“Compound interest is the most powerful force in the world. He who understands it, earns it. He who doesn’t, pays it.”
This quote, attributed to Albert Einstein, underpins much of how we approach investing at Oracle. Compounding is the enabler that allows for wealth creation. It is the bedrock of Australia’s superannuation system and is why many retirees have been able to retire on the equity in their homes.
At Oracle Investment Management, we have always been believers in investing for the long term. In this article, I’d like to articulate why. Essentially it all boils down to finding companies that can reinvest their profits in their business over time and earn high rates of return on this retained profit. That is the essence of compound interest, which is where, over time, interest earnt on an investment (or in a bank account), will itself earn interest, compounding the interest earnt such that you earn interest on the interest. It is the same principle when a company retains earnings and reinvests in its business.
The one person in the world who has demonstrated this better than anyone else is Warren Buffett. Buffett is one of the wealthiest people in the world and possibly the most famous investor, not just because of his impressive investment performance, but the length of time for which he has been able to do it. Many famous investors boast impressive records over 2, 3 or even 4 decades, but there are not many that have done it over 8. The below scatter graph is a bit old now, but it demonstrates the point nonetheless. It plots the performance of famous super investors against their active years. Buffett is far from the highest performer in terms of performance, but his consistently good performance makes him an outlier, even among the best in the world.
Source: CLSA, via Compounding Quality
At 92 years old, Buffett bought his first stock at age 11 and has been compounding ever since. Buffett is not the wealthiest investor in the world because he has had the best performance, but simply because he has been sustaining his excellent performance for the longest.
The fact that drives this point home is that 99% of his wealth was created after his 60th birthday. Think about that for a moment. At 60, Buffett had been compounding for nearly 50 years and had amassed a fortune of a few billion dollars. More than enough for anyone to live and retire on. Nevertheless from this already impressive amount, the compounding has continued for more than another 3 decades at over 12% per year (per Berkshire Hathaway Class A share performance for the last 30 years, via FactSet), turning his fortune into something worth more than 100 billion dollars.
Looking Back to the Nifty Fifty
In a “We Study Billionaires” podcast Mohnish Pabrai, a former apprentice of Buffett and a very successful investor in his own right, discussed the Nifty Fifty. The Nifty Fifty was a basket of 50 stocks in the 1970s that were the bluest of blue chips. They were regarded as so safe that no price was too high. This, of course, turned into a bubble, which eventually popped in 1973. However many of the companies in the Nifty Fifty that were caught up in the bubble are still around today: companies that are household names such as McDonalds, Coca-Cola, and Procter & Gamble.
However, one constituent stands out: Wal-Mart. If you had bought an equal-weighted portfolio (2% each) consisting of the Nifty Fifty, including Wal-Mart at its initial public offering (IPO) in 1970 and held on until today, and if you assume that the other 49 stocks in the Nifty Fifty went to zero in this time, you would still end up with an annualised return of 13.3%, beating the S&P500 by about 3% per annum. Such is the power of compounding that Wal-Mart experienced in the last 50 years even if the 49 other stocks in the portfolio failed (which they didn’t), you would have trounced the S&P500, a notoriously difficult benchmark to beat.
Notably, the return would actually be higher because many of the Nifty Fifty are still with us today that have also performed well. Further, Pabrai goes further and says that even if you exclude Wal-Mart from the Nifty Fifty and you bought an equal-weight portfolio in 1972 at these ridiculous valuations, and you held it until today, the annualised return would have been 10.2%.
As an aside, Wal-Mart founder Sam Walton has long been dead, but his children inherited his Wal-Mart shares, which together are worth well over $200 billion. An outlier for sure, but if he was still alive, Sam Walton would be one of the wealthiest men on the planet.
The Importance of Return on Invested Capital
his discussion with Pabrai highlights the power of compounding but it also hits on another key point in investing relevant to our discussion: the longer you hold a stock, the closer your returns will be to the company’s return on invested capital (ROIC).
This point was made by Charlie Munger in a 1995 speech, where he said:
“Over the long term, it is hard for a stock to earn a much better return than the business, which underlies its earnings. If the business earns 6% on capital over 40 years and you hold it for 40 years, you are not going to make much difference than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you end up with one hell of a result.”
Terry Smith, in a presentation given to MeDirect a few years ago, gave a theoretical example that calculated the compound annual growth rate of two companies: Company A with a return on invested capital (ROIC) of 20% and Company B with a ROCE of 10%. If you were to buy and hold these companies for 40 years, even if the valuation (using a simple price/book valuation) halved for the first company and doubled for the second company, at the end of the 40 years, Company A has still trounced Company B. But more importantly, look at the compounded annual returns, even with the material valuation shift over time, it is still close to the ROCE of the companies.
Source: Terry Smith, Fundsmith
Justified Price-to-Earnings over time
In his 2021 Annual Letter to Investors, Smith discussed some of the best global-performing stocks since 1973 (notably, calculated after the Nifty Fifty crash). On the list are many household names including Colgate, Coca-Cola, Heineken, Nestle, and Unilever. These are companies with proven staying power, and notably, many have very strong brands. The discussion is regarding what an acceptable price/earnings ratio (P/E) might be to pay for a company. He shares the following chart, which shows what P/E ratio you could have paid for the company and still beat the MSCI World Index (in USD). The MSCI World returned 6.2% per annum from 1973 to 2019, and if you had paid these theoretical multiples, you would have achieved a 7% annual return excluding dividends.
The chart above shows that you could have paid 281x P/E for L’Oreal in 1973 and still had a return of 7% per annum, such is the growth that the company has experienced in the years since.
These examples are obviously cherry-picked and are the crème-de-la-crème of high-performing companies over the past 5 decades, but it illustrates several things simultaneously:
- Simple price-to-earnings (P/E) multiples can be misleading. This is a whole other discussion on the arithmetic behind what an appropriate P/E might or should be. It is beyond the scope of this article, but the shorthand is that different companies will have a different “fair value P/E” and it all hinges on the return on capital employed. I hope you are noticing a theme here and that is the return on invested capital is one of the key metrics we look for in an investment.
- When you buy a quality company that has a defendable moat (otherwise known as a sustainable competitive advantage) and high return on capital employed, so long as you can hold it for many years the quality component outweighs the valuation component.
- The longer you hold a quality company, the more likely you are to experience a good return.
In this article, I have allowed some investing giants to do a lot of the heavy lifting for me but I hope the above discussion has illuminated why Oracle focuses on quality companies and aims to hold these quality companies for as long as possible. It is also why we encourage investors to focus on long-term performance and stick with their investments for as long as possible to allow this compounding to work its magic in their portfolios.
Written by Luke Durbin
Lead Portfolio Manager
Oracle Investment Management
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