Wednesday, March 9, 2016

Give your investments time to compound

The most important ingredients for success in investment is initial capital outlay at a favorable valuation, annual return and time. Many times investors are able to identify a good company, which has the potential to grow earnings and dividends over time, and reward them handsomely in the process. For example, a business like Diageo (DEO) is a quality one, which is attractively valued today. I believe that it would still be selling premium alcoholic beverages throughout the world twenty years from now. I also believe that this business will be able to earn more over time, and pay a higher dividend twenty years from now. It is quite possible that the higher earnings per share will make the business itself more valuable as well.

The problem is that the investor bails out because either the stock price goes down, it stays flat, or they sell because of the fallacy that nobody goes broke taking a profit. The other silly reason why people sell is because they get scared by rumors and speculation, that makes them get irrational and emotional, and thus they bail out. If you believe that people will be willing to exchange their hard earned money for a good beverage in 2036, then chances are that Diageo (DEO) might be of interest for further analysis.

Even if the initial analysis was correct, the investor might not earn much dividend income and profit, because they were impatient and didn’t give time for the investment to work out. Unfortunately, good things take time to happen in life. If you bought a company like Johnson & Johnson (JNJ) with $1000 today, chances are that you won’t earn a dividend of $100 in the next year. However, over time, if you let the power of compounding do its magic, it will be able to pay a $100 in annual dividend.

The power of compounding is truly miraculous. The problem is that it takes patience for the fruits of compounding to materialize in a matter that makes them material for your wealth. After a certain critical mass is reached however, the compounding process becomes truly astounding. For example, it took Warren Buffett approximately 56 years to become a billionaire. However, by age of 85 he has a net worth of 60.80 billion. If he wasn’t patient at age of 56, he would not have been worth $60.80 billion 29 years later. The $1.40 billion net worth from 1986 pales in comparison to the $60.80 billion he is worth now.

In the case of a company like Johnson & Johnson (JNJ), a 2.80% yield might not look like much today. In fact, the company’s stock price could move up or down by 3% in any single day. However, if you purchase the stock, patiently reinvest dividends, and let it earn more for you and pay you more dividends each year to hold it, the results would be more than satisfactory. This is because it takes time for things to have a noticeable impact. But once they do, the impact is enormous.

Let’s see what will happen if $1000 are invested, that dividend grows by 7%/year and dividends are reinvested into companies paying 3% and growing dividends by 7%/year. The dividends earned in the first year will be close to $30. This is nothing to write home about (though in my case, I am making my retirement projections using an yield of 3% and dividend growth of 5% - 6%/year). If you wait to year 5, your dividend income would have increased to $45.50 per year. By year 10, the investor will be earning something like $74 per year in annual dividend income. After 20 years, this dividend machine will be earning $196 in annual dividend income. This means that every 5 years, the investment will be sending your enough in cold hard cash that you initially put altogether after that point. After 30 years, the investment will be earning something like $520 in annual dividend income.

Just like a small seed turns into a mighty oak, a small investment in a handful of quality dividend growth stocks could turn into a reliable cash machine after you set it up and patiently let it accumulate for the next 20 – 30 years. Thus, in order to be truly successful with dividend growth investing, you need to not only know how to read annual reports, search for and identify great companies, but you also need to have the patience to sit on those investments for long periods of time.

Full Disclosure: Long DEO and JNJ

Relevant Articles:

Let dividends do the heavy lifting for your retirement
Key Ingredients for Successful Dividend Investing
How to become a successful dividend investor
Five Dividend Growth Investing Lessons I Have Learned Over the Years
Dividend Growth Stocks are Compounding Machines

Popular Posts