Your Money & 'The Flywheel'

A lot has been written about the power of compounding. We’ve all heard illustrations of the extraordinary results that may be accomplished if compounding is allowed to do its work over long periods of time. But why should you care?

 

Quite simply...aside from savings, compounding is the 'engine' that drives your longer-term financial and retirement plans.

 

There’s an extreme example: the story of Native Americans selling the island of Manhattan. As the story goes, the selling party in the deal collected an estimated $20 worth of beads and trinkets from the transaction, which took place in the year 1626. So how does compounding play into this? Let’s say the sellers invested their initial $20 at a rate of 9% per annum and then stuck with this investment program for the following 380 years. Today, their initial $20 would be worth more than $3,335,000,000,000,000.

 

I like this example of compounding because it illustrates that the rate of return on an investment doesn’t need to be extraordinary for extraordinary results to occur. What IS crucial is having the ability to sustain an investment program uninterrupted over a very long period of time.

 

In the real world of investing, “life gets in the way”. It’s rare for an investor to enjoy a streak of decades of compounding in any investment without the interruptions of distributions, taxes and mostly their own destructive behavior when it comes to having investing patience.

 

This story simply reminds us that striving for sustained, uninterrupted compounding over long periods of time is smart investing, and that’s precisely our goal.

 

We focus our clients on the 'flywheel' effect that strategic compounding can have on their savings...

My team and I help our clients invest their savings in companies that have a track record of, and we believe, the ability to compound their per share economic value at above-average rates over the course of many years with lower risk.

 

To think like a compounding investor is very natural for people who buy small or private businesses. The private investor wants to concentrate carefully on a few business investments, and hopes the accountants will report back consistently at the end of each year that equity per share on the financial statements has grown. Private investors don’t think about trying to dart in and out of investments on a daily or monthly basis.

This approach is so basic, it’s often forgotten in the public equity markets.

 

In public markets it’s become far too easy to get distracted by hour-to-hour market gyrations and all the breathless excitement brokers and the media put on short-term news. To be a compounding investor, you truly do need to tune out the short-term noise.

 

In my business, we think hard about and study the ingredients required for a business to compound in value over the course of many years. We believe these include:

 

1) an ability to generate above average returns on shareholders’ capital (business model/competitive position),

2) opportunities to deploy additional capital generated by the business (what we call 'free cash flow') at above average returns, and

3) a management team with both a shareholder orientation and the skill and judgment to sustain the process of compounding over a long period of time in the face of competition and market noise.

 

How does this benefit our clients?

We strive to help clients invest their long-term savings in companies with these three ingredients of compounding, and to buy the equity at reasonable prices in the market from sellers.

 

If we are successful, we're helping our clients build a 'compounding machine' for their longer-term savings - an engine that will deliver powerful benefits over time. With this mindset, there is no reason or need to trade in and out of these equity investments in order to achieve above average returns. Unlike many market participants and pundits, we don’t want to rely primarily on our contrarian instincts or our ability to 'play' market volatility in order to generate returns. We're not trading against price like so many other 'investors' out there. Like the private investor, we want the businesses in which we invest to be growing in real economic value each day.

 

Ideally, we'd like to hold investments for many years to allow their internal compounding to do its work. It’s a wonderful thing not to have to realize a taxable gain. The tax deferral available by investing in businesses that compound internally is an enormous and often under-appreciated advantage.

 

Yet, in the real world, businesses and business models do change. So does management. We need to be constantly vigilant about these changes. Some businesses are getting worse as years pass, while others are getting better, and so our investment portfolio gradually evolves to ensure we are well positioned for the enduring compounding effect.

 

Thanks for spending some time here.

 

Trevor

 

www.Macdougallteam.ca to learn much more.

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credit: Tom Saberhagen