The great Albert Einstein, allegedly, once said “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Conceptually, I have been aware of compounding for many years but in investing terms, I don’t think the penny truly dropped until recently. You see, I always thought that compounding in investing was primarily about reinvesting dividends and it always seemed a terribly slow process to me but that’s because I didn’t really understand it from a portfolio management perspective.

Regular readers will know that my investing attention has shifted over the past couple of years, focusing far less on individual stock research/selection and far more on portfolio management, increasing my number of holdings above 30, compared to previous times when I used to run with a focused portfolio of between 1 (yes, I have twice bet the farm on a single holding in years gone by) and 12 holdings. Perhaps what has recently dawned on me has been obvious to others for many years. Perhaps it is because of the larger number of holdings that this “truth” has become more obvious to me. Or perhaps my awareness has been heightened by the impact of rapid compounding during this latest bull run.

My conclusion is that compounding shows up in a portfolio in several different ways:

Bottom Up Compounding
This is the phrase I have coined for where dividends and special dividends are reinvested in the same or different holding. It is the traditional version of compound investment. Some people do this automatically but I prefer to reinvest dividends based on “best buys” at the time funds become available.

Internal Compounding
Certain shares produce an excellent rate of internal return. For example, Bioventix (BVXP) produces a return on capital of 62.4% based on its last results. Most private investors would be delighted with such a return on their portfolios but BVXP produce this level of return consistently, year-after-year. While sentiment and therefore, share prices are unpredictable over short periods, I would argue that value will nearly always come out eventually. A company that is producing a high return on capital cannot be ignored for long as other valuation metrics will soon make it look ridiculously cheap.

Another quality metric that is important to me is low or preferably no debt (this becomes almost impossible with larger cap stocks but it is a key factor for me with small/midcap holdings). I reason that debt can be a significant drag on earnings and high indebted companies often run into difficulties. I accept that operational gearing can sometimes be put to good use but equally, I really struggle to see why some companies pay a dividend when they should be paying down debt. Anyway, my simplistic view is that I’m not skilful enough to sort the wheat from the chaff through forensic accounting and therefore, I like low/no debt and strong free cashflow.

My core point is that owning shares in high quality companies over the long-term is likely deliver steady growth and therefore, share price appreciation. In effect, these companies should compound my investment by growing the business and all things being equal, this will show up not only in the share price but also via a rising dividend.

Top Down Compounding
This is the phrase I have coined for selling or top slicing winners (I also try to cut losers quickly but that’s damage limitation rather than compounding) and reinvesting those proceeds across the existing portfolio and/or adding new holdings. It is the rapidity of this process that has become so obvious to me over the past 9 months. We are in a bull market and I’m grateful to have had my fair share of winners. Rather than agonising over when is the right time to sell, I’ve simply adopted a top slicing methodology – identifying a core £ amount for each holding and whenever I decide to rebalance the portfolio, I top slice the holding down to the relevant core £ amount. Because markets have been rising, I have been rebalancing quite frequently this year but when the market slows I expect the rebalancing to maybe normalise at twice a year. I have been able to observe how impactful this is, especially if the profits are cascaded into other shares that perform well (either via capital appreciation and/or dividends).

While I don’t expect this current bull run to last much longer, I do believe that most years, there will be share price appreciation for some of the companies in my portfolio (I don’t necessarily know in advance which ones will do well of course), especially if I maintain a quality focus. Now that I have seen the impact of top down compounding, I will be much more relaxed in slower markets, knowing that there will nearly always be some top down compounding going on and that it will be having a meaningful impact on my portfolio.

Cash is King
This is a phrase one sees used in the investment world when markets start crashing and everyone runs for the safety of cash. I did explore the possibility of having a handful of cash proxies in my portfolio to move money into when things got hairy but in truth, I’m not confident that such holdings will necessarily perform as expected when the time comes. Therefore, I am simply addressing this via diversification (more on that shortly).

Anyway, the phrase Cash is King is one that I have coined to describe how my investments are performing. A great holding will be contributing to all three dimensions of compounding; it will pay a (rising) dividend, produce a high ROCE which shows through in rising earnings and the share price will have risen sufficiently for me to top slice some profits. Some holdings will just be contributing to one or maybe two dimensions. But the key thing is this, if a share is not contributing to the compound effect of my portfolio, I don’t want to keep it in the portfolio.

So be warned constituents of my portfolio, you are being judged primarily on how much cash you are contributing to the portfolio and how likely that cashflow is to continue into the foreseeable future.

Billionaire investor Warren Buffett famously stated that “diversification is protection against ignorance. It makes little sense if you know what you are doing.”

I would be deluding myself if I thought I could pick only winners in my portfolio. I would also likely be deluding myself if I thought I was a better stock picker than you – or you, or you! What special investing super power do I have that you don’t? I know investors who are better at studying accounts than I am. I know investors who research more deeply than I do. I know investors who can spot value better than I can.

Having accepted that I am averagely competent (or perhaps slightly above average now that I have Stockopedia to help me), the obvious conclusion is that I should protect myself against poor stock selection by diversifying. My observation over the past nine months is that diversification doesn’t really hurt returns at all when supported by effective compounding.

This brings me to my final point and that is, how does one diversify? At the basic level, diversification is about putting together a set of uncorrelated assets, paying particular attention to sectors and industries. I could never really find the right balance until Stockopedia introduced their risk ratings a few months ago. Now, I can diversify by volatility and StockRank style as well as company size, sector, industry and importantly for me, investing strategy. It really feels like I am making progress towards building a portfolio for all seasons which will provide compound returns in a variety of market conditions. As ever, history will be my judge on that front.

One thing is for sure, I am thoroughly enjoying the challenge of portfolio management and discovering the magic of compounded returns.

Happy investing folks!
Simon (Twitter: @BrilliantLeader)

Disclosure – at the time of writing I own shares in Bioventix (BVXP) mentioned in this article.