I am a big fan of frugality. I believe that frugality is all about the most efficient use of scarce resources. This could mean thinking outside the box in how to be resourceful and get more out of less, without sacrificing quality.
Frugality to me is very well connected with the concept of intelligent investing. In intelligent investing, you are getting a future stream of future cashflows at a bargain price today. This simple concept has made a lot of people very rich.
You want to avoid overpaying for things. This thought process is applicable whether we are talking about socks or stocks.
I recently stumbled upon a passage from the 2024 Markel Annual report, about the concept of frugality and super-investors.
Frugality
My friend and accomplished investor, Shelby Davis, once told me about a study of great investors. It sought to identify the principles, qualities, educational backgrounds, training, demographics, or other characteristics linked to future investment performance. The study only found one common characteristic among great investors: they were all frugal.
We agree.
That’s why we manage your capital at extraordinarily low costs. The returns we earn flow through to the company's value with minimal friction, which also compounds. Another unheralded, but incredibly important, component of our resilience is the frugality of our tax efficiency. The ability to select securities and hold businesses over long periods defers tax liabilities and compounds your company's value.
Now that I think about it, I could think of several prominent super-investors and business people who are frugal.
The first one is no other but Warren Buffett. He still lives in the same house that he bought in 1958 for $31,500, despite the fact that he is worth north of $100 Billion, and has been one of the world's richest people for over three decades.
He focuses on what gives him value, and doesn't really focus on ostentatious consumption.
He doesn't need to buy Gucci bags, or expensive sports cars to appear rich to others. He doesn't care what others think of his wealth. He enjoys it the way he wants, which is what matters to him. He cares about his inner scorecard, and donating as much as possible to charitable causes.
Buffett also has simple tastes when it comes to food, clothing and cars. He drives a Cadillac that was bought at a discount because it was slightly dented. Big deal, it still took him from point A to point B.
He does care about the most efficient use of resources at Berkshire Hathaway and his life. When he invests money, he makes sure that he can attain a certain annualized rate of return. He asks his businesses to reinvest everything that could be reinvested at this minimum rate of return, and to send back as dividends anything that they cannot reinvest at a good rate of return. He can then reinvest it.
He is also very careful about how he spends his time. He focuses on talking to people he admires, who are in his circle. He also spends time reading and learning, while spending as little time as possible on useless endeavours.
This frugality is all about intelligent and optimal use of the limited resources we have in this world. It is a mindset that drives your entire being. This mindset has helped Buffett be rational in an otherwise irrational world, and take bets that have paid off hugely. He has been able to structure deals and tax scenarios in a creative way so as to reduce tax drag for example. It's all about understanding trade-offs, opportunity costs and decisions that lead to the most optimal outcome all else being equal.
For example, he has sold companies where he didn't believe in the prospects anymore, and paid tax because the forward returns were not as exciting. But he would hold on to other investments while the increase their profits and capital gains, therefore failing to recognize capital gains. His deal to sell Procter & Gamble stock for Duracell business, helped Berkshire defer recognition of capital gains taxes. That's a good example of frugality helping you in deferring taxes. Deferring tax liabilities compounds your value over the long term.
He does understand the power of compounding, which is a magnificent force. The young Buffett often presented compound annual growth tables to his partners, calling them "The Joys of Compounding". The young Buffett understood that each dollar he spent in his early 20s is equivalent to $100 or more by his 70s, assuming a 10% annualized rate of return. In reality, he has outperformed this, but he has been very careful with that. He understands the risk of ruin, and wants to avoid losing money because each dollar today has a very high future value. An example of this thought is his business venture in the 1950s, where he bought a Sinclair gas station. He did lose 20% of his net worth on this venture, which didn't pan out. He does calculate the opportunity cost miss in the tens of billions of dollars on it.
Buffett has done well because he always focused on the best opportunities for his money. His frugality helped him buy great investments at a bargain price, and then patiently compound his fortune for decades. He never cut corners however, which is expensive in the long run. He also always treated his partners and investors ethically and honestly. He treats his employees fairly as well. For example, his salary at Berkshire Hathaway has been $100,000/year for at least three decades per Berkshire's filings with the SEC. This is a bargain price for one of the world's best capital allocators. He does like to spend time with like-minded individuals he could learn from and whose company he enjoyes. All of this is a great use of time, as that knowledge and relationship builds like compound interest.
But one of my favorite examples of efficient use of resources is the float that Berkshire Hathaway generates from insurance operations. Float is money received in insurance premiums from customers. Over time, the amount received in premiums is slightly higher than amount the payouts given to customers. That float is stable, and in effect a low cost pool of money that Berkshire could invest at a good rate of return. This in effect provides some leverage to Berkshire that further turbocharges returns. On the other hand one could argue that the deferred capital gains taxes on long-term holdings like Coca-Cola are another type of float, that compounding quietly for Berkshire.
Many rich people understand the compounding aspect and future value, which helps them define and understand opportunity cost. It prevents them from making unnecessary and frivolous outflows of money.
For example, the Shelby Davis that was quotes above managed to turn $50,000 investment in 1947 into a fortunre worth close to $900 Million by the time of his death in 1994.
He did that through investment in insurance companies that were very cheap at the time. Many had single digit P/E ratios and had high dividend yields. Insurers grew their earnings at a rapid pace. In 1950, insurance companies sold for 4x earnings; 10 years later, they sold for 15x to 20x earnings and their earnings had quadrupled. He refused to overpay for stocks.
He took loans to further magnify his buying power, whose interest rates were much lower than the generous dividends they paid (which grew too). That's an example of understanding the current environment, and taking risks where the benefits outweighted the risks. While I am not a fan of using leverage, if you know what you are doing, it could magnify returns.
Since he had a seat on the New York Stock Exchange, he had access to lower margin rates and could buy more shares on margin because the regulator – the SEC, gave firms more leeway to borrow money than it gave individuals. He utilized the maximum allowable amount of margin (slightly over 50%). The interest payments on his margin were tax deductible (another savings). He did not leverage himself by 5x or 10x. He used a sensible amount of leverage that did not drastically increase his risk, yet significantly increased his returns.
But he didn't really trade in and out of stocks. He bought, and then held for many years, if not decades.
There's a fascinating anecdote about Shelby Davis, written by his grandson Christopher:
Christopher recalls working summers as a teenager at the elder Davis' insurance brokerage firm. The pair were coming back from a meeting of the New York Society of Insurance Analysts, and it was lunchtime. He had forgotten his wallet and asked his grandfather for a dollar to buy a hot dog from a street vendor. The elder Davis replied, "Do you realize that if you took that dollar and invested it at 15%, when you're my age that dollar would be worth $1,000?"
"I learned three lessons from that," says Christopher Davis. "The power of compound interest, the importance of not overpaying and not to forget my wallet."
That's a great summary of opportunity costs and trade-offs in one anecdote really.
Another example is Jack Bogle, the man who saved investors billions of dollars in fees, as he popularized low cost mutual funds for the masses. He correctly saw that most of Wall Street adds zero value. However, it does cost ordinary investors a lot in fees each year. Those fees also tend to compound too, working against the balances of ordinary investors. The higher the fees, the less money ordinary investors have working for them. The lower the fees, the more money ordinary investors have working for them. Fees matter.
My other example is Sam Walton, the founder of Wal Mart stores. His frugality was on display in the mid 1980s, when he was spotted driving an ordinary Ford truck. This was not a vehicle that a billionaire was supposed to be driving. But Sam Walton didn't care. All he needed was a truck to have his dogs in, not a Rolls Royce.
This mindset helped him use resources efficiently on a scale, to eventually overcome other more powerful retail adversaries. For example, he managed to focus on fast selling items at his stores to the point where he would receive the cash for the items from customers, before the invoice to his supplier was due. This in effect created float for him, that could help further expand operations.
My last example is Ingvar Kamprad, thee founder of Ikea. He was worth $60 billion at the time of his death in 2018. I read an article about him, which discussed some of his frugal habits. For example, he drove a 1993 Volvo for about two decades. He flew coach, and purchased clother from flea markets. My favorite one was that he got his haircut when he traveled to cheaper countries. It makes sense that a haircut will cost more in Amsterdam than say Vietnam.
This may sound weird to the ordinary person out there. To me it shows a person who understand the value of each kroner (the Swedish currency). If you are careful with one kroner, you would be careful with billions of kroner. His frugality mindset had him go in overdrive in his effort to cut taxes on his company, and also to obtain tax residency that was the most advantageous to him. This saved tens of billions in income and estate taxes over his lifetime. Definitely a great example of how taking care of the little money you have at the beginning gives you the training to be able to take care of the money that comes later with compounding...
Unfortunately, most individuals today do not think this way. To the average person out there, being a millionaire translates to spending a million dollars. This is the opposite of having a million dollars.
Instead, that million dollars (or more) is a tool to help you live life on your own terms, aka own your freedom. Money gives options in life, which can help you design the life to your values.
The point is that those small trade-offs and opportunity costs compound over time. Over time as well, those frugal trade-offs become second nature as well.
The proverbial "latte factor" is a great example of this tendency of intelligent frugality.
A $5 spent on coffee does not seem like a big amount on it's own. However, if you do this every day, over the course of an year, that translates to $1,830. If you do this over the course of a lifetime, and if you add in a reasonable return of 7%/year, that little habit could turn to hundreds of thousands of dollars over a 40 year time span.
It's $365,332.25 to be exact, but who's counting?
That doesn't mean not to enjoy your coffee, if it is really THAT IMPORTANT to you.
It is more of an example of a mindset that weighs each decision carefully, thinking through trade-offs, and understanding the opportunity cost of that decision.
If you do that over a lifetime, the end results will follow.
That mindset of efficient use of resources that is trained on a small decision, is easily usable with large decisions as well.
A few questions that have been helpful for me are listed below:
Should I buy the largest house just because I was approved for the largest mortgage, or should I perhaps buy a more economical house that fits my needs? Or perhaps, should I rent for a few more years at a place with a lower cost of living? (remore jobs can help tremendously there, especially with geographic arbitrage of working remotely in a HCOL JOB but living in a LCOL area)
Should I buy an expensive shiny new car right after college or should I use a more economical car that does the same job?
Should I go to a college that I could afford with working or should I take high loans at an expensive college?
What steps can I make to minimize tax drag and commissions/fees on my investments? What investment strategy would provide the best outcomes for me in the long run?
Should I invest in a quality company at 50 times forward earnings and a dividend yield of 0.50% or should I invest in a quality company at 20 times forward earnings and a dividend yield of 2%?
All of this makes perfect sense to me.
It doesn't matter how much money I earn, but how much I get to keep, and how much I end up having compounding for me.
There are lessons in personal finance, and getting the first dollar to work for me, while keeping as much as I can working for me. There are also lessons in finding the right stewards for my capital. These frugal type individuals build wealth. If you can identify such an individual early on, you can theoretically do well. Provided you hang on for the ride of course.
Frugality helps build wealth. It then helps compound and keep it.
Most great investors are frugal indeed.
