Update No. 11 – 12/06/11

EGP Fund No. 1 Pty Ltd. Up by 12.35%, leading the benchmark by 17.74%.

EGP 20. The EGP20 index is Down by 13.17%, lagging the benchmark by 7.78%.

S&PASX200TR The benchmark index is Down by 5.39% since April 1 launch.

This week I would like to touch on ‘compounding’. I come back to compounding often, because in my view, there is no more important concept for an investor to grasp. Albert Einstein once said:

“The most powerful force in the universe is compound interest”

Warren Buffett gets attention for the power of his returns. Legitimately so, $10,000 invested in Berkshire Hathawayin 1980 would be worth about $2.45m currently, and would have grown in value by about 19.88% p.a. over that period, Buffett’s early returns were better still. My favourite, though a less well known example of compounding assets are the returns of Leucadia National Corporation. $10,000 invested in this company brilliantly managed by Ian Cummings and Joseph Steinberg in 1980 would now be worth about $7m – this equates to about a 24.1% p.a. return. They have over the course of this 30 or so years split the stock 12 for 1. A share you had purchased for the equivalent of 6 cents allowing for splits would now be worth $35.78 and you would have received about $6.16 (over 100 times your original investment) in dividends along the way. Had you reinvested your dividends, your returns would be higher still – you see why I regularly touch on compounding, because when done well and for a long period of time, its results can be truly astonishing. Much like Buffett’s shareholder letters, the ones from this pair are a demonstration of the correct demeanour required for success. (By the way, I believe that following a similarly ruthless investment strategy, Buffett’s return may well have been more like Leucadia’s, but he prefers to hold onto businesses, even if the returns are diminishing, Leucadia have no such preference, and are much more ruthless)

A quote from Buffett at the start of his biography “The Snowball” by Alice Schroeder says, “Life is like a snowball: the trick is finding wet snow and a long hill.” This is how an investor should view compounding.

If I were to nominate a singular reason for Berkshire Hathaway’s (or Leucadia’s) success, it would be the efficiency with which its assets have been able to compound the cash inflows. The return on marginal capital is the key. A standalone business has to decide what to do with its profits. There are 3 realistic options, return of profits in the form of dividends (or possibly buybacks), reinvestment of profits in ‘organic’ growth, or reinvestment of profits in the form of ‘acquisitive growth’. Most businesses perform some combination of these. The power of ‘investing businesses’ like Leucadia and Berkshire are that there have been superior capital allocators, who takes the cash thrown off by businesses (which they own) with minimal prospect of reinvesting them with high returns and finds superior applications for the capital elsewhere. The 2010 shareholder letter from Buffett addresses this. More important than the rate of compound of the original investment is the rate of return that can be generated from the stream of cash it generates. If it has a lower return than the original investment, overall returns diminish.

The Australian market has on average a higher proportion of dividend return than virtually any other advanced market. Our fairly unique dividend imputation system creates this situation. This forces most Australian companies into a much higher payout ratio than in other markets. This is not so bad as managements generally are poorly-skilled in capital allocation in my view. I can stand behind that statement purely on the basis of how few companies despite rock-solid balance sheets and sound prospects initiated significant buy-backs in the 2008/2009 financial year, with stocks at once or twice in a lifetime lows.

However, in my view the recent buy-back actions undertaken by JBH, WOW & BHP are excellent ways turning the ‘handicap’ of franking credits into an advantage. The companies have managed to use the franking credits to buy the shares back at a 14% discount (this allows a ‘margin of safety’ for management, in case the shares were more fully valued than they had thought) to the prevailing market price. At the same time, getting the franking credits into the hands of the shareholders who can best use them. The alternative of paying a massive dividend, with a dividend reinvestment plans, would increase outstanding shares at a higher price and dilute future compounding. The buyback instead reduces outstanding shares and increases the remaining shareholders’ compounding effect. It does so without requiring a tax payment or an additional investment. These buybacks are an action to be commended, dividends are lovely, but capital growth is generally the most tax effective way to take your gains.

When investors make a decision to participate in a DRP, they must think hard about the power of compounding. Even when offered at a 5% discount (as some companies do). If we assume participation in a DRP with a 5% discount in a company with an expected return of 14% p.a., or an alternative investment in a company with an expected return of 1% more, the second investment, from the 6^thyear onwards offers a superior return. Tony Hansen 12/06/11