The Reinvestment Imperative

Investors face daily decisions about how to invest their capital — Infinite reinvestment options abound, with no clear answer — Reinvestment decisions ultimately drive portfolio returns.

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THE REINVESTMENT IMPERATIVE (Reinvestment Part I)

Capital is not free. All investors seek to be rewarded for the use of their capital, by receiving either interest, dividends, or value appreciation (i.e., a rising stock or bond price). As investors are paid for their capital, every dollar earned must be either spent or invested. For capital to compound, returns must be reinvested.

Investors are faced, daily, with the decision about how to reinvest their capital. This decision determines the future earnings an investor will receive. Reinvestment decisions, or in other words, an investor’s capital allocation decisions, determine their success or failure in the markets.

Buying A Portfolio Every Day

Theoretically, an investor can “reinvest” their entire capital base every day. Everything, even illiquid alternatives, can be sold, at a price. This capital can then be reinvested elsewhere.

Through this lens, an investor is faced with an infinite number of investment choices every second of every day. Taxes, fees, trading costs, and other frictions typically conspire to encourage investors to buy and hold, setting aside the notion of buying a portfolio every day.

This theoretical flexibility highlights the challenges associated with reinvesting, namely the impossible challenge presented by infinite investment choice.

Reinvestment Challenges

Even if an investor does not turn over their portfolio holdings, they will still receive distributions that must be reinvested. Investors are faced with the task of putting their money back to work on an ongoing basis.

Dividends are plentiful in good times when businesses have excess cash. Illiquid alternative assets often only return capital in bull markets (as we see today, in less robust markets alternative distributions slow). Buyouts accelerate in bull markets, driving turnover even for investors willing to hold.

Timing is never perfect. When reinvestment proceeds are available, great reinvestment choices are often lacking. Assets sitting in cash are a drag on returns, but reinvesting at unattractive prices puts capital at risk. When capital arrives, investors face difficult reinvestment problems. 

Conversely, when capital is scarce, investment opportunities abound. This phenomenon follows the cyclical nature of the markets themselves, as this capital is the resource for the market’s supply/demand-driven pricing mechanism.

Levels of Reinvestment

For individuals not dedicated exclusively to the capital markets, it is reasonable to outsource reinvestment. Most investors do not have the time, interest, or desire to make continual reinvestment decisions.

Wealth managers or institutional allocators handle the ongoing reinvestment of income, dividends, and other investable proceeds for their clients, in addition to constructing diversified portfolios across asset classes.

The next level of reinvestment occurs via active managers selected to invest on behalf of allocators. Active managers, in the public or private markets, focusing on equity or fixed income, construct portfolios and reinvest continually for clients.

Finally, every business is tasked with reinvesting retained earnings on behalf of equity holders. This reinvestment of retained earnings is the distinguishing feature of equity investment, and the driver behind equity investments outperforming bonds in the long run. Bond holders are not entitled to the future benefits created by businesses reinvesting capital to drive growth, ultimately allowing for larger dividends or capital gains for equity holders.

Discovering Reinvestment

Astonishingly, this fact was not widely recognized until the early 1900s. Edgar Lawrence Smith, in his seminal work “Common Stocks As Long Term Investments,” highlighted the long-term outperformance of equities over bonds. John Maynard Keynes, an early reviewer of the book, highlighted this essential insight, saying “I have kept until last what is perhaps Mr. Smith’s most important, and is certainly his most novel, point. Well-managed industrial companies do not, as a rule, distribute to shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest operating in favour of a sound industrial investment.”¹

In 1988, Warren Buffett emphasized this critical point, highlighting the importance of management’s reinvestment prowess. “The lack of skill that many CEOs have at capital allocation is no small matter: After ten years in the job, a CEO whose company retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all capital at work in the business.”²

The Cornerstone

From individual investors, to their advisors, allocators, and active managers, and ultimately to management teams running businesses, reinvestment decisions drive return.  Reinvestment is the cornerstone of investment strategy and is a requirement no investor can avoid.

¹ “Common Stocks As Long Term Investments” - Edgar Lawrence Smith, 1924

² 1987 Berkshire Hathaway Shareholder Letter