Everyone knows intuitively that the earlier you start investing the better. We've all seen the "magic" examples of a young 20-year old compounding a small amount of funds over a 40- or 50-year investing lifetime. Those are great illustrations. However, they can be a bit abstract.
With that in mind, I continue to look at what results you can pile up during even intermediate time frames. Let's take a look at IBM (NYSE:IBM) - a company that has taken a ton of flak for slow growth during a good part of this decade - to get a better feel for what I mean.
The last time IBM had a "frozen" dividend was from the third quarter of 1993 through the first quarter of 1996. Thereafter, the company has been increasing its dividend by a solid and consistent rate. There were two stock splits leading up to the dot.com bubble - one in 1997 and another in 1999.
I'm not going to "cherry pick" this example - let's start with a particularly poor time to start thinking about an investment in IBM. At the end of 1999, shares of IBM were trading around $108. The company was earning $3.70 or so per share and paying out $0.47 per share in cash dividends. Those numbers equate to a starting yield of 0.44% and a valuation of 29 times earnings.
Given that the yield is now north of 3% and the earnings multiple is down to 11 or 12 times profits, you can guess that an investment from that point of 1999 has not performed particularly well (something like a 3% or 4% annual rate). And this single piece of information is the type of thing that the media likes to fixate on: IBM from 1999 to today was a subpar investment.
Yet that type of thinking ignores reality (and indeed, ignores the goals of many investors). We don't just invest once and sit on our hands; instead we invest regularly and over a great deal of time. For this example, I wanted to focus on how seemingly small investments can grow to sizable cash flows.
Imagine you could get your hands on say 10 shares of IBM per year. Usually you'd think about a set amount to invest each year, but we're changing the example up a bit.
In that first year this would require an investment of ~$1,080 and you'd go on to receive $4.70 in annual income. I think this is one of the reasons many people don't get excited about investing. Not only do you have to learn about all of this new stuff, but also the results in the first year or five aren't exactly life changing.
One thousand dollars a year is about $20 a week. We know what just this small amount can do over time, but it's a hard sell to begin, especially in this IBM example: "You can take that $20 and go have a fun afternoon or invest it and receive 9 cents in passive income this year." The tangible benefit just isn't that high to start.
Yet, if you hang in there, things begin to compound. In the second year, another 10-share investment would only require $850 or so. You'd be up to 20 shares, and receive $10.20 in passive income; still not life changing, but an improvement nonetheless.
After years three, four and five, you'd be up to 50 shares now paying out $31.50 in annual income. The per share dividend increased by 34%, but most of your gains were from buying more shares.
After 10 years you'd be up to 100 shares even. Your nominal cost at this point would be $9,500 and you'd be generating $190 in annual dividend income. This still may not be life changing, but it's starting to cover a small expense each month.
After 15 years, you'd be up to 150 shares, now paying out $550 in annual income. That's starting to look like something that changes your perception. At this point, your nominal cost has been about $3.30 per day and your investment is paying out $1.50 per day. Every day that you hold that's another $1.50 coming your way.
And today, after 18 separate annual investments - with a cost of about $25 per week - you'd be on the verge of collecting a cool $1,000 in passive income. This isn't retirement, but I find it to be an important intermediate step. Small investments along the way turned $0 in passive income to $1,000 in under two decades.
Moreover, those shares would carry an underlying earnings claim of about $2,500, with a market value of about $29,000.
And naturally things could be vastly improved by adding a few tweaks or additional effort. For instance, if the above scenario we're talking about collecting $5,000 or so in dividends along the way and spending them as you choose. If you instead elected to reinvest, your passive income could be $1,200 per year with a market value closer to $35,000.
The annualized return here isn't spectacular (~6%), but that's sort of the point. Even in a circumstance where you begin investing at a terrible time and run into a security that has been stagnating (or declining) for the last couple of years, you still could have generated a nice cash flow stream from consistently investing.
Further, you're not limited to only IBM or just those 10 shares. Instead you could take the same logic and apply it to a basic index fund or a group of excellent businesses. If instead of ~$1,000 we start talking about $10,000 invested each year, the passive income starts to multiply by 10 as well.
The takeaway is that investing tends to compound on itself. It's easy to get discouraged seeing that first $2 or $10 or even $40 dividend check rolls in. Yet, when you start compounding things by double-digits (highly probable given "organic" dividend growth, reinvestment and "fresh" capital), the results become more and more impressive in quick order.
Disclosure: I am/we are long IBM.
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.