Michael Topley and Olivia Lewis: Compounding

31 Jan 2024 Expert insight

Michael Topley and Olivia Lewis study the power of compounding in long-term investing.

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A long-term investment strategy is essential for charities to maximise their assets, and to sustain or expand their activities in the future. With charity finances under increasing pressure from soaring prices and the cost-of-living crisis, many will also be keenly aware of the need to mitigate the impact of inflation. In the current environment, it can be tempting, even essential, to prioritise meeting short-term financial needs, but it’s important trustees also keep focus on investing for the years ahead.

Building a diversified investment portfolio of risk assets, such as equities and bonds, can help charities achieve an attractive real return over the long term. While charities may need to draw down some investment returns to fund their activities, staying invested as far as possible is often the best way to build up returns over time – thanks to the power of compounding.

The basics of compounding

Compounding is a force that our linear minds often struggle to fully comprehend. Albert A. Bartlett, a US professor of physics, went as far as to say: “The greatest shortcoming of the human race is our inability to understand the exponential function.” In the classic illustration of compounding, if a 64-square chessboard had a grain of rice placed on the first square, then two on the second square, four on the third and so on – with the number doubling each time – the final square would contain over 18 quintillion grains.

Compound growth is key to successful long-term investing, and its benefits accumulate over time. As a simple example, a hypothetical £10,000 investment returning 5% annually would double within 14 years (to £20,108.26), provided you reinvest the returns and leave the initial capital untouched. If you double the timeframe to 28 years, the original capital would more than quadruple (to £40,434.22) on the same basis. Market fluctuations mean that investment returns are rarely that consistent from year to year, and there is always the risk of investment loss to contend with. However, the longer the holding period, the greater the compounding potential.

For equity investors, it’s also about how and where your capital is invested, and identifying which companies are well placed to compound returns for shareholders. But what attributes can help a business grow exponentially over the long term?

Cash is king

Firstly, generating a high level of cash is important, as it influences how much a company can reinvest in its future. When a company sells something, it will receive cash as payment from the customer. With this cash, it needs to pay for the raw materials used to make the product, the employees who produced it, as well as any associated business costs, such as administration, marketing and rent. It may also need to allocate some to repairing machinery, or to paying the interest on its debts. At the end of the year, the company aims to be left with a metaphorical pile of cash on the desk – and ideally, a bigger one than the year before.

But it’s also important to consider what it took for the company to generate this pile of cash, and whether it was a worthwhile investment. Understanding how much capital a company has invested in previous years to achieve this level of cash can help determine whether it was a good investment.

For instance, perhaps the company invested £100m into a new factory a few years earlier to produce a low value widget, then at the end of the year that factory had £1m of cash on the desk. Was that a worthwhile investment? Alternatively, perhaps instead of buying a factory, the company hired a world-class coder for £200,000 per year, who created a software application that generated £1m in cash from sales.

You can see that both decisions resulted in the company having £1m of extra cash at the end of the year, but the second option required a significantly smaller investment to generate it. The latter option therefore provided the company with a higher level of return on capital.

Developing a secret sauce

Achieving a high level of return on capital is not straightforward, however. If it were, then competitors would likely enter the market, pushing prices down and resulting in less cash coming through the door. In order to achieve a sustainable high level of return on capital, a company needs to possess a durable competitive advantage – its secret sauce – which means others find it hard to compete.

A company’s competitive edge could stem from several sources, whether it is intellectual property, such as the patent on a molecule or technology, owning a powerful network that aggregates buyers and sellers, or building a strong brand that commands a premium. It can also come from scale, where sheer size means a company can produce things more cheaply that its competitors – enabling it to capture market share and achieve a higher profit margin than peers.

Corporate culture is another, often underappreciated factor in determining high returns on capital. Businesses that foster long-term creative thinking and make far-sighted investments in anticipation of future demand, can develop extraordinary market leadership. Strong management, a highly engaged workforce and a deep customer focus are also key elements in building a culture of innovation.

However, generating high returns on capital invested is only part of the story when it comes to compounding. A company that successfully raises high levels of cash then needs to decide what to do with it. There are several options available to management: invest it organically back into the business; invest it inorganically by buying other companies; use it to buy back shares; or pay it out as a dividend.

Reinvesting in growth

If a company has strong growth opportunities, investing its cash into expansion may be the preferred option – provided a good level of return on capital can be maintained. This could be through new product development or expanding distribution into new geographic markets.

For instance, if a company invested £100m into a factory which produced a 20% return on capital, it could earn £20m in cash each year. If the company is able to spend £1bn building more factories, and maintain that 20% return on capital, then it would earn £200m a year in cash. This is a powerful way of compounding the capital invested in a business. However, as a company grows, the return on capital often begins to deteriorate. After all, there are only so many widgets their customers need, for example. In which case, perhaps there is a better use of this cash.

Acquisitions are an alternative use for excess cash. By purchasing new businesses with high levels of return on capital, it is possible to keep reinvesting this cash and generate even more. Perhaps if the acquired company is similar to the core business, it may be possible to drive synergies, reduce costs and further increase the return on capital.

Returning cash to shareholders

If a company has no opportunities to invest its excess cash and maintain high levels of return on capital, then it may consider returning it to shareholders. One way to do this is to buy its own shares in the market. Share buybacks can be a very powerful driver of a stock’s return over time. When a company generates a profit, each share in the company has a claim on a slice of it. If a company can reduce the number of shares outstanding by repurchasing and retiring them, then this profit will be distributed over a smaller number of shares.

Alternatively, excess cash can be returned to shareholders in the form of a dividend. Charity investors often rely on investment income, such as dividends, to fund their activities, or they can of course reinvest them, buy more shares in the company, and compound their overall returns in the longer term. However, if a company’s capital base is not growing, they need to consider how meaningfully the share price could compound in the future.

Investing for the long term

Identifying high-quality, high-return businesses with re-investment opportunities is key to seeing your investment compound over the long term. It is then a matter of resisting the temptation to sell as staying invested, regardless of the market backdrop, can help maximise risk-adjusted returns, and protect against the harmful effects of inflation over time. (Needlessto-say, performance is never guaranteed and there is always risk of investment loss.)

Many charities are able to invest with a long-term horizon, so are well placed to benefit from compounding returns, from equities and other assets. However, it’s important to ensure your investment portfolio is well-diversified and aligned to your investment goals and risk appetite.

When it comes to equity investing, there are different ways to assess a company’s share price potential. It’s important to understand your investment manager’s philosophy and approach to investing, and how they aim to generate long-term returns.

As ever, open and regular communication with managers can help charities to understand their options, and build a long-term portfolio strategy that’s right for them.

Michael Topley is head of sustainable portfolio management & senior global equity manager, and Olivia Lewis is a private banker – charities & not-for-profits, at Barclays Private Bank

Charity Finance wishes to thank Barclays Private Bank for its support with this article 

The Charity Finance Yearbook is the ultimate reference source for charity finance professionals. Produced by the Charity Finance editorial and research team it includes updates, advice and trends on accounting and audit, VAT and taxation, investment strategy, responsible investment and finance, risk, funding, performance and governance, law and regulation, HR and pensions, IT and property. Purchase online here.

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