Albert Einstein famously stated: “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t, pays it.” We tend to agree – compounding returns over time can lead to some great results. So how does this play out in the world of small caps?
Firstly let’s consider a business generating $10 million in cash flow per year. This business has a choice: use the cash generated to buy a new piece of equipment to expand production, or pay the cash out as dividends to investors.
Buying $10 million of equipment means the business can, at a 20% return, generate $2 million more cash flow in the following year. In turn, this $12 million can again be used to expand production. This time, spending $12 million will generate $2.4 million in extra cash flow: the next year the business can expect to generate $14.4 million in cash flow. And so on, if such opportunities continue to be available to the business. The magic of compounding is at work here.
Many of the small caps we look at have plenty of opportunities to deploy capital to generate high rates of return. However that does not last forever and eventually the returns a business can earn on retained capital reduces. Growth naturally declines and the business now produces excess cash. At that point companies are often encouraged to return more of their cash to shareholders.
If the company does decide to reward shareholders with a dividend, shareholders will have their own choice to make. Many companies offer a dividend reinvestment plan to allow the investor to return that cash back to the company and allow the funds to compound once again. This can be a popular choice for investors and is often offered at a discount to the prevailing price.
If the investors takes the cash dividend there is another choice to make. Reinvest the money into another compounding machine or spend the cash. Reinvesting into another growing compounding machine starts the process all over again. If the cash is spent, instead of reinvested, the wonderful process of compounding grinds to a halt.
All these years later compounding remains a wonder.
The information contained in this article or video is general in nature and does not consider your personal financial situation. The information is not a recommendation or offer to buy securities. You are advised to seek professional financial advice prior to making any investment decisions. The views expressed in this video may change at any time, such is the nature of the investment markets.