Many of you have asked me whether there is compounding in Stocks or in Mutual Funds.
To understand that, we should first know how compounding works in a business.
When we know that, we will automatically know the answer for this questions.
This episode is to explain that. Hi. My name is Vijay Mohan. You are watching - Investment Insights.
Let's say that we are starting a tea shop business by investing Rs. 10 Lakhs.
The revenue from that team shop in the first year is 10 Lakhs.
This is same as the revenue or total income that we see in Income statements.
That means, revenue is the total sales that happened in the tea shop in that specific year.
To run this tea shop, we have spent 8 Lakhs as expenses.
Buying milk, tea, paying salary for the tea master, paying rent for the place etc. are the total expenses 8 lakhs.
In that case, what is the profit that we made that year? 10 - 8 = 2 lakhs.
We start saving this 2 lakhs for investing the amount again in the same tea shop business.
How much do we need to start another tea shop? We need another 10 lakhs.
But we have only 2 lakhs so far.
If we are saving 2 lakhs every year, how long does it take to save 10 lakhs? 5 years.
So, we would have saved 10 lakhs in 5 years. We open a new tea shop on 6th year.
"Hello, you have forgotten the inflation. In 5 years, wouldn't the cost of opening a new tea shop rise?" - you might wonder.
That is correct. But to understand the compounding, let us assume that there is no inflation in this situation.
This new tea shop is giving a profit of 2 lakhs every year as well.
Then in that case, what can we expect as the profit for the 6th year?
2 lakhs profit per shop for a total of 4 Lakhs profit.
How long would it have taken to save the next 10 lakhs to open the third tea shop?
If the profit is 4 lakhs per year, we would have saved 10 lakhs in 2.5 years.
It took 5 years (60 months) to open the second shop.
To open the third shop, it took only half of the first - 2.5 years (30 months).
Now we are getting 2 lakhs profit from 3 shops. How long would it take to save the 10 lakhs for 4th shop?
In 20 months. 5th shop - in 15 months. 6th shop in 12 months.
At this rate, we would have opened the 10th shop in 7 months.
It took 5 years to open the second shop. But only 7 months to open the 10th. This is "Power of Compounding".
That is, reinvesting the profits from a business into the same business to grow the profits exponentially is compounding.
The business started with one tea shop, but by reinvesting the profits in the same business it has grown to 11 shops in 15 years.
In the same 15 years, the revenue is increasing from 10 lakhs to 1 crore 10 lakhs.
Profit is growing from 2 lakhs to 22 lakhs.
What do we learn from here? Compounding works in business as well.
What would that mean? If that business is trading as a stock in stock market, the compounding will work in that stock as well.
That would mean, mutual funds formed based on stocks has compounding as well.
Does this compounding work in all business? Yes.
But it is not necessary for the compounding to be positive for all businesses. It can be negative as well.
Our example tea shop is a wonderful business that gives 2 lakhs profit every year.
If we are seeing 2 lakhs profit from a revenue of 10 lakhs, that means our profit margin is 20%.
Would all tea shops be profitable like that? Not necessary.
Let's say that we have 10 tea shops. For a revenue of 10 lakhs, our expenses are 12 lakhs in one shop.
That means, 2 lakhs i.e 20% is loss for us.
If that is the case in all 10 shops, we have a loss of 20 lakhs per year.
Then we would have to sell 2 shops to make up for that 20 lakhs loss. This is negative growth.
If this continues every year, it compounds negatively and we will eventually loss everything.
That is why we should be investing only in profitable business.
The future growth of the business will be as much as the profit margin. Positive Compounding.
So what are all the characteristics do we see in a successful business?
Let's take our tea shop business as example. To run that business successfully, what does it need?
It has to be in the middle of crowded places. If it is in a corner of a junction, even better.
We need a talented tea master. We need quality milk supplier.
We need good management that keeps the employees happy and gets the most out of them.
These are all examples of dependencies that we have to run a great business.
Even if one of these does not turn the way we expect, it will hurt the business.
It is applicable not just for the tea shop, but for all businesses, including the ones those are trading in the stock market.
That is why if we are investing in individual stocks, we should know their business well. Also understand the risks very well.
Most importantly, we should know whether the company is growing positively. Only then, we can take advantage of positive compounding.
If we are not capable of identifying a positively growing business like that, that is the reason we have index fund.
As the index only has the top companies in it, it would have automatically pushed the negative growth companies out of it.
Index will be having companies that are overall growing positively.
That is why, we are calling the index fund investing as no brainer approach.
We should note another thing in this compounding. Like we saw in the tea shop business example, we cannot expect the same 20% profit every year.
That profit could be 10% one year. 30% another year. Because of a virus outbreak, it could be in negative as well.
Then, how can we measure this compounding? We use CAGR - Compound Annual Growth Rate formula for that purpose.
What this formula basically doing is, starting value is this, ending value is this, invested period is this...
Every year our business has grown at different rate. But given the final value, what would have been the fixed interest rate for this growth? That is CAGR.
In our tea shop business example, we invested 10 lakhs and started one shop.
But if it has grown to 10 shops in 10 years of value 1 Crore, then its CAGR is 26%.
That means its growth rate is 26% every year on average.
10 lakhs has grown to 1 Crore in 10 years. If Fixed Deposit has given 26% interest, 10 lakhs would have grown to 1 Crore in that as well.
Does that mean CAGR is same as compound interest?
Compound interest would have grown at the same rate every year.
The interest we earn from Fixed deposit is compound interest as they are giving the same interest every year and it grows further.
It would have grown smoothly at a constant rate in fixed deposit case. But in a business, that growth would be different every year like 10%, 25%, 35% etc.
End result is same. But in fixed deposit, that growth would have been smoother. In a business, it will be a rough ride with different growth rates every year.
That is one difference. Another difference is, we know at what rate money is going to grow in a Fixed Deposit when we invest.
But in a business, we will know the growth rate only after the fact.
Because of that uncertainty, we are seeing business as risky and Fixed Deposit as Risk Free.
If business has compounding, then why many experts are saying that there is no compounding in Stocks and Mutual Funds?
They are all like Nakeeran who found fault in the meaning of the poem, but not on the word.
For them compounding means "Compound Interest".
As we saw before, other than in money laundering, no business has compound interest. But there is definitely compounding.
Compounding is different from Compound interest. Those experts are actually implying that there is no compound interest in stocks or mutual funds.
But what is important for us? Yeah, food is the most important one. But I am asking from investment perspective.
Our invested money should grow. At what rate is it growing? That is what is important to us.
It is a waste of time to do over analysis on whether it has compounding or not.
If anyone argues with you saying that there is no compounding in stocks and mutual funds...
Just say, "A rose can be called as rose. Or can be called like you are calling it. Or can be called like he is calling it." and walk away.
We will soon meet again in another episode. Thank You.