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The eighth wonder of the world - September 2015

16 November 2017

Russell Harrop, Head of International Equities

The list of Albert Einstein's achievements is long and varied and included a fifty year struggle to disprove quantum physics. (Un?)fortunately his quest was in vain and it does seem that we are all products of semi-randomness and probabilities. I heartily recommend Walter Isaacson's biography of Albert Einstein nonetheless.

Einstein was not known for his pronouncements on financial markets, yet he's widely credited with referring to compounding as the 'eighth wonder of the world' which is a pretty punchy thing to say given competition from the likes of Macchu Picchu, Angkor Wat and the Angel of the North. I'm a huge believer in the power of compounding though and so should everyone else be.

I prefer to give compounding the tag line 'small numbers become very big if given enough time to grow'. Any investor looking to increase their wealth should take advantage of both compounding and Old Father Time.

Which is exactly what we do at Vestra when searching for international stocks for clients to own. We call it Quality At a Reasonable Price (QARP). We want to invest your hard-earned assets in high return businesses where barriers to entry mean the returns achieved to date have a reasonable chance of continuing at a similar rate for the next 5-10 years. The 'reasonable price' part of the equation comes from the myopic nature of many investors who consistently under-estimate longer term growth when valuing stocks.

Past performance may only be a guide to future performance, but in terms of companies it can give you a possible insight into the future. The simple maths of compounding is striking. If a company is able to grow its actual profits at 7% every year then (all other things being equal) after five years profits will be up 40%, ten years 100%, fifteen years 175% and after twenty years profits will have almost quadrupled. So if one buys stock A and it grows profits at 7% per annum, after 20 years the company's value should have quadrupled or septupled if profits grow 10% per annum, all of course assuming no change in how the stock market values it.

To think of it another way, there's the rule of 72 that states that if one divides the number 72 by the annual growth rate it tells you how long it takes one to double your money. So at 7% per annum it takes ten years and at 10% only seven years. Long term sustainable growth is very attractive.

When you're reading about the latest 'hot tips' in the financial press remember two things. Firstly, hot things can easily burn you or turn cold quickly; and secondly, that over the long term, the tortoise always beats the hare.