Albert Einstein was pretty good at doing sums. He called compound interest ‘the eighth wonder of the world’, which is quite an accolade from the man who gave us special relativity theory.
By holding onto investments for a long period and reinvesting our annual income, we can generate some surprising returns. A nice rule of thumb is that it takes seven years to double your money by compounding it at 10 per cent a year. And this compounding effect means that it only takes a further four years to increase your original stake by the same amount. That’s why 99 per cent of Warren Buffett’s wealth was earned after he turned 50 – as big numbers continue to compound they turn into huge numbers! Think of a small snowball rolling down a hill and turning into a giant boulder by the time it reaches the bottom.
When compounding returns in equities we aren’t looking just at reinvesting our dividends, though they can be a very important part of the equation. It also means identifying companies that can reinvest their profits into the business over a long period of time at attractive rates of return. If we can find stocks capable of that without paying too much for them, then we are on our way to becoming mini-Buffetts.
Patience is a virtue
Because despite being labelled as a ‘value’ investor, Buffett is in fact an immensely gifted growth stock investor. He has famously said his fortune is down to paying ‘fair prices for wonderful companies’, rather than ‘wonderful prices for fair companies’. In other words, quality is more important than price. His fortune is also down to the exercise of patience. Bucketloads of patience. After all, he enjoys reminding us that his preferred holding period for an investment is ‘forever’.
Simple but hard
Yet despite intellects like Einstein and Buffett reminding us that investing in great companies and holding them for very long periods is the way to get rich, we steadfastly refuse to take their advice! It’s very simple advice, but somehow hard to carry out. That’s because there are so many emotional and psychological factors stacked up against us. Patience is often in very short supply with investors, especially in our era of instant information and online trading. It’s so easy to feel well informed and to place an order. Being active makes us feel in control, we can take profits in a winner and feel good about ourselves.
But doing nothing really is an option – and when we take a long-term view it’s often the best option by far.
Let me give you a very painful example.
Back in 2004 I bought £10,000 worth of ASOS (AIM: ASC) shares at 24p. Today they stand an incredible 22,900 per cent higher at £55. ASOS is a great example of what happens when a wonderful company reinvests at high compound growth rates over a dozen or more years. That original £10,000 is today worth £2.3 million. The only problem is that I sold my shares within a couple of years for about £25,000. This was easily my most expensive mistake in thirty five years of investing!
Why on earth did I sell? I didn’t need the cash and whatever share I bought with the proceeds will have produced a fraction of ASOS’s return. From memory I was a bit worried about the outlook for consumer spending, or some other temporary factor, and was tempted to book a nice profit. Big mistake.
I knew the ASOS story was an exciting one, but I clearly didn’t have the vision to realise it would become a £4 billion company in a decade. However I shouldn’t have needed such foresight to keep me in the shares. All I had to do was recognise ASOS as a really good story and to confirm that management were executing the strategy – therefore no reason to do anything but sit tight. That simple insight, plus a lot of patience over the following years, would have seen me right.
Back then I was managing money professionally, which made me even less patient. The pressure of monthly and quarterly performance statistics can force you into activity – either looking to protect the returns you have, or to go chasing after them when you’re underperforming.
But private investors have the luxury of answering only to themselves (and their spouses!) and don’t need to measure themselves against artificial time periods. This means we can afford the necessary patience to sit through some dull periods. The key is to resist the temptation of trading to alleviate the boredom!
Quality + Time = Wealth
Of course great companies don’t grow on trees and many of our selections we believe to be great companies might only have a strong three or four years before having their returns eroded by competition or changes in the marketplace. So this isn’t a manifesto for permanent inertia. But where we do own really strong companies that are continuing to deliver, hang on for dear life and resist the sirens urging you to sell. As ASOS shows, wonderful small caps are out there and if we’re patient, they grow into large caps while making their investors rich.