The unique ad­van­tage of eq­uity in­vest­ment

Due to the com­pound­ing ef­fect, eq­ui­ties can cre­ate phe­nom­e­nal growth — but only if there is a source of growth.

Finweek English Edition - - Marketplace - By Terry Smith ed­i­to­rial@fin­week.co.za Terry Smith

nvi­est­ing

in eq­ui­ties presents one with a unique ad­van­tage over other as­set classes, which in my ex­pe­ri­ence is rarely un­der­stood and al­most never dis­cussed. Eq­ui­ties can com­pound in value in a way that in­vest­ments in other as­set classes, such as bonds and real es­tate, can­not. The rea­son for this is quite sim­ple: com­pa­nies re­tain a por­tion of the prof­its they gen­er­ate to rein­vest in the busi­ness.

If you look at com­pa­nies in the ma­jor in­dices, such as the S&P 500 or the FTSE 100, you will find that on av­er­age com­pa­nies pay out about half of their earn­ings in div­i­dends. The earn­ings that are not paid out are in­vested in the busi­ness. No other as­set class pro­vides this.

If you own bonds, you re­ceive an in­ter­est pay­ment but it is not au­to­mat­i­cally rein­vested in the bonds. The only ex­cep­tion to this is so-called pay­ment-in-kind bonds is­sued by highly lever­aged com­pa­nies, which pro­vide the op­tion for them to is­sue more bonds if they are un­able to pay the cash coupon. So you get more bonds but only at a mo­ment when the last thing you want is for your in­ter­est pay­ment to be in­vested in more of this junk. Sim­i­larly, if you own real es­tate, you will re­ceive rental in­come but none of it will be rein­vested in prop­erty for you.

As well as be­ing a unique fea­ture of eq­uity in­vest­ment, this can also be a valu­able source of com­pound­ing in the value of your in­vest­ments. For ex­am­ple, if you owned the av­er­age com­pany in the S&P 500, it earned a re­turn on eq­uity cap­i­tal em­ployed of 13% last year. If it can re­tain half the earn­ings which are at­trib­ut­able to you as an in­vestor and it can con­tinue to in­vest at its cur­rent rate of re­turn as its busi­ness grows, that half should also earn 13%.

What makes it even more at­trac­tive is that, on av­er­age, the com­pa­nies in the S&P 500 trade on three times book value, so for ev­ery $1 of earn­ings they re­tain, they cur­rently cre­ate $3 of mar­ket value, although of course this – the val­u­a­tion – can change. This is not the same as the fre­quently ut­tered mantra that the ma­jor­ity of the re­turn on eq­ui­ties comes from rein­vest­ment of the div­i­dends paid.

Div­i­dends that are rein­vested have to be used to pur­chase shares at mar­ket value – at three times book value cur­rently in the S&P – whereas each $1 of re­tained earn­ings gets rein­vested at book value. It is the rein­vest­ment of re­tained earn­ings, not div­i­dends, which pro­vides the ma­jor­ity of the growth in the value of eq­ui­ties.

What is even more at­trac­tive is, if in­stead of sim­ply own­ing the in­dex and see­ing the com­pa­nies rein­vest your re­tained earn­ings at an av­er­age rate of re­turn, you own only com­pa­nies that can achieve a high re­turn on cap­i­tal and that can as a re­sult man­age to trans­late each $1 of re­tained earn­ings into a mar­ket value which is a much higher mul­ti­ple of book value.

If you fol­low this rea­son­ing, you would con­clude that if a com­pany is able to in­vest re­tained earn­ings at a high rate of re­turn, then the last thing you would want it to do is pay you a div­i­dend. This is per­haps best il­lus­trated by Warren Buf­fett’s Berk­shire Hath­away, which has not paid a div­i­dend in over half a cen­tury.

Of course this needs to be pur­sued with care. There is a rea­son­ably sound piece of eco­nomic the­ory called mean re­ver­sion, which sug­gests that com­pa­nies which gen­er­ate high re­turns should at­tract com­pe­ti­tion, which will even­tu­ally re­duce their re­turns to the av­er­age, or worse. The very small group of com­pa­nies that man­age to avoid this eco­nomic law of grav­ity have some kind of de­fence that en­ables them to fend off the com­pe­ti­tion. This is the oft-quoted con­cept of the “moat”, pop­u­larised by Mr Buf­fett.

While this ar­ti­cle de­scribes the ben­e­fit of eq­uity in­vest­ment purely in fi­nan­cial terms, the com­pany also has to have a source of growth to en­able it to rein­vest re­tained earn­ings and, fur­ther­more, the growth has to pro­vide an op­por­tu­nity for it to rein­vest at a good rate. There are plenty of ex­am­ples of com­pa­nies that start with good rates of re­turn but then in­vest re­tained earn­ings at much lower rates and de­stroy value for share­hold­ers. Tesco comes to mind. ■

Div­i­dends that are rein­vested have to be used to pur­chase shares at mar­ket value – at three times book value cur­rently in the S&P – whereas each $1 of re­tained earn­ings gets rein­vested at book value.

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