Two Wheels of Compounding (a.k.a. the most powerful force in nature) - Part I

"Compound interest is the most powerful force in nature"

- Unknown

I don't know who said that, though it is alleged those words were uttered by Albert Einstein. Despite the controversy surrounding it, it is a profound statement. 1.1 raised to 20 is 6.72 and 1.1 raised to 40 is 45.25. Let us not even go to 1.1 raised to100.

But interest is not the only thing compounds. There are other things which compound as well. If anything can compound forever at a good enough rate, eventually it will become larger than the known universe. That is why it is so powerful. It seems like a good thing to profit from!

The principle of compounding is that if the interest earned so far itself bears interest in future, it leads to compounding. Similarly if anything earned so far also contributes to further growth, that thing will compound. That is why businesses compound (in other words the inherent value of the businesses compound). Compounding forms the basis of long term investment. Of all the factors that affects the market value of business (i.e. the stock price), the one that compounds will eventually become the most powerful. It also helps that factors behind compounding are slightly easier to predict than other powerful factors like interest rates, fund flow, inflation, reddit users etc. (these days one can also include Jerome Powell's speech pattern in the list). I don't say they are unpredictable because it is my opinion. I say they are unpredictable because I have not come across anybody who have had a more than 50% chance in being able to predict these factors over a long term. Fortune teller's parrots would probably have a more enviable track record in predicting these factors compared to any Mensa member.

Essentially, you can describe stock price at any point of time as a factor of two things as given by the following simple equation:

Stock Price = Inherent Value + Powerful Unpredictable Factors (PUF)*

* Powerful Unpredictable Factors (PUF) include inflation, fed policies, fund flows, investor sentiments etc. Some factors like inflation will compound but at a much lower rate compared to inherent value of good businesses.

If we can determine that the inherent value is compounding at a fast enough rate, it should make sense to bet on it because no matter how powerful other factors are, eventually compounding will win. This is the basic difference between assets that don't compound (like gold) and stocks. You can depict it as follows:

That is why over short term gold* or any stock irrespective of its fundamentals can outperform but in long term the business that compounds will win. That is why stock market is a voting machine in the short term and weighing machine in the long term. And that is why Warren Buffet's following comment on gold makes sense:

"If you convert all the gold in form of a cube, a century from now the gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond."

Note that by betting on compounding, you can appear completely stupid over a short term. The powerful unpredictable factors can make even useless assets appear like winners for multiple years while compounding stories can stagnate. However, there is no use of trying to focus on these unpredictable factors to determine which assets will outperform, mostly because these factors are unpredictable! No matter how powerful these other factors are over a short term, your only choice to reliably make money is to bet on compounding. That is why you shouldn't pay attention to stock prices except while buying or selling, since paying attention to stock price movements actually means trying to predict things that are unpredictable. It is akin to try to push a concrete wall. You cannot possibly gain anything from it. Though one difference between stock market and the concrete wall is that in stock market you can get the illusion of winning and being able to predict these PUF factors if you just had a lucky streak.

If you have been following a different philosophy for years or if you just had a good streak, you are likely to disagree with most of what I have said. But if you believe in whatever I have said about compounding so far, naturally your inclination will be to bet on compounding. But how do we determine what leads to compounding and how can we predict that compounding is going to happen in a business.

Since I do not want to make it a really long article, I will cover it in the next part of the article. I have already left a clue though. The trick is to find out things that have been generated earlier and that will contribute to further growth.

* To dramatise the difference between stocks & other assets, I didn't include the possibility that gold prices may have some compounding factors like inflation. But the rate of compounding is much smaller compared to good business.

Disclaimer

Abhishek Chauhan is Principal Officer of Eklavya Capital Advisors, a SEBI regulated Portfolio Management Service Provider.

The information, opinion, or analysis provided in this article is not an investment advice and is intended for general informational purposes only.?The contents and information in this document may include inaccuracies or typographical errors and all liability with respect to actions taken or not taken based on the contents of the article are hereby expressly disclaimed.?

Any reader or this article should refrain from acting on the basis of this article without first seeking independent advice in that regard. The views expressed in the article by the author is in their individual capacities only.