The compounding factor

Explanation

This may be old hat to some readers but it is worth remembering how compounding is one of the keys to Warren Buffett’s investment success.

The compounding factor is easy to understand. Compound interest (or compounding of earnings) is simply the ability of interest (or investment return) earned on a sum of money to earn additional interest (or investment return), check thereby increasing the return to the owner of the money or investor. It works like this and we will use interest as the exemplar:

You deposit a sum of money, say $1,000, in a bank or other financial institution that earns interest at the rate of 5 per cent, payable annually. At the end of the first year, you have earned $50 and have the right to get your $1,000 back.

Suppose however that you want to invest the money long-term, for say 10 years. You now have two options.

Option A: Take interest payments

You can have the interest paid to each year, in which case you will receive $50 each year to spend or use as you wish. At the end of the 10-year period, you will get your final interest payment and your $1,000 back.

Option B: Re-invest interest

You can choose to re-invest your interest and earn interest each year on the accumulated interest payments as well as on the original investment. This means that you do not get annual payments but, at the end of the 10-year period, you will get a lump sum payment of $1625. This is compound interest.

Why this much larger amount? Because your interest earns interest each year like this (calculations rounded to nearest 50 cents).

The higher the interest, the bigger the capital gain. At 10 per cent, the sum would increase to $2594.00; at 15 per cent, to $4055.00.

Warren Buffett is said to look at the compounding factor when deciding on investments, requiring a stock investment to show a high probability of compound growth in earnings of at least 10 per cent before making an investment decision.

Compounding and retained earnings

Warren Buffett has on several occasions referred to the use by a company of its retained earnings as a test of company management. He tells us that, if a company can earn more money on retained earnings than the shareholder can, the shareholder is better off (taxation aside) if the company retains profits and does not pay them out in dividends. If the shareholder can achieve a higher rate of return than the company, the shareholder would be better off if the company paid out all its profits in dividends (taxation situation again excluded) so that they could use the money themselves.

Put simply, if a company can retain earnings to grow shareholder wealth at better than the market rates available to shareholders, it should do so. If it can’t, it should pay the earnings to shareholders and let them do with them what they wish.

 High returns on equity

This is why Buffett is interested in companies that have rights rates of earnings on equity and likes them even more where the return rates are increasing. He reasons that, with a company like this, he is better off if the company pays no or little dividends and retains the money to earn even more for its owners.

In addition, where no dividend is received, there is no income tax payable by the shareholder. Instead, the investor gets the value of the increase in value in the shares which will, eventually, rise to reflect the enhanced earnings. The shareholder can then retain the shares, sell them at a time that best suits them, if they wish, and take advantage of the capital gains taxation regime.

It is why potential investors should calculate the company’s history of returns on equity and management of retained earnings.

Berkshire Hathaway and retained earnings

Berkshire Hathaway does not, following Buffett’s mantra, pay dividends to its shareholders and this is one reason why its compound return over the years of Buffett-Munger management has been so high.

The downside of course is that shareholders have not received dividends, meaning, that if they were dependent on money coming in at a given time, their only recourse, in relation to their shareholding, would be to sell the shares or borrow against them.

Having regard to the huge price of a single share over the past few years, this meant that investors may have had to either keep all their shareholding or dispose of it, not always the choice they wanted. Berkshire Hathaway partly catered for this dilemma by introducing B shares, which are in essence a fractional unit of the normal shares.

A powerful force

When asked to nominate the most powerful force on earth, Albert Einstein is reputed to have answered ‘compound interest’. Buffett might well agree.