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The Power of Compounding Returns with Time
Weekly updates on the innovation economy.
In this newsletter, we have charted a series of illustrations to visualize the power of compounding returns with time. With these illustrations, we hope that this knowledge allows you to visualize the following topics:
The relationship between CAGR (Compound Annual Growth Rate), MOIC (Multiple on Invested Capital), and time.
How generating higher returns enables individuals to enjoy their lifestyle through balance sheet expansion instead of a constant, recurring focus on saving.
The power of compounding returns and how seemingly trivial differences in returns can have non-trivial implications in building wealth.
The outcomes associated with managing investment losses
Benefits of investing in high-growth innovative companies
Before we get started, we would like to define 2 key terms:
CAGR stands for “compound annual growth rate”. CAGR is a method of displaying returns that are annualized over time, and CAGRs are displayed as percentages. Future dollar value = today’s dollar value * (1+CAGR) ^ (time in years). For example, a $1,000 initial investment with a 20% CAGR over 10 years would grow to $6,192.
MOIC stands for “multiple on invested capital”. For example, if a $1 million investment becomes $2.5 million, then this is a 2.5x MOIC. The MOIC metric is great for easily answering a common investor question, “How much was returned from my initial $X investment?”.
Notably, MOIC does not define a time period in its calculation formula, while CAGR calculations are influenced by the length of investing time periods. For example, turning $1 million into $2.5 million in 5 years or 20 years would have the same MOIC but a different CAGR.
Charts & Illustrations
In order to 10x an investment in a short amount of time, the required CAGR must be extraordinarily high. As an investing time horizon increases, a lower CAGR is needed to achieve a 10x MOIC. For example, while a 10x MOIC in 10 years implies a ~26% CAGR, a 10x MOIC in 40 years implies a ~6% CAGR.
Additionally, there is a relationship between seeking higher portfolio returns and the acceptance that high-growth investing can have periods of sour performance.
The next chart below displays the relationship between annual savings and CAGR in trying to achieve a 10x MOIC in 10 years.
3 insights from the above chart:
Higher returns allow individuals to enjoy a lifestyle, spend more, and save less.
In contrast, low returns lead to a necessity for higher savings (implying less consumption and spending) in order to achieve a desired future financial outcome.
If an individual desires to transform $100,000 into $1 million in 10 years with ongoing savings contributions, a higher CAGR leads to lower required annual savings. For example in this scenario, a 2% CAGR in a portfolio would lead to a required ~$80K per year in annual savings, while a 25% CAGR would lead to only a savings need of ~$2K per year (excluding taxes, fees, etc.).
The next chart below highlights the relationship between CAGR, MOIC, and investing time horizons.
3 insights from the above chart:
Positive compounding of returns is a beautiful thing. Higher positive CAGRs over longer investing time periods lead to higher MOICs. While the difference between a 5% CAGR and a 10% CAGR in 3 years might appear small in terms of MOIC, marginal improvements in investment returns over long investing time periods can lead to significantly higher wealth outcomes due to the benefits of compounding positive returns.
The distribution of outcomes becomes even more magnified at higher CAGRs. For example, a 25% CAGR over 10 years from an initial $100K investment would transform into an ending value near ~$931K, but a 5% CAGR over 10 years from an initial $100K investment would lead to an ending value of only near ~$163K.
A higher CAGR leads an investor to recognize a higher MOIC in fewer years, which is advantageous to the investor. For example: a 25% CAGR over 3 years has a higher MOIC compared to a 5% CAGR over 10 years.
Compounding positive returns lead to larger outcomes. For example, if you had a 25% CAGR, that implies a ~2x in 3 years, ~3x in 5 years, or a ~9x in 10 years. The delta between 10 years and 20 years from a MOIC perspective with a 25% CAGR is that the multiple on invested capital jumped by about nine times even though the time range only doubled from 10 years to 20 years.
3 insights from the above chart:
Based on your desired multiple on invested capital, you can work backwards to see your required rate of return to achieve your investment goal. For example, if you desire to double your initial value of your investment portfolio in 10 years without making deposits or withdrawals, then you need a ~7.2% compounded annualized rate of return, which has historically been the approximate after-tax long-term return of an S&P 500 index fund.
For a 5x MOIC in 10 years, you would need a ~17.5% CAGR.
For a 20x MOIC in 10 years, you would need a ~35% CAGR.
Of course, while the previous charts present an optimistic view about investing, investment losses can occur, and appropriate risk management of a portfolio is a common trait among many successful investors.
3 insights from the chart above:
After suffering from a numeric investment percentage loss, you need to recover more than your percentage loss number in order to break even.
To recover from a 10% loss, you need ~11.1% returns to break even.
To recover from a 50% loss, you need 100% returns to break even.
Investing in high-growth, high-margin companies can be lucrative.
All else equal, companies with higher revenue growth rates and higher margins should command higher EV/sales price multiples because they have greater ability to generate higher and growing cash flows.
In the long term, if investors evaluate a business as the present value based on discounted future cash flows, then having a higher revenue growth rate allows the company to increase future cash flows due to more future revenue, and higher margins allow the company to convert more of the revenue into cash flow. Hence, when companies both increase margins and increase revenue (especially when they outperform consensus estimates/expectations), this is a "double win" scenario.
The chart below highlights that on the median over the past 5 years, companies with higher revenue growth rates experienced higher stock price appreciation.
Additionally and as of June 13, 2021, there are only 19 companies in the S&P 500 Index that have experienced 25% revenue CAGRs or higher over the past 5 years.
We share the view that this performance alpha from growth investing in disruptive innovators will continue to occur, and COVID-19 has accelerated existing trends in digital adoption. Over the past 10 years, the S&P 500 Index has delivered above-average returns, and investors in funds indexed to the S&P 500 over the long term have been well rewarded. Nonetheless, a wide dispersion in the constituents of the S&P 500 is increasingly present, with a handful of growing technology companies leading the index and a group of financially engineered value traps negatively detracting from the overall index return.
Traditionally defined value investing that focuses on price multiples (such as price-to-earnings, price-to-book value, etc.) works well in a combination of a declining interest rate environment, high capacity of inorganic shareholder return programs (such as dividends, share repurchases, and M&A activity), high use of tangible assets, and when there is an emphasis on seeking value by buying assets at a discount to their present values of future cash flows. One cannot simply extrapolate these characteristics in the future when there are headwinds to the likelihood of the repetition of these characteristics (ie. it's tough for nominal interest rates to fall below 0 in America, there is increasing scrutiny on consumer M&A activity by Big Tech and share buybacks, intangible assets such as enterprise software is increasingly being deployed across a range of industries, and buying discounted assets is more difficult when buying at high price multiples).
At Drawing Capital, we believe that a significant source of future performance return in the coming decade will derive from investing in innovation and transformative technologies with reasonable entry valuations, high growth, and high margins.
Additionally, we have identified a number of key themes that will help drive transformative innovation over the coming decade. We believe that a range of key high-growth themes will generate positive compounding returns over the next several years ahead. Please feel free to reach out to Drawing Capital at firstname.lastname@example.org to learn more.
Overall, we are attracted to the creativity of new technologies and remain committed to seeking multi-period growth opportunities with a tech-focused lens that enables scalable growth. In this age of hypercapitalism and a continued low interest rate environment that is supported globally by central banks, investors are increasingly seeking positive inflation-adjusted returns with limited likelihood of permanent capital loss, and well-informed investors will often seek investments in high-growth transformative innovation in an effort to generate significant performance alpha in the coming decade.
We hope you enjoyed reading this newsletter. In summary, the topics discussed in this newsletter include:
The relationship between multiple on invested capital (MOIC) and annualized returns is good to understand, both from a knowledge perspective and also from an implementation perspective in matching your investment goals with your return targets. Higher annualized returns lead to higher MOIC. Longer time periods of positive compounding returns lead to higher MOIC.
The relationship between annual savings and CAGR can be helpful in understanding the difference between a person’s current financial situation and where the person aims to be financially in the future.
When an investment loss occurs, it is important to rationally understand the math behind the returns that are needed to break even and recoup the loss from an investment.
Leverage is your friend when used appropriately and prudently. Do not put your portfolio in such an overly financially leveraged position to such a degree that tiny movements in the prices of portfolio investments lead to catastrophic losses. As we’ve seen, these investments can take several years to recoup, if ever.
There is a select group of high-growth companies in the S&P 500. Over the past 5 years in the S&P 500 Index on the median, there is a positive relationship between higher revenue growth rates and higher stock price appreciation.
In conclusion, understanding multiple on invested capital (MOIC), compound annual growth rate (CAGR), historical outcomes, risk mitigation of losses, and the changing investing landscape and interest rate environment can help more investors get the odds of investing success in their favor.
This letter is not an offer to sell securities of any investment fund or a solicitation of offers to buy any such securities. An investment in any strategy, including the strategy described herein, involves a high degree of risk. Past performance of these strategies is not necessarily indicative of future results. There is the possibility of loss and all investment involves risk including the loss of principal.
Any projections, forecasts and estimates contained in this document are necessarily speculative in nature and are based upon certain assumptions. In addition, matters they describe are subject to known (and unknown) risks, uncertainties and other unpredictable factors, many of which are beyond Drawing Capital’s control. No representations or warranties are made as to the accuracy of such forward-looking statements. It can be expected that some or all of such forward-looking assumptions will not materialize or will vary significantly from actual results. Drawing Capital has no obligation to update, modify or amend this letter or to otherwise notify a reader thereof in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.
This letter may not be reproduced in whole or in part without the express consent of Drawing Capital Group, LLC (“Drawing Capital”). The information in this letter was prepared by Drawing Capital and is believed by the Drawing Capital to be reliable and has been obtained from sources believed to be reliable. Drawing Capital makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this letter constitute the current judgment of Drawing Capital and are subject to change without notice.