Compound interest: the snowball effect

Remember that the value of investments and any income from them may fall and you may not get back the amount invested. Past performance is not indicative of future returns.

Companies that reinvest the profits of steady growth over decades are the market’s unsung heroes, says Scottish American Investment Company co-manager James Dow

Early in his career, Warren Buffett bought shares in the bankrupt textile company Berkshire Hathaway. In 1965 he increased his stake to take control, later turning it into a legendary investment conglomerate.

So why is he now calling Berkshire Hathaway “the dumbest stock I’ve ever bought”? The answer lies in the “composition”.

In 2010, the Sage of Omaha said pouring money to turn around the Rhode Island business was a huge mistake. What he should have done, he suggested, was put the money in a steadily growing insurance company. And left it there.

Thanks to the wonder of compound interest, he would have been about $200 billion richer 45 years later.

To understand why, you need to understand how compounding produces exponential returns. It works because you not only earn interest on your initial investment, but also on additional returns.

Buffet compares it to a snowball rolling down a slope. The further it travels, the faster it grows in size.

The Scottish American Investment Company (SAINTS) is also a strong proponent of capitalization value. Our job is to better identify companies that can provide it.

Take Watsco, the Miami-based air conditioning distributor. Over the past decade, it has grown its profits at a compound annual growth rate of 12%. He never made a loss.

As a relatively small player, it still had the ability to take a big chunk of the $17 billion US air conditioning market.

After honing its business model in hot and humid Florida, Watsco continues to expand in the United States. It’s easy to see it enjoying another decade of compound annual growth of 10%.

The Starbucks coffee chain is a better known example. Even after two decades of strong growth, it remains a small enough player in the ever-expanding hot drinks universe to keep adding stores and menu items. We believe it can generate 10% growth for at least another decade.

Companies like these are rare. Michael Mauboussin, a professor of finance at Columbia University, found in 2016 that only one in five of the 37,000 stocks he studied consistently increased earnings by 10% a year or more. To build a portfolio of these names, it helps to invest globally.

Other examples in the SAINTS portfolio include:

  • Edenred (France, voucher management)
  • Admiral (UK, car insurance)
  • Sonic Healthcare (Australia, medical diagnostics)

None of these are growing at a spectacular rate year over year. Their outperformance over time is based on the relentless compounding of earnings and dividends.

Moreover, these stocks are often undervalued due to the chronic short-termism of the markets. A company that can rack up its profits for a decade and grow for another decade often doesn’t seem useful to an investment manager motivated by short-term performance.

The search for these actions is, to borrow another Buffetism, “simple but not easy”.

No algorithm will help you choose them, although a predictable period of “more of the same” certainly helps. We call these companies “long tracks”.

Then there is another type of long-established business that is nimble enough to spot similar but new markets for its products. We call them “adjacency producers”.

Swedish industrial giant Atlas Copco is a classic example. Originally a manufacturer of compressors, it has used its engineering expertise and customer base to launch attacks in the market for power tools and, more recently, vacuum pumps.

Companies committed to paying growing dividends typically have a proven business model, strong defenses against competitors, stable earnings and cash flow, good reinvestment habits, and the kind of growth that generates lots of excess cash. .

Capitalization is not the only way to outperform, but it is a way that works.

Investments exposed to foreign securities may be affected by changes in stock market conditions and exchange rates.

Some of the opinions expressed are not necessarily those of Baillie Gifford. Markets and investment conditions can change rapidly, so the opinions expressed should not be taken as statements of fact nor should they be relied upon when making investment decisions.

Investment funds managed by Baillie Gifford & Co Limited are listed on the London Stock Exchange and are neither authorized nor regulated by the Financial Conduct Authority.

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HOLY dividends

2017 2018 2019 2020 2021
11.1 11.5 11.9 12.0 12.7

Source: Baillie Gifford & Co. Total dividend per ordinary share (net). Pence per share. As of December 31, 2021.

Past annual performance as of June 30 of each year (% net)

2017 2018 2019 2020 2021
The Scottish American investment company PLC 6.8 15.0 4.5 22.4 -3.0

Source: MorningStar. Share price, total return, GBP.

Past performance is not indicative of future returns.

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