Compounding Outsourced


“I’m a value investor, which says I want to buy 50-cent dollars, but given my firm’s predilection for serving the needs of taxable investors, I also want that dollar to tax-efficiently compound in value over long periods of time. That means the businesses must have great capacity to reinvest, which is not all that common...I want our money to work for us – in essence, I am passing through to our portfolio-company management much of my obligation to reinvest.”     –Tom Russo Albert Einstein called The Rule of 72 the “Ninth Wonder of the World” and supposedly said this rule (not E = MC^2) was the greatest mathematical discovery of all time .

Compounding is an integral part of investing, no matter how you define investing, your strategy or approach – similar to how Islam, Christianity, and Judaism all share the commonality of monotheism.

Compounding can be achieved by the portfolio manager / investor when making investments, which then (hopefully) appreciates in value, and the repetition of this cycle through the reinvestment of principal and gains. However, this process is limited by time, resources, availability of new ideas to reinvest capital, etc.

Operating business achieve compounding by reinvesting past earnings back into the same business (or perhaps new business lines). In this respect, the operating business has an advantage over the financial investor, who must constantly search for new opportunities.

Tom Russo of Gardner Russo & Gardner, quoted above in a November 2011 edition of Value Investor Insight (many thanks to Rafael Astruc of Garrison Securities for tipping PM Jar on this), highlights an important and useful shortcut for portfolio managers – why not outsource part of the burden of compounding to the operating businesses in one’s portfolio? (Price dependent, of course.)

For example, Warren Buffett figured this out early and part of Berkshire’s success lies in the entity’s ability to constantly reinvest and compound capital, through a wide variety and extensive network of investment securities and operating companies – a broadened horizon of opportunities versus what is commonly available to the usual financial investor.

Last but not least, outsourced compounding via operating business reinvestment also minimizes tax leakage. Not too shabby: less work AND less taxes.