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Fund Selector: Unilever’s compound error

Fund Selector: Unilever’s compound error

Einstein is widely credited with saying compound interest is the most powerful force in the universe. The fact that he almost certainly did not say it should not change the fact that it is the most powerful force in investment. 

The laws of mathematics are generally stacked against the investor: for example, a 50 per cent fall can only be recouped by a 100 per cent rise. Compounding is the surest way of turning the odds in our favour. Several decades ago, in the twinkling years of my career, the estimable annual publication of the BZW Equity Gilt study showed the significant majority of long-term returns arise from the reinvestment of income. Without compounding, capital growth is cyclical and transient. 

There is no doubt that the best businesses compound. They generate profits and cash, which they then reinvest, making larger profits and even more cash. It is a simple, virtuous circle that has been recognised by the best managers of both businesses and equity funds alike. It is also something that can be lost in the heat of the moment. 

It was with a sense of inevitability that we read Unilever’s review of its businesses in the aftermath of its rejection of Kraft Heinz’s amorous intentions. Instead of sticking to the compounding principles that made such a great business, the board has succumbed to short-term and value-destructive shareholder pressures. Investing less, and borrowing more money simply to hand it back to the shareholders. Overall, these shareholders can only reinvest into ‘the market’ average, meaning businesses with lower returns than Unilever. It is necessarily a value-destroying exercise in the name of short-termism.

The review, however, has been received well. It has promised higher margins, disposals of slower-growing operations, special dividends and share buybacks. All these are likely to be delivered. This creates a difficult balancing act for shareholders. Should a fund manager buy or sell shares in a business that has forgotten the most powerful force in investment, but where a likely stream of good news should support a buoyant share price? 

There is no right nor wrong answer to this. A well-diversified portfolio has plenty of room for both. Much the more important point is that the manager should understand why they are doing what they are doing. And to know that, an investor has to know the fund manager and their process extremely well. Just as Unilever is foregoing its long-term profitability, so any gains the share price makes in the short-term are merely taking from the future.

For those holding UK index funds, it is someone else’s problem. No matter that the more expensive a share price becomes (and so the greater proportion of the index it makes up), the more of it you own. Except it does matter, because expensive shares built on castles of sand do not last forever. The true investor will know and care why their fund managers hold a stock in their portfolios, safe in the knowledge the immutable force of compounding will never change. 

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