Simple interest is one in which the interest is paid out at regular intervals. In compound interest, the interest is not paid out at regular intervals, but instead added to the principal and the subsequent period interest is then charged on the modified larger principal. In other words there is interest charged upon the unpaid interest and so forth till the outstanding principal (which includes accumulated interest) is paid out. A simple interest loan in contrast will have only the last period of interest plus the original principal to pay back at the end of the term of the loan. When compounding happens over a sufficient period of time the owed principal can swell to astronomical sums. For example a principal of 100Rs earning 8% interest compounded, will result in a total amount of 4700Rs over a 50 year period. That is 47X the original principal! Compounding creeps upon you. Early on the impact of compounding is barely discernible – however as time passes it takes on a life of its own and gathers speed and momentum incomprehensible to the human mind. How does this power of compounding apply to businesses and do the same principals of compound interest apply?
For simplicity let us consider a business funded 100% by equity capital (i.e no loans). Compounding in a business would be akin to a company being able to generate growth in profits by re-investing part of the profits generated back into the business and increasing the capital base of the business with the rate of profit generation remaining the same at this increased capital base. A business unable to generate growth in due course of time would simply have to pay these profits out as dividends or worse, retain profits and bloat the balance sheet of the company with cash and drag down the return on capital. This would result in the business not being a compounding machine but in-fact a simple interest machine.
For a business to be a compounding machine it should be able generate growth in profits without dropping the rate of return on its capital base. What characterizes a business’s ability to grow its profits while maintaining the rate of return on its capital? Two critical factors dominate the answer : The first is the scale of the market opportunity for the company’s products and/or services and the second is a sufficiently high competitive advantage over its competitors. In the absence of the former, the company will not be able to find opportunities to sell its products/services - something like a big fish in a small pond and in the absence of the later, competitors sensing market opportunity will increasingly squeeze profit margins which eventually will lead to a lower rate of return on capital. Both conditions are necessary for a business to be a compounding machine – a large market opportunity AND a competitive advantage.
The market clearly recognizes such compounding machines and can reward them with staggering valuations. A standard way of looking at a company’s valuation is to divide the price of a share by its earnings per share (PE ratio). The reciprocal of this number (i.e earnings per share divided by share price) is some kind of return rate that equity investors in a company could expect (based on current price and current earnings) in the near future. By looking at the PE ratio, investors can guage whether they are paying too high a price for a given level of company earnings. PE ratios are a function of a wide array of inputs including quality of earnings (how fast are earnings resulting in cash), capital structure (the method by which the company finances itself – i.e equity vs debt) and expected growth. Nevertheless even when we compare companies with identical capital structure and similar earnings quality, we can see that the market clearly rewards companies who have large market opportunities in front of them AND at the same time generate high returns on their capital, with significantly superior valuations.
The irony is that investing in businesses that are compounding machines is not a sufficient condition for the investment to similarly compound in value. The market valuation of a business can be fickle and oscillate significantly. The earnings multiple awarded to a business by the market can move based on the market expectations of profit growth. The measure of the investment compounding depends on the valuation multiple at which a business has been bought, its earnings at the point of exit and the valuation multiple the market assigns at the point of sale. Invariably it is noted that excess return is created more through an increase in the earnings multiple than increase in the earnings itself – and the same applies in the reverse. That is, investing with a margin of safety in the price provides a cushion for good investing outcomes. Of-course one way out of this problem is to simply hold a compounding business for a very long period of time – it is then said given sufficient time even investments bought at pricey valuations can give “compounding” returns making the historical price of purchase less relevant. The problem with staying put and giving the investment sufficient time to compound, is that, competitive advantages in only a very few companies sustain over long periods of time. Invariably competitive advantages reduce and the return on capital drops, which will reflect in lower valuation multiples being awarded by the market. Identification of compounding business machines over an investors time horizon remains a key component of investment alpha
As I ramble through this blog, the reader will sense diffidence and an inability to make up my mind. It is true – especially in these times of relatively high valuations, when prospective returns look bleak (to us) - should we simply continue to invest (in compounding businesses at high valuations) assuming that given enough time the purchase price becomes irrelevant or do we wait to give ourselves a margin of safety in the price ? This question is at the heart of the investing conundrum.