Blue-Chip Investing And The Back End Of Compounding

Includes: CL, GE, JNJ, K, KO, NSRGY, PG, XOM
by: Tim McAleenan Jr.

One thing to keep in mind, when thinking about the nature of investment compounding over a long period of time, is that most of the compounding occurs at the back end of an investment. It's straightforward enough. If you buy $1,000 worth of Kellogg (NYSE:K) stock and see it grow 10%, we are only talking about $100 in added wealth. But, if your Kellogg position grows to $100,000 over the course of twenty-five years, a year of 10% growth will add $10,000 to your wealth. Although the 10% sounds the same, it actually adds $9,900 more wealth in Year 25 than it did in Year 1.

It's a trap that I have to guard against regularly, because there is a strong tendency for me to think about most things in life in linear terms-it's easy for me to forget that Exxon's dividends in Year 25 could be more than the total dividends generated by an Exxon investment in Years 1, 2, 3, 4, 5, 6, 7, and 8 combined.

When performing your own calculations, it's really important to remember that the multiplier isn't linear.

Look at something like Johnson & Johnson, my largest personal investment.

A $10,000 investment in Johnson & Johnson stock in November 2003 would be worth $23,680 today.

Yet, the same investment in November 1993 would be worth $130,587 today.

And if we go real old-school and back it up to 1983, the same investment would be worth $639,520 now.

That non-linear multiply is why people have attributed supernatural powers to the compounding process, using words like "magical" or in Einstein's language, going as far as to call it the 8th wonder of the world. Over a ten-year stretch, a Johnson & Johnson (NYSE:JNJ) shareholder saw his wealth increase by a factor of 2.36. But over a twenty-year stretch, the wealth increases by a 13.05. And if we back it up to thirty years, each dollar got multiplied by a factor of almost 64, turning every dollar invested in Johnson & Johnson in 1983 into $63.95 today.

That's why I wrote this article in the middle of October talking about why some investments that you hold need to be untouchable for the course of your life. Over most ten and fifteen year stretch, a moderate-sized investment will turn into a nice chunk of change-it's cool doubling, tripling, or even sextupling your money. But still, it's unlikely that a $10,000 investment is going to truly transform your life over a ten to fifteen year compounding period.

Rather, it's during the fifteen years after that the life-changing wealth creation starts to occur. That's when the $10,000 investment turns into over half-a-million dollars. That's why I think it is important to get the five pillars of dividend investing in place-say, $10,000 investments in Exxon Mobil (NYSE:XOM), Colgate-Palmolive (NYSE:CL), Procter & Gamble (NYSE:PG), Coca-Cola (NYSE:KO), and Nestle (OTCPK:NSRGY)-in place, ideally before the age of 40-45 so that they can have the time to do the necessary heavy lifting before it comes time to lean on them for financial independence.

I think that an honest understanding of the compounding process can explain why it can be doable, but also explains why it may not be appealing to everyone. When you buy $1,000 worth of Exxon Mobil, the initial dividend will not be all that impressive-it will probably be somewhere around $25 to $28 in the first year. And even in the first four of five years, it won't necessarily look like a whole lot is happening (the past 4-5 years are an exception, because you had dividend reinvestment at low prices and surging equity markets that have given buy-and-hold investors nice capital appreciation and instant observance of how nice it is to reinvest at low prices before a boom-in fact, seeing what a General Electric (NYSE:GE) dividend reinvested at $15 per share looks like perhaps may make you more sympathetic to the argument of desiring lower prices for your holdings).

But in general, the compounding process during the first fifteen or so years is not what is going to change your life with dividend stocks. If you need to increase your wealth by a factor of 10 within a ten year or so stretch, then it is unlikely that many traditional blue-chip stocks are going to satisfy your expectations. However, if you are willing to put in the "second set of fifteen years", that is when the compounding effects of dividend investing start to change your life because a relentless stream of profits starts to fold over and feed into itself in a way that increases your wealth in a non-linear way. With most investments, years 26-30 will do more than the first 25 years combined. If you are looking to dividend stocks to change your life, then it is going to be investment years sixteen through thirty that will change your life, rather than the first fifteen.

Disclosure: I am long GE, XOM, PG, JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.