Investing in quality companies can be a wonderful thing. Businesses that can make large returns on the investments they make and also have the growth potential to plough that cash into similarly lucrative opportunities can generate incredible value for shareholders. Such companies harness the magic of compounding. Each year, they grow from a larger base, meaning they have progressively more money to invest the following year.
The incredible maths of compounding means we all struggle to get our heads around how powerful it is as a means of wealth creation. As a highly simplified example, let’s take a company that does not use debt and has no maintenance spending needs. If it starts life with £1m of shareholder equity, consistently returns 20p on each £1 invested in the business (ie, a 20 per cent return on capital) and ploughs all its profits back into a limitless growth opportunity, the value of shareholder equity would hit £1bn in 38 years. That’s a mind-blowing 1,000-fold return! No wonder Albert Einstein is said to have called compound interest “the eighth wonder of the world”.
However, another consequence of the maths of compounding is that businesses that are exemplars of the phenomenon are few and far between. The global economy simply isn’t big enough for many of them.