It’s claimed that Albert Einstein called compound interest “the eighth wonder of the world”, reportedly saying: “He who understands it, earns it; he who doesn’t, pays it.”
Compound interest, or compounding, is the process in which earnings from either interest or capital gains are reinvested to generate additional earnings over time. It’s seen as a key component of successful long-term investing.
Chris Elliott, co-manager of the TB Evenlode Global Equity fund, is one of those that ascribe to this view. When running through the fund’s investment checklist, he brought up compounding by referring to Thomas Austin, remembered for one of the greatest ecological disasters in Australia – the introduction of rabbits.
Austin, a first-generation British migrant, settled in Australia in the mid-19th century. His unfortunate legacy was cemented when he released 24 non-native rabbits for hunting onto his Victoria estate.
“With no natural predators and plenty of food, the population grew rapidly,” said Elliott. “Austin’s rabbits showed the raw power of exponential growth.”
Indeed, eight years after they were released, there were some 14,000 rabbits on his estate. By 1898 the Australian rabbit population was estimated at 300 million.
Compounding: Einstein’s eighth wonder
Elliot outlined that a single pound invested at an annual return of 8 per cent will double in nine years, quadruple in 18 and increase eight-fold in 27.
“As with the Australian rabbits, many would scarcely believe the consequences of compounding an initial investment until the mathematics are laid bare,” he said.
“An investor that can achieve consistently high returns will reap rewards over time, but the challenge is not just in finding the rates of return but maintaining them.”
10% simple interest versus 10% compounding interest
Source: Finance Strategies
TB Evenlode Global Equity, which launched this month, has a focus on attributes shared by serial outperformers within a checklist of three factors.
“To consistently compound, a company must have structural market growth, a durable competitive advantage, and the ability to sustainably invest,” said Elliott.
The manager asked whether companies in a declining industry can outperform the market over the long term, even with a strong competitive advantage and resources to invest.
Even with a strong product and falling competition in the industry, a declining industry means that capital returns and business performance will eventually decline.
“A structural growth driver can allay this by providing continued demand,” he said. “Mastercard, for example, benefits from the society’s move to a cashless economy.
“Alternatively, companies can pivot to adjacent markets and Microsoft’s transition to cloud provided a growth opportunity beyond operating systems and business software.”
Maintaining a competitive edge
To express the competitive advantage factor, Elliott imagined DisadvantageCo, a fictional company that competes with several stronger peers and has few barriers to entry.
The company operates in a structurally growing industry and invests sustainably. While it does well at first, competition is weak as there are plenty of new customers to share.
However as DisadvantageCo invests and enters new geographies, earning attractive returns on investment, these high returns attract new entrants.
“As customer churn increases, price competition intensifies and returns on investment fall,” he said. “It becomes harder for DisadvantageCo to compete and returns on capital to converge with the cost of capital.”
When demonstrating sustainable investment, Elliott envisaged DrainCo, a ‘cash cow’ company that cannot sustainably invest.
Initially, the company has a structural growth opportunity and a competitive advantage. DrainCo wins share and uses its ample free cash flow to boost shareholder returns.
The manager said: “Low investment prevents DrainCo from creating new revenue opportunities, but the existing market position is secure as barriers prevent new entrants.
“DrainCo fails to innovate and the distance between the product served and the potential product grows and this innovation gap is the primary ingredient for disruption.”
He added that ultimately companies with a focus on immediate returns are not acting in the interests of long-term shareholders.
“Microsoft came close to falling into the disruption trap in the noughties after failing to invest initially in cloud technologies, but redirection of the R&D budget and improvements to the development culture enabled a recovery,” he said.
Down the rabbit hole
“The lesson for investors who seek to leverage the power of compounding is that understanding the factors that are driving growth is an absolute necessity and the returns on careful analysis are significant,” said Elliott.
Therefore, how does this relate to the rabbit comparison?
Elliott outlined that Australia was undergoing a period of agricultural market growth in the late 19th century, with increased farming providing additional food.
He added that without any natural predators, the rabbits had a material competitive advantage over native species and therefore the rabbits had the ability to multiply, or sustainably invest.
Apparently when Austin requested the rabbits to be sent from England, he wrote: “The introduction of a few rabbits could do little harm and might provide a touch of home.”
“The estimated population of rabbits in Australia peaked at 10 billion,” said Elliott.
TB Evenlode Global Equity launched in May and has an ongoing charges figure (OCF) of 0.85 per cent.