Understanding Compounding: Berkshire's Not-So-Hidden Dividend Contrarian Secret

Briar profile picture
Briar
308 Followers

Alice Schroeder’s biography of Warren Buffett, The Snowball, takes its title from a quote of his, “Life is like a snowball: the trick is finding wet snow and a long hill.”

Warren Buffett has long been lauded as the best investor of our day. And Berkshire Hathaway (NYSE:BRK.A, BRK.B) has been envied for its superior long-term performance. Many reasons have been given for this record. One that has received perhaps less attention is the efficiency with which Berkshire has been able to compound.

To try to understand better how compounding manifests itself in investing, let’s start with a simple model: You have an account which holds a single position of $10,000 all of it in a bond bought at par paying 10% and maturing in 20 years.

The first question is, what is the return on the bond at maturity? Yield to Maturity (YTM) says 10%. But, now, assuming that nothing is withdrawn, what will be the return on the account at the end of 20 years? We don’t know. While YTM assumes the coupon was reinvested at a 10% return, we don’t know what actually happened. If the coupons simply accumulated in the account for 20 years the IRR would decline to about 5%. If, on the other hand, you withdrew the coupon each year, the IRR makes the same assumption as YTM, that what you withdrew compounded at the coupon rate. Hence, it would tell you that the account had compounded at 10%, even though there will be only $10,000 in the account at the end of 20 years, when Cinderella turns into a pumpkin.

This example helps us to get at the realities of compounding in the real world. How well the account performs depends crucially on the marginal, actual return on the coupons. In the

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Briar profile picture
308 Followers
I have been investing since the late '70s and was a Registered Investment Advisor from 1985 to 2016, when I retired.

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