What is compounding?
A lot has been written about the power of compounding. We’ve all heard illustrations of the extraordinary results that may be accomplished if compounding is allowed to do its work over long periods of time. But what is compounding? How does it work?
There’s an extreme example: the story of Native Americans selling the island of Manhattan. As the story goes, the selling party in the deal collected an estimated $20 worth of beads and trinkets from the transaction, which took place in the year 1626.
So how does compounding play into this? Let’s say the sellers invested their initial $20 at a rate of 9% per annum and then stuck with this investment program for the following 380 years. Today, their initial $20 would be worth more than $3,335,000,000,000,000.
I like this example of compounding because it illustrates that the rate of return on an investment doesn’t need to be extraordinary for extraordinary results to occur. What is crucial is having the ability to sustain an investment program uninterrupted over a very long period of time.
In the real world of investing, “life gets in the way”. It’s rare for an investor to enjoy a streak of decades of compounding in any investment without the interruptions of distributions and taxes. This story simply reminds us that striving for sustained, uninterrupted compounding over long periods of time is smart investing, and that’s precisely our goal.
Many people think of us as a “value investor” and others ask whether we are a value or a growth investor. We’ve started to say, we’re neither, we are a compounding investor.
What does it mean to be a compounding investor?
It means we try to invest in businesses that have the ability to compound internally over the course of many years.
To think like a compounding investor is very natural for people who buy small or private businesses. The private investor wants to concentrate carefully on a few business investments, and hopes the accountants will report back consistently at the end of each year that equity per share has grown. Private investors don’t think about trying to dart in and out of investments on a daily or monthly basis.
This approach is so basic, it’s often forgotten in the public equity markets. In public markets it’s become too easy to get distracted by hour-to-hour market gyrations and all the breathless excitement brokers and the media put on short-term news. To be a compounding investor, you need to tune out the short-term noise.
We think hard about the ingredients required for a business to compound in value over the course of many years. We believe these include: 1) an ability to generate above average returns on shareholders’ capital, 2) opportunities to deploy additional capital at above average returns, and 3) a management team with the skill and judgment to sustain the process of compounding over a long period of time in the face of competition. You’ll recognize this is just another way of describing our “three-legged stool” approach: Business, Management, Reinvestment.
How does Akre’s investment philosophy demonstrate the power of compounding?
We strive to invest in businesses with these three ingredients of compounding, and to buy them at reasonable prices. If we do this, there is no reason or need to trade in and out of these businesses to achieve above average returns. We don’t want to rely primarily on our contrarian instincts or our ability to play market volatility in order to generate returns. Like the private investor, we want the businesses we buy to be growing in real economic value each day.
We like to hold investments for many years to allow their internal compounding to do its work. It’s a wonderful thing not to have to realize a taxable gain. The tax deferral available by investing in businesses that compound internally is an enormous and often under-appreciated advantage.
Yet, in the real world, businesses do change. We need to be constantly vigilant about these changes. Some businesses are getting worse as years pass, while others are getting better, and so our investment portfolio gradually evolves.