SAINTS: The wonder of compound interest

Please remember that the value of investments and any income from them can fall and you may not get back the amount invested. Past performance is not a guide to future returns.

Companies reinvesting the profits of steady growth over decades are the unsung heroes of the market, according to James Dow, joint manager of the Scottish American Investment Company 

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

So why does he now call Berkshire Hathaway “the dumbest stock I ever bought”? The answer lies in ‘compounding’.

In 2010, the Sage of Omaha said pouring money into turning around the Rhode Island firm was a huge mistake. What he should have done, he suggested, was put the sum into a steady-growth insurance company. And left it there.

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

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

Buffet compares it to a snowball going down a slope. The further it travels, the faster it gains size.

The Scottish American Investment Company (SAINTS) is also a big believer in the value of compounding. Our job is to get better at spotting the companies that can deliver 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 per cent. It’s never made a loss.

As a relatively small player, it still had the ability to take a big bite of the US’s $17bn air conditioning market.

After honing its business model in hot and humid Florida, Watsco continues to grow across the US. It’s easy to see it enjoying another decade of 10 per cent compound annual growth.

Coffee chain Starbucks is a better-known example. Even after two decades of strong growth, it’s still a small enough player in the ever-expanding universe of hot drinks to keep adding stores and menu items. We think it can deliver 10 per cent growth for at least another decade.

Companies such as these are rare. Michael Mauboussin, a finance professor at Columbia University found in 2016 that only one in five of the 37,000 stocks he surveyed steadily compounded their earnings at 10 per cent a year or better. To construct a portfolio of these names, it helps to invest globally.

Other examples in SAINTS’ portfolio include:

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

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

What’s more, these stocks are often underpriced thanks to chronic market short-termism. A company that can compound earnings for a decade and grow for another decade often doesn’t seem valuable to an investment manager incentivised on short-term performance.

The search for these stocks is, to borrow another Buffet-ism, “simple but not easy”.

No algorithm will help you pick them, though a foreseeable period of ‘more of the same’ certainly helps. We call these ‘long runway’ companies.

Then there’s another kind long-established companies that are nimble enough to spot similar-but-new markets for their products. We call them ‘adjacency growers’.

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

Companies that commit to paying growing dividends usually have a proven business model, strong defences against competitors, steady earnings and cashflow, good habits of reinvestment and the kind of growth that generates lots of spare cash.

Compounding isn’t the only way to outperform but it’s a way that works.

Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates.

Some of the views expressed are not necessarily those of Baillie Gifford. Investment markets and conditions can change rapidly, therefore the views expressed should not be taken as statements of fact nor should reliance be placed on them when making investment decisions.

The investment trusts managed by Baillie Gifford & Co Limited are listed on the London Stock Exchange and are not authorised or regulated by the Financial Conduct Authority.

A Key Information Document is available by visiting bailliegifford.com

SAINTS dividends

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

 Annual Past Performance to 30 June Each Year (Net %)

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

Past performance is not a guide to future returns.