The Magic of Compounding

Hello everyone!

Whether we've connected via LinkedIn, or through our shared interest in our stock research platform, Numfin.com, or perhaps we're simply old friends, I'm pleased to welcome you all to my newsletter, "Think and Invest."

For those who are less familiar with me, allow me to reintroduce myself: I'm Eugene Alexeev. With more than a decade of experience in the IT industry, I've gathered a wealth of knowledge and insights about launching and managing a business, investing, and finance at large. I'm confident that this daily newsletter will prove invaluable for those of you aiming for financial independence and those seeking to make smarter decisions about their finances and investments.

#1 rule (and second too) in investing

In today's issue, we'll be discussing the golden rule of investing: never lose money. It might interest you to know that this is also the second rule.

Why is this so critical? The reason is rather straightforward - compounding. You cannot leverage its full power if you lose part or all of your capital. Here's a brief illustration of how compounding works:

Consider an initial investment of $100,000, earning a fixed interest rate of 10% annually over a 25-year period. In this scenario, no additional money is added, and all interest is collected annually. At this rate, you'd be receiving a fixed dividend of $10,000 each year, accumulating to $250,000 over 25 years. So, your total balance at the end of this period would be $350,000.

Now, let's change one factor: instead of collecting the dividends, you reinvest them, allowing for compound interest. Here's a quick breakdown:

Year | Deposit | Dividend

--- | --- | ---

1 | $100,000 | $10,000

2 | $110,000 | $11,000

...

25 | $984,973 | $98,497

TOTAL | $1,083,471

By simply reinvesting your dividends, your final balance skyrockets to over $1,000,000 - a vast difference from the original $350,000. Three variables shape this outcome: your initial investment, the annual interest rate, and the investment period. Any change in these factors can dramatically impact your final result.

Here's how the legendary Warren Buffett explains this rule - link

This serves as a reminder of the importance of protecting your capital and thoroughly evaluating your investment and business opportunities.

More advance stuff

For those ready to delve a bit deeper, let's discuss how this rule can be applied in business and stock investing. For instance, reinvesting profits back into a business can bolster its capitalization and enhance its competitive edge. Buffett may not have a concrete formula for determining stock prices, but his approach deeply incorporates the concept of compounding when assessing a business.

Here's how Buffett might implicitly use the principle of compounding:

Earnings Retention and Reinvestment: Buffett favors businesses that retain a significant portion of their earnings (instead of paying them out as dividends) and reinvest them effectively, thus leading to compound growth.

Return on Equity (ROE): He focuses on high ROE, indicating how well a company generates additional earnings from reinvested earnings.

Sustainable Competitive Advantage: Businesses with a competitive edge or 'moat' that enables them to earn high returns on capital over extended periods are attractive to Buffett. This aspect is crucial for compounding, ensuring that reinvested capital continues to generate high returns.

Estimating Intrinsic Value: Much like the Discounted Cash Flow (DCF) analysis, Buffett estimates a company's intrinsic value by projecting its future cash flows, focusing on the company's ability to generate and compound these cash flows. He then discounts these cash flows to their present value using a suitable discount rate.

Margin of Safety: After estimating the intrinsic value, Buffett seeks to purchase the stock at a price significantly lower than its intrinsic value. This margin of safety buffers against uncertainties and risks associated with future projections and assumptions.

Long-Term Perspective: Buffett is known for his long-term investment approach, allowing compound interest to work its magic over time.

The bottom line

In essence, the principle of compounding is not just a tool for personal investing, but also a fundamental aspect of business growth and stock investing. It's a powerful concept that can lead to exponential growth if understood and used correctly.

Until next time, remember: guard your capital, evaluate your opportunities carefully, and let the power of compounding work for you.