The power of compound growth

Steve Clayton - Fund Manager

25 November 2016

Mighty Oaks - Why Compounding Matters

In the HL Select UK Shares Fund we like shares capable of compounding, steadily increasing their earnings over the long term. It’s a mighty oaks from little acorns thing. Something that starts off small, buts adds a bit more each year soon enough ends up pretty chunky in its own right. The stock market has been a great example.

£1,000 invested in UK shares 30 years ago would have grown to over £4,600 today. However, if dividends that companies have paid over the years were reinvested it would be worth £13,815. This demonstrates the powerful effect compounding can have, and companies can also benefit from the same effect. The next 30 years will be different, of course, so this isn’t a guide to future performance.

Generate the cash, reinvest, grow the business

But it’s not just the compounding effect of adding back the dividends that we’re interested in. Our research focuses on the cash generation of companies and the rates of return they achieve. We do this, because if a company can generate a lot of cash, then it should have plenty of funds to reinvest back into growing the business, as well as paying a dividend back to its shareholders.

The higher the rate of return the company makes on the cash it reinvests, the faster the business can grow. Hopefully, our focus on the strength of cash flow and the return on reinvested cash will lead us to some fabulous compounders. Consistency of growth is vital; if a company is strong enough to prosper even in the tougher times, it is far better placed to keep the compounding maths on track.

Fortune favours the strong

That's why we place such emphasis on financial strength. We know that when things get tricky, it is always the companies with large debts that are most likely to get blown off course. So we avoid stocks where debts look high and focus on trying to find reliable compounders that can add value over the long run.

Our search for businesses capable of strong compound growth will inevitably steer us toward some areas of the market more than others. We expect to spend little time looking at commodity stocks; mines and oil fields require huge capital investment, offer little growth once completed and produce output where the price is set by the market, not the maker.

Tread carefully when looking for compounders

There is more chance of finding interesting companies with strong growth potential in areas like technology, but here the key is to find growth backed up by underlying quality and durability, for technology can change rapidly. Consumer goods sectors can be fertile hunting ground for compounders, if the brands are strong. But even here, one has to be careful; Mulberry shares for example have soared and crashed in recent years as its products moved in and out of fashion.

We’ll tell investors what we buy and why

Our style is designed to limit risk by focusing on quality and financial strength in the shares we pick, although we cannot mitigate it entirely. We’re looking forward to telling our investors about the stocks we’ve bought for the HL Select UK Shares Fund after we’ve launched and built the positions. It will be an eclectic mix, ranging from the Small Cap to the FTSE. But everything we choose will be businesses that we believe are capable of compounding out far into the future.

What is HL Select UK Shares?

HL Select UK Shares is a completely new Hargreaves Lansdown Fund. Offering access to a portfolio of exceptional UK shares, chosen and managed by our experts in the convenience of a single fund, with a new level of transparency and insight.

More about HL Select UK Shares

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