Compounding: The Eighth Wonder of the World
Timing of Reinvestment Can Have a Material Impact on Long Term Returns
Many people attribute Albert Einstein with this quote: “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.” Effectively and efficiently compounding your capital as an investor can materially influence your long-term net returns as I plan to show you today.
Even the late Charlie Munger conveyed rather concisely the importance of compounding.
“The first rule of compounding: Never interrupt it unnecessarily.”
- Charlie Munger
Today, I will illustrate the effects of compounding for private investors and contrast this with other investments such as public equities through a lens of reinvestment opportunity, which may carry more influence on returns than you realize.
Once you are finished reading this, you will understand:
the effects of reinvestment and compounding in your own private (or public) investments;
the effects of cash drag on returns;
why taxable investors must pay attention to the larger effects of distributions and exits.
You can find the chart illustrating the effects of reinvestment at the end of this article — the scale of the impact may surprise you.
Reinvestment Defined
Reinvestment involves the investment of funds within the same entity from which it was generated. A CEO may repurchase shares, invest in capex or acquire another company. A GP may reinvest a property’s cash flow into renovations to boost rents, or recycle capital during a fund’s investment period to increase return.
The manager of the entity (i.e., CEO, GP, etc) may obtain the funds for reinvestment from any internal source but the implications from each will vary. Two common sources to us include:
Proceeds from sale of an asset, and
Operating cash flow (or retained earnings)
As you can imagine, certain types of reinvestment are more efficient than others. Below are three different scenarios using some of our common investment types: (1) REITs, (2) Real Estate Private Equity (REPE) funds, and (3) growth stocks. I will start with what I consider the least efficient.
1. REIT the Landlord vs. Chipotle the Tenant
A REIT pays nearly all its distributable income (e.g., essentially #2 above) out to investors per government regulations in order to maintain its tax advantaged status. This leaves only option #1 above for any meaningful reinvestment opportunity before the REIT must tap capital markets for external financing. Unfortunately, the sale of assets is generally less efficient than operating cash flow. As you will see, the only true reinvestment to compound capital here is operating cash flow.