28 September 2017

Introduction

There is some debate as to whether Albert Einstein actually said the following words: "Compound interest is the eighth wonder of the world. He, who understands it, earns it ... he, who doesn't ... pays it."

Based on this statement, we would like to shed light on the effect of compounding and its importance for long-term investments. As the aim of every investment portfolio is to meet the goals of the investors, compounding plays an important role in the process of creating and managing investment portfolios. One cornerstone of our investment philosophy at LAPIS Asset Management Ltd is to take advantage of the positive effect of compounding.

This document serves the purposes to explaining the effect of compounding as well as to describing how LAPIS Asset Management Ltd adopts this principle in its investment solutions for institutional and private clients.

To show the incomprehensible effect of compounding, let us start with the following question: What is the thickness of a 0.099mm-thick-paper if you fold it 103 times?

According to Nikola Slavkovic's YouTube channel the thickness of the paper will be larger than the observable universe (93 billion light-years)! Of course, this is just a thought experiment as the record in paper folding is currently at twelve times. This folding record achieved by Britney Gallivan is surprising but also understandable. As the thickness of the folded paper grows exponentially (i.e. each time you fold it the size doubles) more and more energy is required to make the fold. Paper folded several times, will become as hard as a steel beam and then quickly even thicker.

In the paper-folding example, available energy is the critical success factor. When it comes to investing, the critical success factor is time. An investor needs to select the best shares and allow them to grow over time. The longer the time horizon, the bigger the effect of compounding. Hence, what counts over the long run is average return and not volatility of returns.

Warren Buffet described the effect of long-term investments and compounding using the following example. If King Francis had invested USD 20,000 in 1516 in an investment yielding 6 percent per annum, rather than purchasing the portrait of Mona Lisa, his investment would have a value of about USD 1 quadrillion today!

The formula to calculate the future value of an investment (including interest on interest) is as follows:

FV=PV•(1+r)n

Notation:

FV = Future Value

PV = Present Value (Principal)

r = Annual Return

n = Number of Years

Hence, the future value of an investment of USD 100,000 in equities over a period of 10 years with a return of 8 percent per annum can be calculated as follows:

FV=USD 100,000•(1.08)10=USD 215,892

To demonstrate the relevance of dividend payments, we can apply the same formula. Under the assumption of a dividend yield of 4 percent, the future value of the investment after 10 years (only dividend yield, no capital gains) can be calculated as follows:

FV=USD 100,000•(1.04)10=USD 148,024

Without compounding the total amount of dividends after 10 years would only be USD 40,000 (10 x USD 4,000). Including the effect of compounding (reinvested dividends), the amount increases to USD 48,024, which is about 20% higher than USD 40,000.

The chart below underpins the importance of dividend yields as part of the total return:

The effect of compounding (reinvested dividends) amplifies with an increasing investment horizon. The chart below compares the performance of the S&P 500 Price Index (without dividends) to the S&P 500 Total Return Index (including reinvested dividends) over a period of 28 years:

Obviously, it is valuable to invest in equities that produce a steady income in the form of dividends, especially if the dividend income is reinvested into similar dividend yielding equities every year. Due to the positive effect of compounding, the longer the dividends are reinvested, the more they contribute to the performance and future growth.

While in the chart above, the differences around the turn of the millennium appear small, they have grown ever larger since the financial crisis in 2008. The price index generated an average return of 7.5 percent per year for the entire period under review. By contrast, the average return of the performance index was 9.7 percent per year over the same time horizon. A more extreme picture is revealed by looking at the period since 2000. The average return of the performance index was 4.5 percent per year, while the price index only posted an average return of 2.5 percent per year.

LAPIS Asset Management Ltd has taken the principles learned and concluded that if we are able to invest our clients wealth in a way which takes advantage of the principles of compounding, then over time we could increase the amount of the invested assets exponentially! For that reason, we created and successfully launched our LAPIS Top 25 Dividend Yield Fund at the beginning of 2017.

To see the comparative effect of investing in equities offering high dividend yields, we can take a chart, which is included in the next insights paper. This chart clearly demonstrates the effect of investing in companies that pay a continuously increasing dividend and the compounded result (over time) that this has on the growth of the investment.

In this scenario, the dividends are reinvested which allows them to participate in the future development of the share price. This has a corresponding impact on the overall performance of the investment. The remarkable historic performance of our LAPIS Top25 Dividend Yield Fund confirms that the effect of compounding (reinvested dividends) together with a long-term investment horizon leads to an outstanding performance.

The purpose of this paper is to explain some basic concepts and principles of finance. It is not to be understood as a buy recommendation of any investment product. If you have any questions or need more information please do not hesitate to get in touch with us.

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