"All I can do is remind them of the truth of Albert Einstein’s alleged response when he was asked, “What do you, Mr. Einstein, consider to be man’s greatest invention?” He didn't reply the wheel or the lever. He is reported to have said, “Compound interest.”"

There's nothing so much fun as playing with a compound interest calculator and seeing the crazy numbers that get spit out for one's investment lifetime. Money invested at 15% for 50 years multiplies a thousand fold. The difficultly, of course, is achieving 15% - no mean feat at all. I like to think of there being two general 'routes' to compounding: Closing discounts and intrinsic value growth.

Closing Discounts

Value investing disciples love to trot out the lines about buying £1 for 50p. Obviously, that's kind of a good deal. The problem with it comes down to what is that £1 made up of? How do you know it's worth £1? Sometimes you can find stocks which have liquid assets that have market values of X and the security is selling at less than X. This is a case where the return is largely going to be driven by the closure of discount - you don't expect X to grow necessarily over time but you reckon that the gain possible justifies the time you'd have to wait in the investment to realise your return. This approach works very well and is essentially the true 'Graham and Dodd' approach to investment and one that worked nicely for Buffett during the early years of his partnership.

The downside to this approach is that it requires the constant finding of good reinvestment opportunities - once the discount is closed, where do you go from here? You have to sell and find another discount to close. This is why this style of investing is commonly known as the 'cigar butt' approach; you're getting one last puff but that's it. Whilst you're buying £1 for 50p that £1 isn't going to grow in to £2, or £10, or £100.

Intrinsic Value Growth 

The alternative approach is to find opportunities where intrinsic value can be compounded internally by the management of the company over a very long time period. These kind of situations are exceptionally rare…

Unlock the rest of this article with a 14 day trial

Already have an account?
Login here