EquitiesMay 10 2018

The benefits of compounding

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The benefits of compounding

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.

Technological disruption offers both threats and opportunities and although retailers are enduring short-term input cost inflation as a result of the fall in the value of sterling, they are reacting via the adoption of technology.

Dunelm, for example, is using driverless forklift trucks to relocate pallets from the ‘goods in’ area to the warehouse racks – they work 24-hours a day, are never ill and are not susceptible to increasing wages. 

On The Beach is capitalising on the growth of online dynamically packaged holidays. The internet, via both mobile and desktop, is being used increasingly to book holidays abroad. In addition,  On The Beach has no physical stores, owns no aeroplanes, does not take stock risk on hotel rooms and as a result has an incrementally lower cost, lower risk model than the traditional travel agents. As with many other companies that use the internet as a means of distribution, the barriers to entry are low, but the barriers to success are high and as market share builds, so does a ‘defensive moat’.

Evolving economy

Technological advancement is also increasing asset utilisation. AirBnB, Uber, Cloud Computing, Zipcar offer the ability to rent assets on a flexible, short-term basis with a reducing need to own. This increases utilisation of resources and therefore reduces the requirement for such a large asset pool to offer the same total amount of usable capacity. 

Dechra pharmaceuticals is another example. This company develops, markets and sells principally to the small animal market and is benefiting from the increased incidence of pet ownership globally, together with a rising propensity to spend on the welfare of domestic pets. Dechra also develops novel products for the large animal market and has shown success with products such as Osphos, used to treat Navicular Syndrome in horses.

When investing in UK equities, we constantly question how our investments will be impacted, both positively and negatively by these forces, for example, Clinigen is benefiting from the growing need to keep counterfeit drugs out of the global supply chain; as stock pickers, we can allocate capital to the beneficiaries of these forces and let the index money allocate to those areas of secular decline.

We remain confident that actively investing in UK-listed companies that are compounding their earnings and dividends – where corporate governance is world leading, where contract law and title law are dependable and where company management teams are permanently accessible – will continue to be a rewarding strategy. 

Chris St John is manager of the Axa Framlington UK Mid Cap fund