Council Post: The Compounding Returns Of Stocks

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Jonathan Dash is the founder of dash investment, As CIO, he is responsible for the firm’s investment management and asset allocation decisions.

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in its most recent annual Letter To shareholders, Warren Buffett declared that “bonds are not the place to be these days.” Buffett has never been a fan of bonds as an investment, but he specifically cited the prospect of rising interest rates as a reason to avoid them for now. To me, this raises the question of whether bonds are ever the place for a long-term investment strategy.

Key Differences Between Stocks and Bonds

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The key difference between stocks and other asset classes is that stocks can add to their value whereas assets such as bonds cannot. This may be because, overall, companies keep a portion of their earnings to reinvest in the business for the benefit of their shareholders. Their bondholders only receive interest payments and, ultimately, the face amount of the bond upon maturity. This is not a subtle difference. This is a significant advantage that many investors don’t consider in stocks compared to bonds — often to their detriment.

With bonds as an investment, you get what you see. You receive fixed periodic interest payments, but they cannot be automatically reinvested into more bonds. With real estate property, you receive rental income, but it also cannot be automatically reinvested into the property. While you can use the rental income to make improvements to the property, the change in value is likely to be minimal or incremental.

compound profit of shares

If you consider the stocks that comprise the S&P 500, the companies in the index pay an average of 41%. Income as dividend to the shareholders. This does not happen with any other asset class. But for shareholders, dividends are only one part of the compound return story. Although with many companies, dividends can be automatically reinvested to purchase additional shares, they have to be purchased at their market value, which is in present Less than three times the book value of the average S&P 500 company.

However, when a company retains its earnings to reinvest in the business, each dollar of retained earnings is reinvested at book value. Therefore, it is through reinvestment of retained earnings rather than dividends that contribute greatly to the increase in shareholder value.

Furthermore, when you take into account the return on earnings retained in the business, it becomes clear how companies can add value to your investments. NS Average return on retained earnings Or capital in the past 12 months is about 14% among companies in the S&P 500, and any additional capital produced through that return also earns 14%. This is the magic of compounding.

Where to Look for Compounding Returns

Of course, you can only own shares in an S&P 500 index fund or ETF and benefit from that compounding. But why settle for the average return on capital generated by 500 companies when you can own individual companies that consistently generate high returns on capital? Instead of turning $1 of retained earnings into book value three times, these companies can do it at a much higher book value multiple.

These are just a few of the thousands of publicly traded companies that, year after year, manage to generate recurring revenue with high gross margins and low capital intensity, resulting in sustainable returns on capital. In addition, companies with higher returns on capital can generate higher profits at lower costs without relying on physical assets that require greater capital outlays. This allows them to focus on developing intangible assets such as technology innovation, patents, brand-building and distribution channels to create a more sustainable competitive advantage and strengthen their market position.

That’s the “ditch” that Warren Buffett often calls Speaks when he says,I seek the economic palace guarded by impassable moats, In Buffett’s world, the bigger the gap, the more impervious the company is to competitive infringement of its market share. As a result, these companies tend to perform well regardless of economic conditions. This enables them to continuously compound their returns, while gradually increasing shareholder value over time.

Now may not be a good time to be in bonds, as Warren Buffett says. But, for many investors, bonds are an important source of portfolio diversification, providing ballast in times of stock market sell-offs. It is between you and your investment advisor. For investors with a long-term outlook, nothing can provide the compounding effect of well-chosen, high-quality stocks.

The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.


Businesshala Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms. am i eligible?


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