Jonathan Dash is the founder of Dash Investments.. As CIO, he is responsible for managing the company’s investment and making asset allocation decisions.
Warren Buffett declared in a recent annual letter to shareholders that “bonds are not a recent place.” Buffett wasn’t a fan of bonds as an investment, but he specifically cited the possibility of rising interest rates as a reason to avoid them so far. For me, it raises the question of whether bonds are a place for long-term investment strategies.
The main differences between stocks and bonds
The main difference between stocks and other asset classes is that stocks can synthesize their value, while assets such as bonds cannot. This can generally occur because a company holds a portion of its earnings to reinvest in a business for the benefit of its shareholders. Their bondholders simply receive interest payments and, ultimately, the face value of the bond at maturity. It’s not a subtle difference. This is an important advantage of equities over bonds, which many investors don’t really consider.
Bonds as an investment, what you see is what you get. Fixed interest is paid on a regular basis, but you cannot automatically reinvest any more bonds. In the case of real estate, you can earn rental income, but you cannot automatically reinvest. You can use rental income to improve your property, but the change in value can be minimal or gradual.
Benefits of compound interest in stocks
Considering the shares that make up the S & P 500, index companies, on average, pay shareholders 41% of their earnings as dividends. This does not happen with other asset classes. But for shareholders, dividends are only part of the compound interest return story. Many companies can automatically reinvest dividends to buy additional stock, but they must buy at market prices. This is currently just under three times the book value of the average S & P 500 company.
However, if a company reserves profits to reinvest in a business, $ 1 of the reserved profits will be reinvested at book value. Therefore, it is the reinvestment of retained earnings, not dividends, that contributes much more to shareholder value growth.
In addition, taking into account the return on equity held by the business reveals how a company can increase the value of its investment. For S & P 500 companies, the average rate of return on retained earnings or capital over the last 12 months has been around 14%, and the additional capital generated by that revenue also earns 14%. That is the magic of compound interest.
Where to look for compound interest
Of course, you can benefit from the compound interest simply by owning a stake in the S & P 500 Index Fund or an ETF. But why compromise on the average rate of return generated by 500 companies when you can own an individual company that consistently achieves a higher rate of return on capital? Instead of converting $ 1 of retained earnings to three times the book value, these companies can convert it to a significantly higher book value multiple.
Among the thousands of listed companies, there are several companies that have high gross margins, low capital intensity, and are able to generate recurring returns that result in sustainable capital returns each year. In addition, a company with a high rate of return on capital can generate higher profits at a lower cost without relying on physical assets that require more capital expenditures. This allows us to focus on developing intangible assets such as innovation, patents, brand building and distribution channels, creating a more durable competitive advantage and solidifying our market position. ..
It ’s the “moat” that Warren Buffett often talks about., “Find an economical castle protected by an unbreakable moat.. “ In Buffett’s world, the larger the moat, the more impervious a company is to competitive infringement of market share. As a result, these companies tend to perform well regardless of economic conditions. This allows them to continually increase their profits and gradually increase their shareholder value over time.
As Warren Buffetts says, it may not be a good time to form a bond. However, for many investors, fixed income is an important source of portfolio diversification and provides ballast when the stock market is sold. It’s between you and your investment adviser. For investors with a long-term outlook, nothing can provide the compound interest effect of carefully selected, high-quality equities.
The information provided here is not investment, tax, or financial advice. You should consult a qualified professional for advice on specific situations.
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