their situation they begin to look for something more fulfilling. It usually starts with a dream of being financially independent and some actually take the next steps and start their journey towards FIRE.

Many FIRE aspirants don’t have a finance degree nor a financial background so investing might not be something that comes naturally. They might not even have any interest in investing besides from trying to reach their financial goal so that they can ditch that dead end job of theirs!

By googling around they come across FIRE and the 4%-rule which is a rule of thumb stating how much money one would need to have invested to be able to retire, cool!

They do their numbers and realize that they will have to start investing in the financial markets and most likely the stock market. As they have no interest in the markets (more than the hope of making money), they want something simple that can be automated.

Exchange Traded Funds (ETFs) seems to be the thing to buy. An ETF is a security with multiple investments (holdings) which is traded on the exchange. It does not have a traditional fund manager who is actively buying and selling holdings (like a mutual fund). The investments of the ETF are based on the rules of the ETF and often they are “tracking” an index and hence the holdings should be a replica of the index it is tracking and so should the performance. One of the advantages of ETF’s are their low fees, usually 0.0% – 0.5% per year since they are computerized. One of the downsides could be that when investors wnat to sell, they have to sell stocks they invest in without any discretion. Buying “the market” could mean buying an ETF which is tracking the global stock market.

So the FIRE aspirants would probably turn to an online broker to buy their first ETFs, maybe in the VTSAX (Vanguard Total Stock Market Index Fund Admiral Shares). This is a great start for a long term passive investment as it has very low costs and a broad US diversification. This kind of investment stands in striking contrast to randomly investing in expensive mutual funds but of course there are pros and cons with both. Still ETFs are widely used within the FIRE community.

What are Investment Companies?

An investment company (how I define it here) is a company which owns other businesses, these businesses can be listed on a stock exchange or privately held. Some might call themselves private equity companies if they solely invest in non-listed companies. Some might call themselves holding companies if they own different businesses in different sectors, only listed or a combination of listed and non-listed companies.

Often these investment companies buy large stakes in the companies they invest in which gives them a place in the board where they can actively engage to enhance the performance of the company they have invested in. If they buy they whole company, they will obviously get even more involved and might also sell off assets, merge the company with other companies they already own and/or find other synergies etc. This is the value they create for their investors. A traditional mutual fund manager would not get actively involved but they might be voting at the annual general meeting.

To mention a few rather large ones: Berkshire Hathaway (owned by Warren Buffett), Brookfield Asset Management, Markel Corp, Loews Corp, KKR, Blackstone etc…

As you can see, this type of companies is very similar to a fund or an ETF in the sense that they own different businesses and want to make money for their shareholders. The main difference with an ETF is that it doesn’t have an active investment manager allocating the capital, this is done digitally by a computer.

Why they might do better over time?

There are a few things standing out when it comes to investment companies, meaning they might have an edge (or a few) over other investments, in particular in the longer run. These possible advantages are:

“Multiple expansion”: If the investment company invests in unlisted companies, they might benefit of what is often called “multiple expansion”. An example would be an unlisted company which might be valued at a Price Earning (PE) ratio of 5 which means investors are willing to pay 5 times the company’s earnings in order to buy the company. Listed companies often trade at much higher valuations (<10) so when an unlisted company is bought by a listed company (like an investment company), their valuation often increases immediately even if nothing has changed within their business! That’s multiple expansion, which benefits investors as the company they bought might double in value immediately after the purchase has gone through.
They can use leverage! Not only do the companies they invest in use financing in their businesses but the investment company can also borrow money to invest in more businesses. This of course goes both ways, brilliantly in good economic times, not so good in bad times…
Aligned interests as Management are often invested in the company
They can sometimes be bought at a discount to the actual value of their holdings. This basically means that if they company was to be dissolved (sell all their assets and pay the money to the stockholders), one would get more than what the actual stock price was showing.
If they invest in unlisted companies, it is a good way to get exposure to an asset class often only available to large investors. If the investment company has many unlisted companies one also gets the benefit of diversification.
Some pay dividends which is likely to mean that the companies they invest in are making a profit and distributing some of those profits.
Often they are much more cost effective than a mutual fund (one has to check the details in the annual report but often they are run very efficiently and hence costs are similar to those of an ETF).
Many are sitting on large cash positions as prices have been high and lots of competition from other players, during the last month (Feb-March 2020) this have changed as markets have plunged.

As you can see there are some factors that really should be playing in favor of investment companies over time. Of course there are risks associated with these companies too as with any investment.

In a historical context (see the graph below), they can actually beat the VTSAX (could not find a good proxy index for these companies so used Brookfield Asset Management). Obviously no one can know if history will repeat itself, but they do have a few attributes working in their favor over time.

Business specific risks with Investment Companies

There are of course some business specific risks to bear in mind with any and all of these companies. Something one should understand in particular is to what extent the investment company uses leverage i.e borrowed funds to buy more companies. If the market falls and interest rates increase they are likely to take a big hit. On the contrary, when times are good they should be able to produce greater returns when using leverage and this is something which currently is extremely cheap, but that might change (though quite unlikely in my personal opinion over the foreseeable future..)!

If a large part of the investment company’s holdings are unlisted, the stock will most likely take a big hit when markets fall as the value of he un listed holding might be questioned. On top of that, taking unlisted companies public (via an initial public offering) will be very hard when the market is falling. If they still would want to sell a company to the public via a listing, they are likely to have to reduce the price if the market is fragile….

There are numerous more risks but these a couple of the ones I personally find very important, then one of course have to consider all other traditional risks with investing.

Conclusion?

The reason I wrote this article is because I personally like investment companies and also invest in them. As mentioned above, there are a few favorable attributes about these kinds of companies, meaning that over time they should be generating better returns than the average fund or even ETF. This should be especially true if one invests in several of them and hence get a broad diversification (like an ETF). The main difference is that they are more actively managed but still have low operating costs compared to the value of the assets they have.

Now that the prices of most stocks have fallen significantly and if you are a long term investor, then these type of companies might actually help you reach FIRE faster (but there are of course no guarantees)!

Using leverage wisely might be the most important factor when trying to create wealth, I am not sure I know of any wealthy person, who has not used leverage to become wealthy. Perhaps we too should learn from them but let the experts do the job for us.

There is also no reason why one couldn’t complement a passive ETF with a handful of investment companies. There will likely be a commission for purchasing the stocks so monthly investments might not be ideal (depending on the commission compared to the size of the trade).

In Sweden we even have a cheap fund available which invests in Investment Companies, meaning I don’t even have to buy them individually (Spiltan Aktiefond Investmentbolag). This is one of my personal holdings but also the one where 1/3 of my 1 year old daughter’s monthly investment goes.