Power of Compounding
Investor wealth is built by steadily compounding returns over many years. Historically, over time and stable markets, good businesses are the world’s ultimate compounding vehicles and, therefore, are the world’s best investment vehicles. The following table is a sample illustration which demonstrates that compounding at 15% makes investors a lot richer than compounding at 5% or 10%.
The Power of Compounding Works in Great Businesses
Good quality businesses that consistently reinvest large cash flows at high rates of return have ranked the highest among compounding vehicles. For instance, Church and Dwight (the maker Arm & Hammer Baking Soda and related products) has consistently earned well over 15% on reinvested cash over the past 10 years. While this reinvested cash flow is not distributed to investors, and thus its existence is not immediately apparent, the stock appreciated more than 500% over that time period.
The rate of return earned on reinvested capital varies between businesses. In stable markets, a great business earns a rate of return over 15%, a poor one under 10%. By comparison, bonds and real estate typically pay out single digit returns to their owners, which the owners then reinvest at a single digit rate of return. A high rate of return earned on reinvested capital defines the superior compounding vehicle.
The Subtle Power of Rate of Return Earned on Reinvested Capital
In this table, we compare a bond paying 6.5% interest with the stocks of two companies paying dividends of 1.5% while reinvesting a like amount in growing the business. One company earns 20% on the capital it reinvests in the business and the other earns 10%. Reinvestment of earnings gives a business the capital to grow by funding initiatives such as developing new products, building a new plant, and expanding the sales force. A return earned on this investment should lead to an increase in earnings, dividends and eventually stock price. For purposes of the illustration below, we assume that the stock price increases in line with earnings growth and dividends are invested in a money market fund that pays 4%.
Clearly, earning a high rate of return on reinvested capital is the key to long-term compounded growth!