Today we will briefly talk about what the term Compound Investing stands for, so that together with my first article on compound interest we will have a framework for the coming content. First of all I would like to think that I have coined the term Compound Investing myself as various searches on Google and Youtube have only come up with websites or videos that either talk about investing or compound interest, but not their combination in one single investment strategy. However I am not sure if that is really the case and provided you have heard it somewhere else please leave a comment correcting me on that. What I do know for sure is that I did not come up with the content of the strategy myself, but that it is a synthesis of what I have read about and learnt over the past years.
At first let us talk about the goal of Compound Investing and the time horizon over which the strategy unfolds its power. The goal is finding companies to invest in that are able to deliver superior returns to the investor by compounding their earnings within the company. Basically this means they are using the exponential nature of compound interest to their advantage by adding their earnings back to the equity base so that given the same return on equity their earnings in the following period will be greater than before. This process makes a huge difference that will also show in the price of the company’s stock, but as we have seen in my previous article, the magic of compound interest needs time to work best. The biggest growth happens in the later phases. That is why we will look at a time horizon of around ten years. If possible we will hold the company even longer (given they still fulfill our requirements) and in some cases it might be necessary to sell after a shorter period of time.
The three Steps
Compound Investing consists of three separate steps. At first there will be a quantitative and qualitative analysis of a prospective investment. These steps will determine if a company meets our requirements. If that is the case the third step will be a projection of future earnings. The first step, the quantitative analysis, also acts as a filter, because if a company doesn’t fulfill our requirements in this section we will not look any further into it. This also allows us to quickly sort out most of the companies and therefore save a tremendous amount of time that we can then use to thoroughly research the companies that have a high likelihood of being a good investment. During this first step, the focal point will be looking at what the company earns and finding out if they have the ability to compound their earnings over long periods of time and at high rates of return. After that, in the qualitative analysis, we will take our time to really understand and get familiar with the company’s business model. At this point it will be important to determine if the company has a competitive advantage and some measures to shield themselves against possible future competition (i.e. a strong brand). Based on the results from these two steps we will be able to determine if we want to buy the company’s stock. In the last step we will estimate a price at which the stock becomes interesting to us. In order to do that we will be projecting the future earnings for the next ten years.
This was meant to be an overview about Compound Investing. The exact process will be shown over the course of the following articles. I hope you enjoyed reading. See you soon!