Forbes – The Compounding Returns Of Stocks

In his most recent annual letter to shareholders, Warren Buffett proclaimed 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 potential for rising interest rates as a reason to avoid them right now. For me, that raises the question of whether bonds are ever the place to be for a long-term investment strategy.

The Key Difference Between Stocks And Bonds

The key difference between stocks and other assets classes is that stocks can compound their value while assets such as bonds cannot. That can happen because, by and large, companies retain a portion of their earnings to reinvest in the business for the benefit of their stockholders. Their bondholders merely receive interest payments and, ultimately, the bond’s face amount when it matures. That’s not a subtle difference. It’s a significant advantage stocks have over bonds that many investors don’t often consider — often to their detriment.

With bonds as an investment, what you see is what you get. You receive fixed periodic interest payments, but they can’t automatically be reinvested in more bonds. With real estate property, you receive rental income, but it too 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.

The Compounding Benefits Of Stocks

If you consider the stocks that comprise the S&P 500, companies in the index pay out, on average, 41% of their earnings to shareholders as dividends. That doesn’t happen with any other asset class. But for shareholders, dividends are just part of the compounding return story. Though with many companies, dividends can be automatically reinvested to purchase additional shares, they have to be purchased at their market value, which is currently just under 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. So, it’s through the reinvestment of retained earnings rather than dividends that contribute much more significantly to the growth in the shareholder value.

Furthermore, when you factor in the return on earnings retained in the business, it becomes clear how companies can compound the value of your investments. The average return on retained earnings or capital over the last 12 months is about 14% among companies in the S&P 500, and any additional capital produced through that return also earns 14%. That’s the magic of compounding.

Where To Look For Compounding Returns

Of course, you could simply 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 achieve higher returns on capital? Instead of converting $1 of retained earnings into three times book value, these companies can do it at a significantly higher book value multiple.

Among the thousands of publicly traded companies, there are a few that, year in, year out, manage to generate recurring revenues with high gross margins and low capital intensity resulting in sustainable returns on capital. Also, companies with a high return on capital can generate higher profits at less cost without having to rely on physical assets that require greater capital outlay. That allows them to focus on developing intangible assets such as technology innovations, patents, brand-building and distribution channels to create more durable competitive advantages and solidify their market position.

That’s the “moat” that Warren Buffett often speaks of when he says, “I look for economic castles protected by unbreachable moats.” In Buffett’s world, the larger the moat, the more impervious a company is to a competitive breach of its market share. As a result, these companies tend to perform well regardless of economic conditions. That enables them to continuously compound their returns, increasing shareholder value gradually over time.

Now may not be a good time to be in bonds, as Warren Buffets says. But, for many investors, bonds are an important source of portfolio diversification, providing ballast in times of stock market selloffs. That’s 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 with a licensed professional for advice concerning your specific situation.