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

In the first part of this article (https://www.dhirubhai.net/pulse/two-wheels-compounding-aka-most-powerful-force-nature-chauhan) , I had tried to argue why compounding is your best bet to make money over a long term. If you found it convincing, I can move to the more important part, what is it that leads to compounding.

First it is important to understand what compounding is not about. Compounding is not simply about growth. 'A fast growing company is compounding faster' is similar to saying 'The person with the flashiest lifestyle is the richest'. It might be true but it is equally likely the company (or the person) is just enjoying the fruits of something unsustainable (debt, temporary source of money) and any change in the circumstances can lead to a collapse of everything fancy.

To understand compounding, we have to understand what is the engine leading to that growth & what is it that is earned during the process of growth which contributes to further growth. So far from what I have understood is that there are two possible wheels or engines of compounding. The first is the financial wheel of ROE which Warren Buffet so diligently follows and the second is the competitive advantage wheel, popularized by the Amazon Flywheel. Let us understand what these two things are.

Financial Wheel - ROE

The first wheel applies to cash positive companies. These companies generate positive cashflows that can then be invested in the same business for growth. These investments then lead to even more cashflow. The rate of generation of cash flow on the investment is determined by ROE. ROE is essentially the rate of compounding in this case. The cash that companies have earned so far, leads to further cash. That is what compounding is about.

However, there is a caveat here. The wheel needs a long track to be able to run and show it's compounding effect. This means there has to be a certainty about the market growth and market share of these companies. If the market growth and market share is not certain, there wouldn't be any advantage of investing more in the business. Because of this it is important to look at factors that ascertain market growth (whether the customer segment is going to grow, whether the need of the product/service going to remain, can a new kind of a product cater to the need fulfilled by the current product) and market share (strength of brand and associated customer habits, cost/capital efficiency, network effect) etc.

Competitive Advantage Wheel

There is a second compounding effect in the businesses which is related to competitive advantages. There are many competitive advantages which keep strengthening with growth. Most obvious is economies of scale. Larger companies typically have lower costs compared to small companies. So the larger they grow the more effectively they can compete with smaller companies. There is also economies of scope. A large company providing multiple products/services have supply chains, customer relationships, advertising mediums etc. which can allow it to bring even more products and services to the customer. There is also the new age competitive advantage, the network effect. A larger company with a network effect business model has more users and so it is more useful to a new user compared to a smaller company. So economies of scale, economies of scope and network effect are three competitive advantages that can keep growing as the company grows.

The most famous of these competitive advantage wheel is the Amazon Flywheel ( https://www.drift.com/insider/learn/newsletters/dc/the-one-thing-102/ ) which today is ubiquitous in startup pitch decks. The flywheel has both economies of scale as well as scope working for it. Later with the introduction of marketplaces, it also had the third component the network effect working for it.

For me, the competitive advantage wheel is the supporting wheel. Financial flywheel is the primary force which guarantees the compounding effect and the competitive advantage flywheel adds the kick. There are many startups which have the competitive advantage wheels but which require cash injection for up to a decade before they may or may not kickstart their financial wheels. For this strategy to succeed, central banks need to keep printing to continue for a long time. For me it is a powerful unpredictable factor. I cannot bet on it. Just because central bank printing has continued for last 13 years doesn't necessarily mean it will continue for next 13 years.

Now this compounding effect and all is very good. But there is a saying in Hindi: "Chaubey gaye Chhabbe banane, Dubey ban kar laute" [Four went on to become a six and instead returned after becoming a two]. While betting for compounding, it is important that we don't fall in trap of such events. A single dramatic value destroying event can undo effect of multiple years of compounding.

More about such factors and events in the next blog.

Note: Article edited to replace "competency wheel" with "competitive advantage wheel"

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 his individual capacity only.