How 'Virtuous Circles' Bring Maximum Returns Into Your Portfolio

Wednesday: The Independent Investor FROM THE DESK OF MILES EVERSON: There are two circles at work in this world: The Vicious Circle and the Virtuous Circle. In the vicious circle, two or more elements intensify and aggravate each other, leading to a worsening of a situation. On the other hand, a virtuous circle is a complex chain of favorable events that reinforce themselves through a feedback loop. Both these circles are commonly used in economics, sociology, and biology. But do you know that these circles, particularly the virtuous circle, are also applicable in investing? When managed properly, the virtuous circle helps maximize your returns. Keep reading below to know what “virtuous circle” means when it comes to your investment portfolio. CEO, MBO Partners Chairman of the Advisory Board, The I Institute

How 'Virtuous Circles' Bring Maximum Returns Into Your Portfolio You may have heard the term, “vicious circle”… When "vicious circle" was first coined in the mid-1800s, it referred to the worst logical fallacy: circular reasoning. It's when an argument's conclusion is also one of its premises. Over time, the meaning of a vicious circle changed to mean a cascading, bad chain of events that exacerbates itself over time. Take, for instance, the poverty cycle. People born into poverty typically don't get the same access to education as those with higher means and often get worse jobs out of school. Since their jobs pay less, poor people often spend more time working, making it harder for them to pursue an education, making it harder to find better work, and so on. In the mid-1900s, a century later, the need for describing the opposite situation came into play. The term "virtuous circle" was coined, and it's the same concept yet working positively. Cyclical phenomena create powerful wealth creation… They are powerful and govern so much of what happens in the real world. They arise in economics, sociology, biology… and even in investing. The term virtuous circle has evolved into a virtuous cycle. For instance, let's look at microcap stocks. These stocks don't get the high-visibility chatter on social media and financial publications that larger companies do and aren't policed as strictly by the Securities and Exchange Commission (SEC). Microcaps with valuations less than USD 1 billion are often invisible to hedge funds. Oftentimes, their covenants or internal rules can't invest in such tiny firms. When microcaps are truly good and grow large enough to reach around USD 800 million in market cap (with sufficient liquidity), these companies begin popping up on the screens of more investors. When these firms start to receive attention, it leads to some analyst coverage and media attention... And that can lead to larger investment fund stake-taking. In a virtuous cycle, with that added attention, it can lead to sudden explosive growth. Once the microcaps cross USD 1 billion, they appear on so many more funds' radars. Once these firms cross USD 2 billion, it's even more so. It's a virtuous cycle that feeds on itself positively, leading to five-bagger and 10-bagger returns when you can identify those right businesses poised for the big time. It's generally difficult for a USD 50 billion firm to become a USD 250 billion firm. There just aren't that many, and every hedge fund is staring at every one of those companies. Conversely, USD 500 million companies skyrocket into USD 2.5 billion companies incredibly frequently. Legendary investor and billionaire Warren Buffett was once asked why he no longer looks at microcaps. He said it wasn't because he doesn't like them… it's because he can't invest in them. But if Buffett did invest in companies worth less than USD 1 billion, he thinks he could easily attain 50% annual returns with some diligent fundamental research. He says: “The universe I can't play in has become more attractive than the universe I can play in. I have to look for elephants… It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on USD 1 million. No, I know I could. I guarantee that.” That's some serious alpha… Let's think about how the virtuous cycle of microcap growth really works... As a company executes its vision, its valuation increases. Once a company is larger, it is easier to source capital for further growth on better terms. As a company grows, it attracts better employees and partnerships. Once it crosses the USD 1 billion mark, it lands on the radars of hundreds of hungry hedge funds. Hedge fund investments are votes of confidence for a company. These lead to greater talent, higher valuations, and cheaper access to capital―factors that lead to more attention from Wall Street, and before you know it, the CEO is live on Jim Cramer's “Mad Money” show. After all, nearly half of the megacaps today were once microcaps... That is a virtuous cycle we want our money to ride with! It may be the only place in the equity markets where investors could realistically find 1,000x returns. Hope you’ve found this week’s insights interesting and helpful. Follow us on LinkedIn.     Stay tuned for next Wednesday’s The Independent Investor! Warren Buffett, one of the greatest investors in the world, said there are 2 rules of investing. Learn more about the first step to financial freedom in next week’s article!