The First $100,000 And The Power Of Compounding

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Includes: BRK.B, CL, JNJ, KO, PEP, PG, T
by: Tim McAleenan Jr.

About a decade or so ago, Charlie Munger was sitting at a table during the annual meeting for shareholders of Berkshire Hathaway (NYSE:BRK.B) when a lady started talking about how she was having difficulty getting over the hump on her path to wealth creation, and that was when Mr. Munger uttered his famous quote, “The first $100,000 is a b****.” Once you cross that threshold, according to Munger, doors begin to open up fairly quickly and the snowball that we call compounding starts to work its magic in a meaningful way.

Here’s a quote from Janet Lowe, from her work about Munger called Damn Right!: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger, that illustrates the point. On page 242, Ms. Lowe writes:

Munger has said that accumulating the first $100,000 from a standing start, with no seed money, is the most difficult part of building wealth. Making the first million was the next big hurdle. To do that a person must consistently underspend his income. Getting wealthy, he explains, is like rolling a snowball. It helps to start on top of a long hill—start early and try to roll that snowball for a very long time. It helps to live a long life.

I think this insight is important because it helps us calibrate our expectations to our goals, and get an idea of the point at which long-term investing starts to reap significant rewards. If someone bought $100,000 worth of AT&T stock, that would 3,448 shares which would throw off $5,930 in annual income. At that point, your financial standing starts to meaningful improve even if your own life is on autopilot and you stop further investing altogether because of the tailwinds of reinvestment combined with dividend growth.

I included a chart to show how compounding itself would improve your life over a five-year period with AT&T stock. Let’s say someone owns those 3,448 shares that I mentioned in the example above, which generates $5,930 in annual income. Let’s assume that, for the next five years, our investor reinvests his dividends and AT&T raises the dividend by 5% annually, which seems slightly on the side of a conservative/realistic scenario. In this example, I assumed that the price of AT&T stock rose by $1 annually over the next five years, and the chart shows the dividend being paid out and compounded annually (as opposed to quarterly, like it is in real life) so as to avoid the clutter of a long-winded chart, but do keep in mind that quarterly reinvestment does turbo-charge returns even more.

In this example, the 3,448 shares of AT&T turned into 4,367 shares by the end of year five due to dividend reinvestment and modest 5% dividend growth. Over a five year stretch, the annual dividend income grew from $5,930 to $9,170 which represents a 54% growth in annual income over a five-year period. That’s not bad at all—within five years of reinvesting, you’d be earning a 9.17% yield relative to your initial investment, which would presumable grow in time. Many business owners are happy to earn $12,000 on every $100,000 invested, and to think—they have to work and operate their companies to generate that kind of profit—in the case of AT&T stock, you just had to make an initial purchase and sit on your keister while five years of dividend investment got you halfway there.

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But of course, the $100,000 question — how to get to that magical six-figure investment range in the first place. Let’s say you're 30 years old, and decide to max out your Roth IRA—that’s going to mean that you’re going to need $417 per month in disposable income to put towards investment. And you’re going to have to do it every year, for 10-15 years, depending on your returns along the way—this is the excruciatingly difficult part, and requires constant discipline for a decades-long stretch that not a lot of people have.

But after that, things get fun. Let’s say our investor loads up on blue-chips stocks with a record of 8-10% dividend growth in his Roth IRA—companies like Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), Colgate-Palmolive (NYSE:CL), or PepsiCo (NYSE:PEP)—that means that, very roughly speaking, his annual dividend income will double every six years without him contributing another penny (the actual figure will vary depending on actual dividend growth rates and reinvestment levels). Let’s say that when our investor turns 45, the $75,000 worth of contributions has grown an account to $100,000 in value, and the portfolio yields 3%, or $3,000 in annual income. If he stops investing at that point, his portfolio will generate roughly $6,000 annually when he turns 51, $12,000 annually when he turns 57, and $24,000 annually when he turns 63. If he did this all in a Roth IRA, based on the current tax laws, he wouldn’t have to pay a penny in taxes on the distributions.

As Warren Buffett once said, “It’s better to be approximately right than precisely wrong.” It’s difficult to guess specifically how quickly our investor’s dividends will double—there is a meaningful difference between whether AT&T raises its dividend by 7% annually for the next ten years or 4% annually. Likewise, there is a difference between reinvesting at $28 per share or $33 per share over long stretches of time. But just because we can’t pinpoint it does not mean that we should ignore planning altogether.

Getting to that $100,000 mark may not be simple, but the path is clear—you can either significantly underspend your income and make $20,000-$30,000 annual investments and get there in a hurry, or you can be methodical and disciplined in making $4,000-$5,000 investments over a 15-20 year stretch. Once you get there, the compounding monster starts to take a lot of the heavy lifting off your shoulders. The path is there for the taking.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.