Hey folks! Put your Pokemon Go! down for few minutes. Seriously…stop! Everyone is completely obsessed with this game! There’s more to life than Pocket Monsters!
Let’s talk about Compounding for a few minutes.
One of the first things people learn about investing is the power of compounding to make your money grow. It’s a great way to get people excited about investing…mostly by using stories of massive compounding riches.
We’ve all heard the story about the penny doubling in value every day for 30 days. Or maybe the story you heard used grains of rice. Whatever the case, by the end of 30 days the compounding pennies (or rice) are worth $5,368,709.12…more pennies than I can fit in my pocket. That’s for damn sure.
Compounding seems like a great way to grow your wealth, right? These stories are meant to teach how compound interest works, and they all boil down to one thing — compound interest happens because ‘the interest’ earns more interest when reinvested.
The concept is simple, but (as always) reality is a little more complicated. Believe it or not, compounding dollars continuously at high rates is actually a really hard thing to do.
So, how does compounding actually happen with stock investments, and how can we keep compounding happening longer?
Stock Prices And Compounding
First, let’s get a few things straightened out — Compounding is the ability to earn returns on the returns. That’s it. Nothing more, nothing less. A lot of people forget this simple definition, especially when investing in stocks.
Just because a stock’s price goes up, your money is not necessarily doing any compounding. The price of the stock changes (up or down) based upon market dynamics. Buyers and sellers doing their thing. The price of a stock goes up because other humans are bidding up that price. That isn’t actually compounding.
What could be considered compounding is if you were to buy stocks at low prices, and then sell again at high prices. Rinse and repeat until you’ve made millions. That could be considered compounding, but it’s definitely not buy-and-hold investing.
It’s also a pretty risky way to compound money. The likelihood of you eventually screwing up is very high.
There’s several ways stocks can compound, but the simplest form of compounding is from reinvesting dividends. Dividends of course are the excess earnings spit off from a company after all the bills are paid, and all necessary maintenance is done.
Yes, you could choose to spend those dividends, but if you don’t need the money it can be reinvested in more shares. Those dividends of course can be reinvested, like in those classic compound interest stories.
Unfortunately most companies that pay dividends won’t be paying 100% rates of return. They pay considerably less!
The S&P 500 currently pays an average annual yield of 2.03%. At that rate of return, you wouldn’t have over 5 million on the 30th ‘day’ of compounding. You won’t even have two pennies by that time — you’ll have 1.79 cents. I’m totally ignoring taxes here too!
Because I’m such a generous guy I’ll just go ahead and round that up to two pennies for you. Two pennies after 30 rounds of compounding.
Wow, that kind of sucks. Getting any real compounding happening in our lifetimes isn’t going to happen at a 2% rate. There go your chances at easy millions!
We’re going to need far higher rates of return to see any real growth in our money. There has to be a better way…
Reinvesting In The Business
Probably the best way to realize higher rates of compounding is through reinvesting in a business. We’ve talked about this before, but at the time our angle of attack was Return on Capital. Same thing, just a different way to think about it. So how does it work?
Imagine for a moment you owned a small business. Let’s call it Mr. Tako’s Sushi Emporium.
As the name implies, it’s a sushi shop (with a kick-ass name), located in the nice part of town. Your customers enter your shop and order small bits of sliced raw fish, which you happily sell for considerably more than it costs you.
At the end of the year, there’s excess cash sitting in your bank account. Let’s say it’s $100,000.
You could choose to pay yourself dividends, or your could keep that money and re-invest it in the business. $100k would be enough to go open a second store after the first year.
You decide to do just that. You expand, and open a second store.
Suddenly you have two sources of revenue. You’ll need to hire someone to work in the second shop, so profits probably won’t be as high as the original Sushi Emporium. Maybe you only realize $50,000 from that second shop at the end of the second year. That’s still a 50% Return on Invested Capital. Outstanding!
Assuming business continues to go smoothly and you keep reinvesting, by the end of the third year you would have three stores and $200k in the bank. You could afford to build more than one sushi shop from year 3’s earnings. And so on!
That’s how compounding by reinvesting works.
The trouble, of course, is that you just can’t open new stores endlessly. Eventually the market gets saturated and profits at your other stores begins to decline.
Businesses can’t grow forever. Eventually those 50% ROIC (Return on Invested Capital) numbers begin to decline, the law of large numbers comes into play. Compounding that river of cash at good rates of return gets hard.
Stock Buybacks are another way that compounding can happen, but it’s probably the least well understood.
What are stock buybacks? Stock buybacks are purchases of company stock by the company, usually on the open market.
A lot of people think this makes the stock price go up, but that’s actually a very simplistic understanding of what’s going on…
Money leaves the companies’s bank account and enters the account of a selling shareholder. The seller gets the cash, and in exchange the company “cancels” those shares. They are no longer ‘floated’ on the open market.
From an accounting point of view, the company is actually worth less because this happens. Money leaves the bank account to purchase a stock certificate that is essentially torn-up and tossed in the trash.
Thankfully, the assets of the company are still in place. Those assets will earn similar returns in the following years, but the earnings will be spread across fewer shareholders. That’s where the magic happens.
Suddenly through accounting trickery each shareholder gets a bigger piece of the pie, even though the pie was initially smaller due to the cost of the buyback.
Over time, the company will earn back those dollars used to wipe-out the shares. Eventually, the value per share should rise.
The Problem With Buybacks
Buybacks work best when are prices are low. Buybacks at high prices don’t add a lot value (like right now). Companies buying-back shares end-up get less bang for their accounting buck when prices are high.
It’s entirely possible that, (just like our 1.79 cents) the company only realizes miniscule rates of compounding from share buybacks.
In cases like these, buybacks are a waste of shareholder money. Instead of realizing terrible rates of return, the company could just hand back the cash to shareholders as dividends and let them reinvest it other places instead.
Unfortunately this practical use of excess earnings is frequently ignored. Why? CEO compensation plans frequently reward growing earnings per share, not maintaining high returns on capital.
All of these methods of compounding can individually build the value of your investments. When they all compound money together, they create lollapalooza effects — Exceptional rates of return because of exceptional rates of compounding. This is the kind of compounding we’re looking for.
Unfortunately, each compounding method has problems too — They can have the opposite effect on your wealth:
- You can reinvest dividends at market highs instead of market lows. Losses of 50% or more are possible!
- Businesses can reinvest earnings in stupid stuff, realizing little to no compounding. This is more common than you might think.
- Stock buybacks can happen at market highs instead of market lows…essentially wasting all that hard earned cash. Again, this is more common than you might think.
How To Keep Compounding
The easiest way to keep your dollars compounding is by watching the compounding like a hawk.
Keep reinvesting dividends when prices are low. Invest in companies that reinvest in the business (and have a long-tail of reinvestment opportunities) at good rates of return. Stay invested in businesses that have effective buyback plans.
Most of all watch your investment’s Returns on Capital very carefully.
Great businesses with fantastic returns on capital can change into frightening cash burning monsters overnight.
Microsoft comes to mind here — Their ROIC has been declining for years. Anyone remember Nokia? Aquantive? Billions were spent on acquisitions later written off as worthless investments. Ouch. Microsoft would have been better off leaving those billions in bonds. Maybe the $25 billion Linked-In purchase will be the next massive write-off. Who knows!
Back To Pokemon
I’m done talking about compounding now. You can go back to your Pokemon Go, but keep thinking about real life monsters — Money-wasting monsters that eat your compounding for breakfast. Avoid those monsters like the plague and keep your money compounding for the long-term.