Miracle of Compounding

Value Investing is built almost entirely on the founding principle of the Miracle of Compounding. Real wealth is created through the power of compounding or compound effect or the principle of compound interest, and not based on the genius of the investor.

Oh, is it so?

So, what is this miracle of compounding?  Who discovered it?

This universal law, just like any other law of physics, works unfailingly.  It is as sacred and inviolable in the world of finance as Newtons laws of motion and Kepler's laws of planetary motion in physics are. Ironically, this financial law was not discovered by a financial wizard but Albert Einstein, a renowned physicist.  

Albert Einstein

So what does the law say and mean?  If an investment grows at compound interest, without break, for a very, very long period of time, the final sum will be astronomically bigger than the initial investment. 

Further, the spectacular growth in the value of investment starts happening only at the end of the very, very long period and not at the beginning.

The practical implication for a value investor is that even a humble initial investment of say Rupees one lakh ( about US$ 1500) can multiply a hundred times into Rupees one crore (Rupees ten million or US$ 150000), which is a significant sum in India today, on the back of the miracle of compound interest. 

Here I present a graph showing the actual miracle taking shape over time.

Graph shows effect of compounding after 20 years

Here we start with a humble initial investment of Rupees one lakh or hundred thousands.  We have assumed a compound interest rate of 10% per annum, which is also very realistic in Indian conditions.  We see that over a period of 50 years, the investment grows 100 times into Rupees 10 millions or Rupees One Crore.

We also can see that line starts its dramatic, upward climb only from about 25 to 30 years onwards and not before.

Please follow the two links to compounding calculators for investments provided at the end of this post.

But, what is the normal horizon of an ordinary investor, uninitiated into value investing? About one year or may be three years and certainly not more than that.

The minimum investment horizon must be 20 - 30 years and great wealth is created over even longer investment spans of 50-75 years!

Benjamin Graham taught that an investor should make a sound investment, after thorough study, and after that should simply forget about it.  But the mind of an ordinary person is highly restless.  He or she will keep on looking at the value of the investment.  The mutual funds add to the situation by sending regular Net Asset Value (NAV) reports.  The ordinary investor develops cold feet when the NAV goes down (which is perfectly normal in the share market), and sells off the investment ( if he has not already sold it at a loss) the moment the NAV appreciates by say 10-15%.

Alas, such an investor has not given an opportunity for the law of miracle of compounding to act at all!

On the other hand value investors like Warren Buffett clearly understand how the miracle of compounding works - they know the power of compounding or the compounding effect or the principle of compound interest, and sit tight on their good investments for decades at a stretch and reap the astronomical benefits produced by the miracle of compounding.

Related Articles:

• Future Value of SIP Investment Calculator
• Future Value of Single Lump sum Investment Calculator
• Kill the Urge to Splurge
• Everything You Need to Know About Wealth Creation Through Systematic Investment Plan (SIP)

Buy Top Dividend Stocks as Dividends are Investors Wages

Investor Happy at Dividends Raining from His Investments

It is advisable to buy top dividend paying stocks as dividends are the wages of an investor.

How so?

Because, investing, especially value investing, is like farming.  It involves a lot of hard work, patience and character.  So, an investor deserves wages for her labor, and dividends are exactly the wages she deserves.

Stock traders/ day traders are solely focussed on price movements.  Many speculative Indian investors, for whom share market is complementary alternative to a real estate market, are also interested purely in the price rice.  They totally ignore the importance of dividends.

Many listed companies too play on the same theme.  They either do not pay dividends at all or pay a paltry a dividend, on the grounds that they are reinvesting the cash for growth, for the benefit of shareholders.  The supposed logic is that:

1. The company knows how to reinvest cash and generate more rewards better, than the investors.
2. The growth created by the company by reinvesting the cash, instead of distribution by way of dividends, invariably results in an attractive increase in the price of the share, and the investors are ultimately better rewarded in the long run through growth, rather than through dividends paid today.  

However, as the Value Investing Gurus like Benjamin Graham and Warren Buffett have observed, such companies, in the delusional pursuit of growth, may sometimes make huge and serious blunders, and the company may go bust.  In the end the investor losses everything, having neither received a dividend when the company was doing good nor recover the capital invested, as the shares are worthless after the bust.

Therefore there is absolutely no justification for the companies for not paying dividends or paying meagre dividends.

Top Dividend Paying Stocks

There is a lot of criticism of government/ public sector companies and praise of private genius in the media. I too had been a strong critic of the performance of public sectors companies.  However, I was surprised to find that in India a lot of public sector companies are doing very well and distributing dividends over 30% of their net profits.  The reasons for the generous dividend distribution may be attributed more to the coercion by the government to distribute higher dividends to meet its own fiscal needs, than the generosity of the managements, but whatever may be reasons, ultimately the investor is benefitted.

One of the best examples is NMDC Ltd.  The dividend yield of this company is about 10%, tax free. At a maximum tax rate of 33%, this translates into a return of nearly 15%.  This is a fantastic return in addition to capital appreciation (increase in price of share).  What kind of a financial instrument can offer such a return?

I present here a list of high dividend yield stocks, that also satisfy other stringent value investing norms:

Name of Stock	Dividend Yield
Hindustan Zinc Ltd.	12.56%
SJVN	7.03%
NLC Ltd.	6.92%
NHPC	5.67%
NMDC	4.56%
NALCO	4.31%
ONGC	4.29%

On the contrary there are innumerable, excellent private companies, which are highly stingy in paying dividends.  Their managements may be thinking that their policy is in favour of investors, but either knowingly or unknowingly they are doing a great disservice to their investors.

A value investor must only include those companies in her portfolio that pay generous and regular dividends, without a break.

In conclusion, as Benjamin Graham advised, only buy top dividend stocks as dividends are investors wages. Carefully build a portfolio of top dividend paying and high dividend yield stocks.