Why compounding is the key to investment success

They say theoretical physicist Albert Einstein called compound interest the eighth wonder of the world, observing: “He who understands it, earns it. He who doesn’t, pays it.” He’s not wrong – through the years many investors have realised that if they correctly harness the power of compounding it’s possible to achieve investment goals a lot quicker.

Compounding is best explained with a mathematical example. Let’s say you invest £1,000 in a fund with an annual return of 10%. After the first year, you would have £1,100. In the second year you don’t just earn on the initial £1,000 you invested, but also on the additional £100 gained in the first year, ending up with £1,210.

If this process is repeated, you will quickly see your money grow. Of course, investing carries its own set of risks and may lead to financial losses, but generally compounding will help you in growing your wealth.

There are several ways to make money by investing in the stock market in the short term, such as speculating on mergers and acquisitions or chasing trendy investments like meme stocks in the hope of spectacular price rises. However, these are particularly risky ways to invest and can just as easily result in short-term losses as short-term gains. Compounding on the other hand is a long-term strategy, and this means investors need to exercise some patience.

You can harness the power of compounding by investing in companies that can grow and compound their own growth. These companies typically boast repeatable business models, focused management and high profit margins. They are often monopolistic or insulated from the economic cycle and not dependent on external factors like commodity prices.

But they don’t always make spectacular returns, and this is where patience comes in. Compounding companies tend to steadily grow their earnings on a regular basis. It means that they are less likely to suddenly see their share price spike astronomically in the short term.

Indeed, the benefits of compounding are only really seen later on and you might have to wait a few years to really appreciate it’s effects. If we take our mathematical example: in year one the growth is 10% but by year 10 it is 24% of the initial investment - all due to the power of compounding.

The challenge lies in identifying stocks that can continuously compound. To achieve compounding, one must find businesses with the right mix of a strong brand, good management and the right products. Notable examples of compounding stocks include Coca-Cola, McDonald’s, Microsoft, and locally in the UK, the London Stock Exchange Group (LSEG).¹

Although these stocks have provided consistent returns in the past, there is certainly no guarantee they will continue to do so and, like any investment, they can go down as well as up. As a result, it’s prudent to hold several such stocks as part of a diversified portfolio.

Using a fund is another way to achieve diversification. Investors can gain exposure to compounding in their portfolios through both active and passive funds. Active funds are managed by financial professionals who make decisions about how to allocate assets within the fund, and some funds have managers with a particular focus on compounding stocks.

Passive funds are designed to mirror the performance of the index they track, such as the S&P 500, less charges.

Whilst earnings growth should feed through to share prices, another avenue for compounding is by reinvesting dividends. The reinvested income buys more shares, which then pay out more dividends. This can be particularly effective in the UK market, which is known for its higher dividend yield.

Dividend paying companies are typically mature businesses, which may be less growth orientated. However, high yields on a share could also be a warning that something is not quite right, and this may need further investigation.

Sectors with high dividend yields in the UK are usually utilities, commodities, energy and healthcare businesses with large customer bases. These businesses offer no guarantees with profits and dividends affected by external factors. For example, in 2020 Shell cut its dividend for the first time since World War II after the oil price collapsed as demand evaporated due to Covid pandemic lockdowns.

Often, successful income investing involves identifying businesses with a good track record of paying dividends they are also able to grow. This creates a driver for the share price to grow as well, which means you could get a compounding benefit through reinvesting any dividends and share price growth.

Identifying compounders or stocks that pay out regular dividends isn’t without risk. History has shown us that even well-known listed businesses can falter, as seen with some of the Nifty Fifty companies, which were 50 large cap US stocks in the 1960s and 1970s characterised by consistent earnings. The likes of Gillette, Xerox and Polaroid were all stock market darlings but struggled in later years. The Nifty Fifty story serves as a cautionary tale that companies that can deliver consistent returns and compound growth today might not be able to do that forever, particularly if new technologies disrupt their market.

Nifty Fifty stocks were also characterised by high valuations, but a period of outperformance was followed by one of underperformance as markets revalued these businesses back to more reasonable levels. Valuation matters and even the most reliable compounders can become overvalued, potentially leading to poor long-term share price returns even if the business continues to thrive.

While compounding can significantly enhance the value of a financial portfolio, it requires a disciplined approach to investing, a focus on quality stocks and an awareness of the risks involved. By understanding and applying the principles of compounding, investors can set themselves on a path to long-term financial success.

¹ Evelyn Partners.  This is not a recommendation to invest in these companies.