A Return to Old Fashioned Compound Growth

The raison d’être of investment or wealth management is to maintain, or hopefully improve, one’s standard of living, i.e. to earn a real return on the investment amount. This sounds easy enough if one considers that the S&P 500 Index (and its predecessors prior to 1957) delivered a nominal return of 8.7% per annum from January 1871 to June 2008. With an average inflation rate of 2.2% per annum over the period, this meant a real return of 6.5% per annum.

Yes, I can hear many readers arguing that much better returns can be generated by “playing” the market cycles, especially given the fact that the S&P 500 has made no headway since 1998. Ah, the art of market timing! Perhaps, but keep in mind that very few people have succeeded in consistently outperforming the market over any extended period of time, especially once costs and taxes are factored in.

Let’s go back to the total nominal return of 8.7% per annum and analyze its components. We already know that 2.2% per annum came from inflation. Real capital growth (i.e. price movements net of inflation) added another 1.8% per annum. Where did the rest of the return come from? Wait for it, dividends - yes, boring dividends, slavishly reinvested year after year, contributed 4.7% per annum. This represents more than half the total return over time!

Have a look at the following chart:

The numbers are summarized below in table format.

Source: Plexus Asset Management (based on data from Prof Robert Shiller and I-Net Bridge)

In an environment characterized by increasingly shorter investment horizons, the concept of compounding sounds so passé, but it remains one of the most important principles governing investment. The time has perhaps come to look beyond the short-term noise and focus on good old stock picking, and specifically those companies with strong balance sheets that will be growing their dividends over time with a reasonable degree of certainty. After all, compound growth has not without reason been referred to as the eighth wonder of the world.

Comments

[Henry Buttal:]

Great article and supporting chart!

I agree...in pruning and rebalancing my portfolio, I am beginning to give higher value to a)dividends and b)dividend stability or growth than in the go-go days of yore.

Jul 01 02:00 PM

[Archman Inv...:]

I like this article. I like it because if you are a realist and can accept the future of Wall Street and investing, you can hunt and find great high yielding dividend stocks and own them now.

As per the usual norm in this country, it typically takes average Americans many years before they understand and then invest in a trend.

This is a rare opportunity to be involved in the future of long term investing.

Jul 02 02:46 PM

[user396040:]

I agree with the basic position of the author. The only thing that is a bit troubling is that a lot of people are starting to say this and I have always been somewhat of a contrarian. But I don't think that the prices of the blue chip stocks have gone up in response to the developing consensus in this regard, so I think that the thesis is basically sound.

Jul 02 03:35 PM

[Archman Inv...:]

User396040:

I would not worry to much about the fact that many people are talking about dividend investing. Our country is still pretty much a "Mad Money, please give me a winning lotto ticket, so I don't have to work anymore" country.
As I mentioned in my post, I think a person can position themselves in some great long term high yielding assets right now and make a lot of money going forward, long before the main stream really gets involved.

Jul 02 04:12 PM

[Kristjan Ve...:]

Return? I don't think it has never really gone away, it's just that the talking heads on financial news channels usually don't talk about long-term investing and compound growth. What doesn't make it on front page is not worth reading for a lot of people. But the fact is that it's always been there. Warren Buffet and the likes of him have held the flag of compound investing high enough to for everybody to see. Some have decided to follow his path. It's no secret that his books (or rather, books about him and his investing style), along with Benjamin Graham's still sell good. So I would not call it a return per se, but a return to the public consciousness, perhaps. I just hope it stays there long enough to have a permanent influence on the way the layman looks at the markets.

Jul 02 07:00 PM

[donzelion:]

While I am striving to put a long-term dividend growth portfolio into place, I'm wary of long-term risks from currency fluctuations or business models that are not clearly sustainable.

Many US dividend payers are unlikely to replicate successful models in the US abroad. Will the same consumer staples command premiums outside America and Europe in emerging markets where value conscious consumers trade brand names for savings? If so, then expect dividends to be sustainable.

Some industries earn their money from depleting assets, others from assets they can renew through their own actions...dividend paying tech firms (INTC and MSFT) may be better positioned than dividend paying oil/pharms.

Finally, the currency of the dividend itself should also be taken into account, particularly in regions rife with information imbalances (hence, I prefer DEM to other emerging markets ETFs).

Jul 03 05:10 AM

[John Galt:]

I don't believe there is a real "get rich quick" scheme out there, but if you are smart, patient, and young enough you can get rich slow with the power of compound interest.

Some more points about dividends.
- You can't fake them. Enron, Worldcom, Citbank and others can lie and try and manipulate their balance sheet, but it's a lot harder to lie about paying out a dividend.
-Don't just fall into a yield trap, make sure a company has a strong history of paying out dividends and actually increasing them.
- Make sure the company makes excess cash to actually pay out a dividend ( I know this is very simple but often forgotten), some companies will actually borrow money to pay the divy, how long can that last?

Donzelion -
When you invest in a company they do have the ability to raise prices in an inflationary enviornment. You might not beat or even be neutral in the government's inflation game as price increases could lag inflation in other areas, but you are certainly better off than holding cash. You are right though, Forex matters.

Jul 03 09:05 AM

[Chuck Carne...:]

Good article. Add the fact that S&P 500 eps growth rates accelerate after a recession because they are coming off of a low base and long term looks even better. Since payout ratio's tend to persist,faster eps growth leads to faster dividend growth as well.

I especially like the point regarding compounding, it takes time for this principle to work. Finally,valuation is important,and after a rather extended period of excess, stocks are reasonably priced once again.Good old stock picking is a good old idea right now. The free enterprise system will solve the economic problems ,it doesn't need the governments assistance,in my opinion.

Jul 04 10:02 AM

[E Nuff Sed:]

I totally get the power of dividends and compounding.

The reason why market timing does not work consistently is that the market does not follow gaussian (normal) distribution where disruptive events (up or down) are distributed over 3 sigmas and it is possible to model risk. It is now clear the it follows some kind of "power" distribution where say 90% of the spikes (disruptive up or down movements) are concentrated in say 10% of the time. The other 90% of the time the market is "random walking."

I believe the market is efficient and rational in the long run but in the short run it is manic-depressive.

I also believe it is possible to pick stocks and put your money to work in low risk reliable businesses which have high "return on equity". As Buffet has repeatedly pointed out - invest in companies which either re-invests its retained earnings at a return higher than its cost of capital or the company can return its capital to its investors.

What hurt investors in the tendency to "punt" - i.e., the constant quest to find the next genetech, apple, P&G or J&J. Most business go the way of Nortel, Enron and Montgomery Ward.

Of course capital allocation is absolutely key. While there may be a bear market in real estates there may be a bull in gold or bonds.

Jul 04 10:16 AM