Compound interest: the value of the snowball effect
- Compounding means small, early investments with steady returns over long periods achieve more growth than large, short-term investments
- SAINTS values this approach, with compounders Watsco, Starbucks and Admiral in its portfolio. Their stocks are often under-priced due to market short-termism
- With advocates like US billionaire Warren Buffett, compounding is worth notice – it’s not the only way to outperform, but it’s a way that works
Illustrations by Mark Smith
Please remember that the value of an investment can fall and you may not get back the amount invested.
This article originally featured in Baillie Gifford’s Autumn 2022 issue of Trust magazine.
Early in his career, Warren Buffett bought shares in the failing textile company Berkshire Hathaway. In 1965, he raised his stake to take control, later transforming it into a legendary investment conglomerate.
So why does he now call Berkshire Hathaway “the dumbest stock I ever bought”? The answer lies in ‘compounding’.
Speaking in 2010, the Sage of Omaha said that pouring money into trying to turn around the Rhode Island firm’s fabric-making business was a huge mistake. What he should have done, he suggested, was put the same sum into a steady-growth insurance company he was also involved with. And left it there.
Thanks to the wonder of compound interest, he said he would have been about $200bn richer 45 years later.
To appreciate why, you need to understand how compounding produces exponential returns. It works because you not only earn interest on your original investment but also interest on additional returns too. These extra gains start off slowly but gather speed.
Buffett compares it to a snowball going down a long slope. The further it travels, the faster it gains size (see below).
The snowball effect
Compounding is the magic maths by which a small early investment and a decent, steady return achieve more growth over time than a much larger investment at a higher return over a shorter time.
Assume two people both invest £1,000 in an asset with a 10 per cent annual interest rate. One withdraws each year’s £100 gain, leaving only the original sum, the other leaves the interest untouched. After 45 years, the former would have £5,500, the latter just over £72,890.
The compounding that matters to SAINTS is compounding the fruits of ‘return on equity’ (ROE), the efficiency with which a company converts shareholders’ equity into profit.
This profit can partly be paid out to shareholders as dividends and partly – as ‘retained earnings’ – added to the company’s equity to earn more profits in future. Thus the size of the snowball increases, enabling more compound growth in the future.
The Scottish American Investment Company (SAINTS) is also a big believer in the value of compounding. Our job is to keep getting better at spotting the companies that can deliver it.
Take Watsco, the Miami-based distributor of air conditioning equipment, a classic compounder. Over the past decade, it has grown its profits at a compound annual rate of 12 per cent. It has never made a loss.
What attracted us to Watsco was that, as a relatively small player with a proven ability to get results, it still has the ability to take a bigger bite of the US’s $17bn air conditioning and heating market. It’s not ‘capital intensive’ – it doesn’t need much extra investment to grow further – and can therefore pay out profits in dividends more generously than its peers.
After honing its distribution business model in hot and humid Florida, Watsco continues to grow sales across the US. It’s easy to see it enjoying another decade of 10 per cent compound annual growth in a market that’s set to grow by 6 per cent a year until 2030.
Coffee chain Starbucks is a better-known example of this ‘long runway’ of steady compounding. Even after two decades of strong growth, it’s still a small enough player in the ever-expanding universe of on-the-go hot drinks to be able to keep adding stores and menu items. We think it can deliver 10 per cent growth for at least another decade
The hard part is distinguishing the companies with a high probability of successful steady compound growth
Companies such as Watsco and Starbucks that can compound earnings at 10 per cent or more for a decade-plus are rare. Michael Mauboussin, a finance professor at Columbia University, found in a 2016 study that only one in five of the 37,000 stocks he surveyed steadily compounded their earnings at 10 per cent a year or better. To construct a portfolio of these names, it helps to invest globally.
Other examples in SAINTS’ portfolio include:
- Edenred (France, staff benefits)
- Admiral (UK, car insurance)
- Sonic Healthcare (Australia, medical diagnostics)
None of the above businesses are growing at a spectacular rate, year-over-year. Their outperformance over time is based on relentless high-single-digit to low-double-digit compounding of earnings and dividends.
What’s more, these stocks are often underpriced, thanks to the chronic short-termism of much of the market. A company that can compound earnings at 10 per cent or more for a decade and then keep growing at 10 per cent for another decade often doesn’t seem that valuable to an investment manager incentivised on short-term performance. Thus the long-term potential of these stocks is often overlooked.
The search for these stocks is, to borrow another Buffett-ism, “simple, but not easy”. The hard part is distinguishing the companies with a high probability of successful steady compound growth.
Most management teams have a PowerPoint presentation that shows how rock-solid 10 per cent growth is all but assured. But history shows that few companies grow at that rate for more than a decade.
No algorithm will help you pick out those companies, though a foreseeable period of ‘more of the same’, as with Watsco and Starbucks, certainly helps. These are the ‘long runway’ companies alluded to above.
Then there’s another kind of company capable of decades of growth. We call them ‘adjacency growers’. These are long-established companies that are imaginative and nimble enough to spot similar-but-new markets for their products and services.
Swedish industrial giant Atlas Copco is a classic example. Originally a maker of compressors, it used its engineering expertise and customer base as a launchpad for attacks on the industrial power tools market and more recently vacuum pumps.
Companies that commit to paying growing dividends often have what it takes to keep on compounding at 10 per cent or more. They usually have a proven business model, strong defences against competitors, steady earnings and cashflow, good habits of reinvestment and the kind of growth that generates lots of spare cash.
SAINTS believes that the value of steady growth and compounding deserves more attention than it gets. It’s not the only way to outperform, but it’s a way that works. The podcast Acquired summed up Warren Buffett’s doctrine nicely:
“If you own an asset that’s compounding at a high rate with no obvious reason it will stop… Dear Lord do not interrupt it!”
Past performance is not a guide to future returns.
Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates.
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