Time is every investor's best friend. Time allows for compounding, which is the most powerful tool available to any investor.
Over the long term, the power of compounding can turn a small initial investment into a considerable fortune.
To be able to compound successfully over the long term, however, you need to make sensible investment decisions. This is where I think value investing comes into its own.
Value investing and compounding
There are three main styles of investing: growth investing, momentum investing and value investing. All have their advantages and drawbacks, and all require different skill sets to be effectively implemented.
Growth investing is built upon the idea of finding high-growth companies that you can buy and ride out the growth. Momentum investing is based entirely on price action, while value investing is based on valuation and fundamental analysis.
I have found value investing naturally lends itself to compounding because it is a long-term strategy.
What do I mean by this? Well, value stocks are typically established businesses that have fallen on hard times. You already have the evidence the company can grow and manage itself successfully, which means a lot of the hard work is already done for you.
With growth investing, there is always going to be an element of risk that the company cannot meet its growth objectives and, because more often than not these companies trade at high valuations, the market tends to punish them severely if they miss their targets.
You can make a lot of money with both growth and momentum investing, but you need to always be on the lookout for new ideas. Companies usually go through a growth phase and then a consolidation phase. The majority of the money is made in the growth phase. This is also the phase where there is the most uncertainty. It is quite easy to find momentum stocks, but it is hard to decide when to sell as the market usually declines before you can get out.
More is not better
The more ideas you have to find to replace the stocks in your portfolio, the higher the chances are you will stumble across a dud.
At the recent 2019 Daily Journal (DJCO, Financial) annual meeting, Charlie Munger (Trades, Portfolio) tried to explain why Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) and Warren Buffett (Trades, Portfolio) have been so successful over the years. Being a value investor has given the Oracle of Omaha an edge, but so has his desire to act infrequently and only when the best opportunities present themselves.
"We've done better than average and now there's a question why has that happened," Munger said. "Well, I have an answer that is pretty simple. We tried to do less."
He went on to say there are very few investment ideas out there, but many investment managers "act as if they've got an endless supply of wonderful opportunities," giving them similar characteristics to "racetrack tout."
Tying it altogether
This argument ties it all together. If you are always looking for new ideas, the chances of making a mistake are higher, which will have a significant impact on your ability to compound.
On the other hand, if you buy a high-quality stock trading at a low valuation, there is significant potential for this business to grow and compound over the years. Because it is trading at a low valuation, the risks of capital loss are low.
That's why I believe value investing and compounding go hand in hand. I'm not saying it is impossible to compound effectively with growth and momentum investing, as there are always going to be blurred lines between the three different styles, but by following a value strategy, I think it is going to be much easier to compound over the long term.
Disclosure: The author owns no shares of Berkshire Hathaway.
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