Compounding

Research By: Bhumika jain

Legend has it that the renowned physicist Albert Einstein once referred to the mathematical principle of compounding – an essential element for successful, long-term saving and investing as the “eighth wonder of the world.”

If I were to present you with a choice between an immediate cash payment of ₹1 crore or a magic penny that doubles in value every day for 30 days, which one would you choose?

Like many, your initial reaction might be to take the ₹1 crore right away. However, if you pause and do the math, you’ll discover something fascinating. If you start with just one paise and double it every day for 30 days, by the end of the month, that tiny amount would grow to more than ₹50 crore!

This surprising outcome shows the incredible power of compounding over time.

Because compounding has such a significant impact on the growth of money in later years, it is crucial to start saving early. If you explore this concept further, you will notice that even on the 20th day, the value of your paise is only about ₹5,000. The real magic happens in the later days when compounding is applied to increasingly larger amounts.

Now, just for a thought experiment, imagine that each period represents a year instead of a day. Those 30 periods could symbolize your working years, where you have the opportunity to set aside money for retirement.

Now imagine that, for various reasons, you decide not to save anything for the first 10 years, perhaps thinking that retirement can wait or that you can’t afford to save. In this scenario, you would have only 20 compounding periods instead of 30, and the value of your paise would have grown to just ₹5,242 instead of ₹53 crore. Amazing but true! This demonstrates the enormous impact of time on compounding.

“The first rule of compounding: Never interrupt it unnecessarily.”

                                                                                                                       – Charlie Munger

Allow investments to grow over time, rather than trimming positions simply because they seem expensive in the short term. The true benefit of compounding is realized over the long haul, where most of the gains accumulate in the later years. Therefore, selling a winning stock prematurely can result in significant missed opportunities down the road.

The temptation to take action, like trimming or waiting for a slight dip in stock prices before buying, can often lead to mistakes, especially for long-term investors. Instead of focusing on minor price differences, the focus should be on the overall potential of the investment over a decade or more. 

These findings suggest that the “base rate” of success for IPOs isn’t promising, but it’s essential to be cautious when making broad assumptions, especially in investing where a few outliers can drive overall performance. In fact, the base rate for investing in equities, in general, isn’t stellar either. Bessembinder’s well-known study found that most stocks failed to outperform one-month Treasury bills, with the top 1.5% of stocks accounting for all market wealth creation from 1990 to mid-2020.

So, should we abandon equities altogether? Or should we instead focus on identifying the types of stocks that outperform? By applying simple criteria, such as investing only in profitable companies, many underperforming IPOs can be filtered out. Add to this an emphasis on reasonable valuations, strong insider incentives and businesses with competitive advantages and high returns on capital and the outlook changes.

In other words, whether a stock is an IPO should not be a deciding factor. It’s more important to evaluate it using the same thorough process you would apply to any other investment. Automatically dismissing a stock simply because it’s an IPO seems arbitrary. Moreover, many of these studies focus on short-term performance, but what about the long-term?

Some investors may hesitate to buy into a fresh IPO due to the hype and excitement surrounding its launch, which can create a sense of unease. However, it’s important to remember that every stock on the public market was once an IPO, including companies like Microsoft, Tractor Supply, Monster Beverage, and Home Depot – businesses that have grown immensely since their IPO days.

The fact that the original owners, who presumably knew the business best, decided to sell their shares doesn’t necessarily predict the company’s future performance. For example, Rakesh Jhunjhunwala, a highly regarded Indian investor, sold 0.5% of his stake (approx 33 lakh shares) in Titan Company in the quarter ending September 2021, leading some investors to pause, thinking he might be predicting a downturn. However, after Jhunjhunwala’s sale, Titan’s stock continued to rise, doubling in value which was around ₹1700 at that time to ₹3737 currently(Sept 2024). Investors who followed his lead may have missed out on substantial gains. Moreover, Jhunjhunwala had also invested in Jet Airways, a stock that later faced severe financial difficulties and eventually ceased operations, resulting in a significant loss.

Investing is challenging, and everyone makes mistakes, including selling stocks too soon. 

Furthermore, insider selling doesn’t always indicate trouble; it often follows normal patterns. A normal pattern is to sell when something has gone up a lot. A normal pattern is to buy when something has gone down a lot. However, it’s essential to pay attention when insiders deviate from these patterns, as that might signal something more significant. The experiences gained throughout an investment journey, including the mistakes, are valuable lessons that contribute to long-term success.

# Rule of 72

You can use the Rule of 72 to estimate how long it will take to double your money . Simply divide 72 by the annual rate of return you expect to achieve. For example, if you plan to invest ₹4 lakhs in an investment vehicle with an expected annual return of 10%, you would divide 72 by 10, giving you 7.2 years as the approximate time it will take to double your money. While this is an approximation, the exact calculation using the time value of money would give a result very close to 7.27 years.

You can also use this rule to determine the rate of return needed to double your money within a specific timeframe. For instance, if you aim to double your investment in 8 years, dividing 72 by 8 gives 9%, meaning you would need to earn a 9% annual return to achieve this goal.

# Rule of 114

The Rule of 114 is similar to the Rule of 72, but instead of estimating how long it takes to double your money, it helps you determine the time needed to triple it. For example, if you expect an annual return of 10% on your investment, dividing 114 by 10 gives you 11.4 years as the approximate time required to triple your money. If you calculate this precisely using the NPER formula in Excel, the exact time would be around 11.53 years, showing that these rules of thumb can provide reasonably accurate estimates.

# Rule of 144

The Rule of 144 is used to estimate how long it will take for a series of equal annual payments to double. For instance, if you deposit ₹2,000 annually at an interest rate of 6%, it will take approximately 14.4 years for the total amount to grow from ₹28,800 to ₹57,600.

NOTE : The Rules of 72, 114 and 144 assume that interest is reinvested and compounded at the original rate, which typically applies to investments like CDs or zero-coupon bonds where interest accumulates. However, for investments that pay interest or dividends annually, such as certain CDs, bonds, or stocks, reinvesting these payments at the original rate is challenging. Short-term rates are often lower than long-term rates, and unless market rates rise or a higher-yielding investment is found, achieving the original rate is unlikely. Additionally, taxes can reduce the amount available for reinvestment.

Identifying companies

Compounding returns are driven by the compounding of earnings, which is influenced by the cumulative effects of various strategies the company employs to establish and maintain competitive advantages or moats. Some accounting checks to scan companies over six years of consolidated financials –

• Cash Flow from operations (CFO) as % of EBITDA

• Provisioning for doubtful debts as a proportion of debtors overdue for > 6 months
• Yield on cash and cash equivalents
• Contingent liabilities as % of Net Worth (for the latest available year)
• CWIP to gross block
• Free cash flow (cash flow from operations + cash flow from investing) to median revenues

Beside financials,

• Seek out management teams that are intensely focused on their core business and avoid being sidetracked by short-term ventures outside their primary area of expertise.
• Look for companies that continuously strengthen their competitive advantages over time.
• Find promoters who are prudent with capital allocation, avoiding large, risky investments outside their core business and prioritizing returning excess cash to shareholders.