Investments & Compounding
August 2023
The Other Half of the Chessboard
In ancient India, a king known for his love of chess challenged a traveling sage to a game. Upon losing, the sage requested a seemingly modest reward: a single grain of rice placed on the first square of the chessboard, with the amount doubled for each subsequent square. The king, intrigued by the challenge, agreed.
As he began to place the grains of rice, he soon realized the enormity of the request. On the twentieth square, he had to place 1,000,000 grains. By the fortieth square, that number skyrocketed to 1,000,000,000 grains. Finally, on the sixty-fourth square, the total exceeded 18 quintillion grains—an amount so vast it could cover the entire territory of India with a meter-thick layer of rice.
The story of the king and the sage illustrates the profound impact of compounding and exponential growth in various aspects of life —a powerful yet simple mathematical principle that affects various areas of our lives, from finance and investment to education and relationships. In essence, compounding refers to a growth process where the absolute amount of growth is not fixed but depends on existing quantities. The more present, the greater the growth potential.
Although hidden, this principle manifests in many natural phenomena. For instance, in climate science, we see compounding effects such as ice-albedo feedback: as ice melts, it reveals darker surfaces that absorb more heat, leading to further melting. Likewise, in the carbon cycle, thawing permafrost releases methane, a potent greenhouse gas that exacerbates global warming and causes even more permafrost to thaw.
The concept of compounding also plays a critical role in ecosystem dynamics. In predator-prey relationships, an increase in prey can lead to a surge in predator populations. However, if the prey population crashes due to over-predation, it in turn affects the predators, creating a cyclical pattern of decline.
In the realm of biology, compounding effects can be seen in evolutionary adaptations. Small genetic mutations accumulate over generations, resulting in significant changes. Similarly, a weakened immune system can lead to chronic illnesses due to compounded health issues.
Ultimately, the principle of compounding reveals the interconnected, exponential nature of growth, whether in nature, economics, or human interaction.
Concept of Compounding
Compounding can be described as the process through which an investment grows by earning returns not only on the principal amount but also on the accumulated earnings. For instance, if you invest $1,000 at an annual growth rate of 10%, you would earn $100 in interest during the first year, raising your total to $1,100. In the second year, your interest is calculated not just on the initial $1,000 but also on the $100 gained earlier, resulting in $110 in interest and a total of $1,210. Over time, the effect of compounding becomes even more significant, as returns generate further returns, leading to exponential growth.
A critical aspect of compounding is the role of time. The longer your investment remains untouched, the more profound the benefits of compounding, as it builds upon itself. Therefore, starting early is essential for maximizing this potential.
Different asset classes leverage compounding in various ways. In the stock market, reinvesting dividends and capital gains gradually increases your holdings and enhances portfolio value. Bonds offer steady compounding opportunities as interest earned can be reinvested to acquire more bonds or other assets. Mutual funds and exchange-traded funds (ETFs) benefit from the automatic reinvestment of dividends and capital gains, further amplifying compounding through regular contributions. Meanwhile, in real estate, reinvesting rental income into improvements or new properties increases long-term value, while mortgage repayments bolster equity and create additional compounding opportunities. Regardless of the asset you choose, the role of compounding remains crucial in building long-term wealth.
To illustrate the power of compounding, consider an investment of $10,000 with an average annual return of 7%, which is common for long-term stock market performance. Over time, the growth can be visually striking: after 10 years, the investment would be worth approximately $19,672; after 20 years, around $38,697; at 30 years, it would reach about $76,123; and after 40 years, it would nearly multiply to $149,745. Ultimately, that initial $10,000 multiplies about 15-fold in 40 years, all due to reinvesting the returns.
One practical tool for understanding compounding is the Rule of 72, which estimates how long it takes for an investment to double. By dividing 72 by the annual return rate, you can easily find out the doubling time. For example, at a 6% return, it takes about 12 years for an investment to double (72 ÷ 6 = 12). Conversely, if your goal is to double your investment in 10 years, you would need a return of approximately 7.2% (72 ÷ 10 = 7.2). This highlights how crucial higher returns are in accelerating the benefits of compounding.
To grasp the scale of compounding, let's consider the goal of growing $10,000 into $1,000,000. This endeavor would require around seven doubling periods, as $10,000 multiplied by 2 raised to the power of 7 is approximately $1.3 million. The time required changes dramatically with different return rates: at a 6.5% return, each doubling takes 11 years, totaling 77 years; at a 10% return, each doubling takes about 7.2 years, requiring 50 years; and at a 15% return, each doubling takes 5 years, resulting in a total of 35 years. This clearly illustrates how return rates significantly influence the compounding process.
In summary, while compounding is a formidable tool for wealth-building, it is essential to maintain realistic expectations regarding time and returns. Investors should concentrate on achieving consistent, sustainable returns rather than succumbing to the temptation of chasing short-term gains or overpaying for investments. By starting early, reinvesting earnings, and making informed financial decisions, one can unlock the exponential growth potential of compounding, paving the way for long-term financial freedom.
Equities as a Compounding Machine
A compounder is a type of business recognized for its ability to consistently grow free cash flow and intrinsic value at a rate that significantly outpaces the broader market over the long term. These businesses effectively reinvest their profits at high rates of return, creating a virtuous cycle of compounding. The significance of identifying and holding onto compounders cannot be overstated; for a patient investor, discovering a compounder early and maintaining ownership through market fluctuations can profoundly enhance their portfolio.
When it comes to compounders, equities possess a unique advantage over other asset classes due to their capacity to compound in value over time. Companies often reinvest a significant portion of their profits back into the business, which is crucial for their compounding ability. In major indices like the S&P 500 or FTSE 100, companies typically distribute about half of their earnings as dividends, reinvesting the remainder for growth. In contrast to equities, other assets, such as bonds and real estate, do not automatically reinvest earnings for the investor. While payment-in-kind bonds allow for interest payment reinvestment, this is generally limited to distressed situations. Real estate may provide rental income, but owners often do not reinvest this income into the property.
The compounding power of equities is evident in the substantial growth generated from retained earnings that are reinvested at high rates of return. In 2022, the S&P 500 reported a return on equity of 17%, indicating their potential for reinvestment. It's noteworthy that for every dollar retained, these companies create approximately three dollars of market value, supported by high valuation multiples. Moreover, reinvesting retained earnings at book value tends to be more effective for growth compared to reinvesting dividends at market value. High returns on retained capital enable companies to generate higher market value multiples, and for businesses with robust return on capital, retaining earnings rather than distributing dividends can maximize growth.
While high-return companies attract competition, which may erode their returns over time—a concept known as the economic theory of mean reversion—those that maintain high returns often have a competitive advantage or a "moat." This moat protects them from competitors and allows for sustained high returns on capital. However, for retained earnings to be effectively utilized, companies must have opportunities for growth and reinvestment at attractive rates. Investing retained earnings at low rates of return can lead to value destruction, which generally happens when markets saturate or M&A’s fail.
Characteristics of Successful Compounders
Compounders are companies distinguished by their ability to sustain high returns on invested capital (ROIC) over the long term. This enduring success is rooted in a combination of financial discipline, strategic reinvestment, and operational excellence. Central to their performance is their efficient allocation of capital, enabling them to maintain strong profitability and consistently create shareholder value. Typically, their profitability is supported by recurring revenues, such as those from subscription models, which provide stability and predictability even during economic fluctuations.
A critical driver of compounding growth lies in the availability of high-return reinvestment opportunities. Companies operating in industries with substantial TAM are particularly well-positioned, as these markets offer expanded avenues for deploying capital. Without such opportunities, businesses risk accumulating excess cash or resorting to shareholder distributions through dividends or buybacks, which can dilute the compounding effect. Sustainable reinvestment is, therefore, essential for maximizing long-term growth.
Another defining feature of compounders is their ability to build and sustain competitive advantages—or "moats"—that protect their market positions. These moats often derive from intangible assets, such as strong branding, network effects, or technological superiority, which provide pricing power and foster organic growth. Over time, these advantages tend to widen, reinforcing the company’s resilience and growth potential.
Compounders also exhibit financial resilience and adaptability, particularly in challenging economic conditions. Their low capital intensity and high gross margins make them less sensitive to economic cycles, especially when their offerings are nondiscretionary and supported by strong brand loyalty. These characteristics, combined with steady operational cash flows and minimal leverage, allow them to weather downturns effectively. Moreover, their innovation-driven intangible assets provide both a competitive edge and insulation from adverse market conditions, ensuring that intrinsic value continues to grow.
Leadership and culture play a pivotal role in sustaining a compounder’s success. Companies led by founders or CEOs with significant ownership stakes often demonstrate a stronger alignment with long-term goals. Effective management is marked by disciplined capital allocation, prudent reinvestment, and shareholder-friendly policies, ensuring that growth remains both sustainable and accretive.
Historical evidence highlights the consistent outperformance of high-ROIC companies compared to their peers. These companies often dominate monopolistic or oligopolistic markets with high barriers to entry, benefiting from continuous innovation and structural advantages. Importantly, sustainable, high-quality growth takes precedence over short-term earnings boosts or growth fueled by low ROIC, as only the former creates enduring value.When assessing compounders, the markets they serve often outweigh their geographical listing, particularly when evaluating exposure to emerging markets.
In sum, the defining traits of compounders—high ROIC, predictable recurring revenues, ample reinvestment opportunities, durable competitive moats, and disciplined management—enable them to outperform over the long term. By focusing on sustainable growth and prudent financial management, these companies continue to compound value, making them foundational elements of long-term investment strategies.
Evaluating Compounders in Public Markets
Compounding in the stock market is a concept that many investors attempt to apply directly, often expecting consistent and steady annual returns. For instance, a typical assumption might be that, with an average market return of around 7%, one could expect a reliable 7% growth each year. However, the reality is much more nuanced. While long-term averages may hover around that 7% mark, annual returns can fluctuate significantly due to a variety of factors such as market cycles, economic conditions, and investor sentiment.
Understanding stock price valuation is crucial for investors. A stock’s price reflects the equity value of a company, derived by subtracting debt from the enterprise value and dividing by the number of outstanding shares. This evaluation is inherently future-oriented; investors price shares based on their projections of future earnings, taking into account various risks and expected returns. Several elements, including government bond rates, macroeconomic conditions, and company-specific risks, play a significant role in this assessment.
Several key factors influence stock prices and enterprise value significantly. The strength of a company's balance sheet is paramount; a healthy balance sheet reflects low debt, efficient capital utilization, and a history of positive earnings, positioning a company to sustain growth and withstand market downturns. Additionally, the power of earnings drives stock valuation, encompassing aspects like revenue growth, pricing strategies, market protection, and innovation. Companies that effectively grow their revenue through expanding product lines, entering new markets, or leveraging superior technology often attract willing investors who are prepared to pay premium prices.
Effective cost management also plays a critical role. It requires strategic reductions rather than blind cuts, as thoughtful cost control helps maintain employee morale and productivity—ensuring long-term stability and growth. Furthermore, management's approach to capital allocation can profoundly impact a company's growth; wisely reinvesting in innovation, distributing dividends, or buying back shares can amplify returns, whereas poor allocation practices risk eroding value.
The velocity of growth and scalability are vital as well. Companies boasting scalable business models and robust growth momentum stand well-positioned to achieve compounding returns. Access to capital, superior products, and efficient operations enable these businesses to meet rising demand while sustaining growth.
Leadership and corporate culture are additional essential elements. Strong leadership is critical for effective capital allocation, cost management, and strategic planning. Ethical leaders nurture cultures rooted in trust, innovation, and resilience. Companies led by visionary figures who focus on long-term value creation typically outperform their peers. Similarly, those with people-centric cultures often experience higher productivity, innovation, and overall value creation, making it wise for investors to seek out companies that prioritize employee well-being and foster excellence.
In practical terms, studying a company's historical performance can illuminate whether management consistently delivers on its promises and whether the compounding effects are visible over time. Analysts often evaluate a decade or more of financial data to determine consistency and long-term growth potential.
Lastly, stock buybacks and dividends play a pivotal role in amplifying the compounding effect by increasing an investor's stake in a company. It is essential, however, that buybacks are executed at fair valuations to prevent the erosion of shareholder value. Thoughtful reinvestment and effective capital allocation drive returns that can sustain the cycle of compounding growth.