The compounding power of going back to basics

Bruno Paulson

Morgan Stanley IM

In a world of daily financial chatter, it’s easy to get distracted from what drives the core of long-term returns; the power of compounding.

Growing $10,000 at an annualised rate of 8% a year would become $14,693 in five years, $21,589 in 10 years, and be worth more than four times as much in 20 years at $46,610 – a strong real appreciation of capital1. This compounding is fundamental to successful long-term investing, as long as you have the patience for it.

While the rate of compounding matters, the key lies in the ability to keep doing it. This is why we look to hold companies with high and sustainable returns on operating capital, since these companies exhibit the best compounding characteristics, in our experience.

In this wire I expound on the following:

  • Compounding and the ability to keep compounding is fundamental to successful long-term investing.
  • Certain key attributes are essential to achieve high and sustainable returns, including pricing power, hard-to-replicate intangible assets, long-term growth opportunities and capable management.
  • To safeguard compounding, fundamental analysis and engagement is crucial in order to understand any material risks and opportunities ESG issues may pose.

The things that matter

There are a few key attributes essential to achieve these high and sustainable returns: pricing power, hard-to-replicate intangible assets with high barriers to entry, and a leading presence in industries and categories with strong, long-term opportunities for growth. Also vital is a management team able to allocate capital effectively, to drive this growth and navigate the ever disruptive sea of change – you can’t compound if you’re not growing.

Pricing power matters for two reasons. First, it may protect you in both inflationary and deflationary conditions; you can pass on input cost inflation to the end consumer if your costs of goods rise, and you can uphold your pricing if these commodity-driven costs decline. Second, it means you could have better control over your gross profit margin – you can keep it stable.

A high gross margin (our global portfolios average 50% compared with the broader market of 26%) is the signal of pricing power. 
By definition, if you are not able to offset inflationary or deflationary conditions, you would not be able to maintain a high gross margin.

High gross margins help support sustainable growth. As an example, take a leading French beauty company. Its gross margin is 70% and its operating margin is 20%. This means 50% of its sales are operating costs (70% minus 20%). 

These operating costs are the engine room of innovation, sales, marketing and research and development. It means the company can, and does, spend 30% of its revenues on marketing alone, supporting and building its world-leading brands. The average company simply can’t compete, given the average company has a gross margin of 26%. 

If the average company spent 30% of its revenues on marketing, it would make an immediate loss. So high gross margins do two things: they help support high barriers to entry, and they underpin stable profits.

Hard-to-replicate intangible assets are powerful because they enjoy high barriers to entry and durability. Favourite consumer brands, from sports shoes to shampoo, typically have many, many years of investment crafting and positioning the brand, tuning it to changing tastes, keeping it relevant, keeping it desirable, and ensuring ready access in-store and online. 

Leading global technology software franchises have built such strong platforms – entwined in the heart of all we do at work and at home – that switching costs deter us from moving to an alternative. Why take the risk? Why invite the cost? And who is there to switch to anyway? 

As long as the provider supplies us with what works and they innovate to keep relevant, then there’s no switch to be had. Sure, disruptors come along, especially in technology, but typically the disruption helps lift the boats for the most powerful franchises. New digital payment players use the incumbent rails of the established debit and credit card companies – new players benefit from the existing infrastructure. Games, app and social media developers write for the incumbent desktop and mobile operating system suppliers; they need them.

We invest in companies with the ability to grow sustainably over the long term, where this growth is rooted in sound fundamentals at justified prices. We don’t engage in the risk of very high expectations for growth, regardless of price, or in exciting businesses on the cusp of discovery with a distant prospect of turning a profit, or the promise of a new way. 

We want to ensure the industries and categories our companies are in, or are developing, have a genuine road map for long-term growth. 

For example, attractive opportunities in digital payments, enterprise-wide networks, beauty and personal care, medical technology, financial and business software, health and hygiene as well as environmental solutions are all reflected in our portfolio – all backed by world-leading, well-established franchises.

And the things that can’t be ignored

Further safeguarding the potential for compounding, throughout our investment process, we consider the material risks and opportunities that ESG issues may pose to the sustainability of returns. Ignoring, for example, the impact of climate change and the need to decarbonise could impair a company’s competitive advantage and reputation all at once. 

Failing to develop brand equity that speaks to consumers wanting, for example, natural provenance, recyclable packaging, lower carbon footprints or informative labelling, is failing to safeguard the franchise. Not investing in an appropriate framework to confront cybersecurity risk could significantly compromise operations and profits. Not optimising a talented corporate culture by neglecting to foster diversity and inclusion signals further risks to the franchise. 

We bring these conversations to the table through engagement with the company rather than forming an opinion using only third-party scores or data points.

Where can it go wrong? 

The returns will not remain high and sustainable if the management teams in control of allocating shareholder capital do so unwisely. Highly profitable businesses that require limited capital – because they’re driven by their intangible assets – produce significant levels of free cash flow and have powerful balance sheets to deploy. 

This financial capacity could be a risk in the wrong hands. In essence, a lot of money can be spent very quickly at the wrong price for the wrong assets for the wrong reasons. Management might be trying to mask slowing organic growth, they might be accelerating short-term earnings growth (if they’re incentivised to do so), or they might have captured the right asset, but at a very high cost.

How can we control this? 

Through fundamental analysis and engagement. We look to understand if their incentive structure risks short-term behaviour. 

When we can, we meet with management to understand how they think about the allocation of capital (where, how and why) and how they’ve allocated it in the past, and come to our own conclusion as to the risk or opportunity. Being long-term holders with very low portfolio turnover facilitates this ongoing dialogue.

In a world where daily financial chatter looks to dot plots, talking about tapering, non-farm payrolls, the crypto helter-skelter, the stimulus tap, hydrogen or lithium-ion, transitory or persistent inflation, commercial space travel, bad news is good news, good news is bad news, it’s easy to get distracted from what drives the core of long-term returns; the power of compounding. 

That’s what we relentlessly focus on owning and checking and checking again, and then again: that we have a portfolio of those rare companies with the ability to compound at a high and sustainable return on their operating capital.


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Footnote

1The example shown is for illustrative purposes only and does not represent actual market returns. The data has been chosen to convey the concept of compounding. Results are hypothetical.


Bruno Paulson
Portfolio Manager
Morgan Stanley IM

Bruno is a portfolio manager for Morgan Stanley Investment Management’s London-based International Equity team. Prior to that, Bruno worked for Sanford Bernstein, where he was a Senior Analyst covering the financial sector for eight years.

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