Equities  

The benefits of compounding

The benefits of compounding

The power of compounding is a well-established concept, however its potential is often underestimated. The ability of an asset to generate consistent earnings growth by reinvesting operating cash flows is a logic that is fairly easy to follow, but the cumulative effect of building on these incremental gains can often be overlooked.

Underestimation of the power of compounding can be illustrated by posing the following question: if you take a chessboard and place a single grain of rice on the first square and then double the number of grains in each subsequent square until you reach square 64, what is the cumulative weight of rice on the chessboard?

It seems inconceivable but the weight amassed is 461bn tonnes. Investors might well ask how they can benefit from this phenomenon. The good news is that the concept of compounding growth can be observed within the constituent companies of the equity market. By identifying companies with growing profits and dividends, investors can harness the drivers of equity market returns.

Benefiting from the power of compounding takes time and we must invest through the transitory noise of political and macroeconomic ‘events’ such as Brexit. Intellectual and financial capital allocation decisions take time to impact, and patience is required to realise these gains as equity investors. 

Brexit

It is easy to assume that uncertainty always discourages investment but this is simply not the case. Brexit-related uncertainty regarding the surety of supply chains, together with a weaker currency, is encouraging suppliers to move closer to their customers and this has resulted in some businesses increasing investment in productive capacity in the UK.

For example, a French bakery in Milton Keynes recently increased both its UK capacity and locally sourced ingredients as the costs of importing raw materials rose. Post-Brexit investment has also been announced by others, including Boeing (building an actuator manufacturing plant) and Toyota (investing £240m in its car plant in Burnaston). Also, Apple, Facebook and Amazon have announced plans to increase UK headcount.

High street

Global economic growth remains robust and UK exporters are benefiting. This is in stark contrast to the news flow generated by the UK high street, where several restaurant chains and retailers are facing severe financial difficulties.

Recent casualties include Byron Burger, Prezzo, Strada and retailers Toys R Us and Maplin. Brexit may be a contributing factor, but the disruptive effects of internet retailing, increasing minimum wage, business rate changes, inappropriate financing structures and over supply, have been far more influential. Buying goods at wholesale prices and selling at retail prices, without offering value, brand, service or ‘experience’ is no longer good enough.

Those that embrace multi-channel, innovate, have strong branding, offer ‘experience’ and are deemed good value will thrive. 

Key Points

  • The potential power of compounding has been underestimated
  • Brexit-related uncertainty has encouraged suppliers to move closer to their customers
  • It is important to look at forces impacting equities being invested in

Technology 

The proliferation of economic data, artificial intelligence, the development of 3D printing, advanced robotics and ever increasing price transparency is contributing to the acceleration of supply in many areas of life. Via the internet, the supply of retail capacity is constrained by the shelf space in the sector’s distribution warehouses, rather than the ability to take on physical leases in the high street or on retail parks. Capacity to supply is constrained only by the economics of logistics and with price transparency available online, traders must differentiate through brand, choice and service.