The power of compounding is a well-established concept, however its potential is often underestimated. The ability of an asset to generate consistent growing earnings by reinvesting operating cash flows is a fairly easy logic to follow, but the cumulative effect of building on these incremental gains can often be overlooked.
Underestimation of the power of compounding can be illustrated by posing the following question: If you take a chessboard and place a single grain of rice on the first square and then double the number of grains in each subsequent square until you reach square 64, what is the cumulative weight of rice on the chessboard? It seems inconceivable but the weight amassed is 461 billion tonnes. This is 1,000 times the annual global rice production of 2011!
Investors might well ask how they can benefit from this phenomenon. The good news is that the concept of compounding growth can be observed within the constituent companies of the equity market. By identifying companies with growing profits and dividends, investors can harness the two key drivers of equity markets returns.
At the earlier stages of their development, companies have the potential to grow quickly and in addition, as their cash flow profile matures, they can benefit from a falling cost of capital. During this phase, companies with the discipline to grow their earnings, and reinvest sufficiently back into productive activities to generate further growth, can deliver superior returns over the longer term.
The significance of the incremental returns provided by growing profits and reinvesting dividends over time can be seen in the chart below. Compounding dividends from December 1999 to October 2015 resulted in an almost doubling of the capital-only returns generated by the FTSE-250 Index.
Source: FactSet from 29/01/1999 to 31/10/2015.
Past performance is not a guide to future performance.
By investing in companies that are committed to growth – and importantly, that reinvest for future growth – you could help your clients harness the power of compounding to maximise investment returns.]
