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Compounding, in the realm of investing, is quite frankly the most important element in obtaining long term riches. A mechanism that requires time, patience, and trust. One that if implemented correctly, will suddenly expand to unimaginable levels. Don’t believe me? Let’s look at the numbers. 

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Let’s assume the market grows at 10% over the next 30 years. If you started with $10,000 and never added another penny, at the end of the 30 years, you’d have $174,494. That is 17 times your original investment! Now let’s see what a difference of an additional 2.5%  would do. Now instead of earning 10%, you earn 12.5% over the next 30 years. What are you left with? $342,433! That is double the amount obtained before! 34 times your initial investment. Compounding at work.

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Now let’s assume you are adding $10,000 per year for  30 years (which is not unreasonable considering you could add to your 401K). Earning 10% per year for the next 30 years. At the end of 30 years you’d have $1.8 million. At 12.5%, you’d have just over $3 million!

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 It's the process where earnings from an investment are reinvested, generating their own earnings over time. This creates the snowball effect, where your money works harder and harder for you. 

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The significance of a long-term investment horizon cannot be overstated when leveraging the power of compounding. So how do we put this concept to work? By finding Compounding Machines. What are Compounding Machines? These are great companies that are able to reinvest their earnings back to the business and earn high return on the invested capital. Building on their previous success over and over again.

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What do we look for in Compounding Machines?​
 

1. Companies we can understand with superior economics. Companies that are able to earn a high return on equity. Profitable businesses, with little need for capital expenditures, and the ability to earn high margins.
    

2. Companies with sustainable competitive advantages that allow them to maintain their position and earn high returns. 
    

3. Companies that have long runways. Growth opportunities to deploy their capital by either gaining market share through their competitive advantages of participation in a secular growth story.

 

High ROE:

Great companies earn high returns on their invested capital. A company with excellent economics is able to earn high earnings with little deployed capital, in turn earning a high rate of invested capital. This does not include companies that are highly leveraged by using lots of debt to finance the company’s operations. We are talking about companies that have superior economics.

 

Sustainable Competitive Advantage (MOAT):

Scale Economics, Network Effects, High Switching Costs, Strong Brands (Loyalty), Superior Technology or Patents. These are all examples of competitive advantages that allow companies to either be the low cost producer, or are able to raise prices and earn higher returns. Most importantly we need to be able to see with some level of certainty that their competitive advantages will continue to stay intact. 

 

Growth:

If a company earns a high return on invested capital but does not have any potential for growth through an expanding market share or secular growth, then the company is no different than a bond. Something that pays a coupon to investors but will not grow over time. 

 

If you have these elements in place then we wait for the market to provide us with an opportunity to invest. The tricky part is that most people know these companies are great and have priced them accordingly. But there are the occasional mispricings that provide opportunities. When those opportunities present themselves you have to act with conviction, because they don’t come often. The last step after investing is to just wait. Wait for the returns of a superior business to bear fruit over the long term all the while keeping an eye on the economics of the business and the strength of their moat. 

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Opinions expressed here are not to be

taken as investment advice. Consult with

your own investment advisor. 

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