Compound investing is a popular topic that is not as widely practiced as it is popular. For some, there is not enough understanding of how it works. For others, there is not enough information to help develop a strategy for investing with a compounding model. In this post, we set out to tackle both problems (though, on a very basic level) using stocks as our asset class of choice.
Compound investing is any investing method where the proceeds of the initial investment are reinvested. The reinvestments, therefore, facilitate the accrual of returns on both the initial investment and the returns as well. Put simply, compound investing, is when your interests earn interests. Compounding can be applied to any investment that pays a cash interest (or return). The “cash” is critical to compounding because it enables the key compounding principle of reinvestment, to happen.
Compounding produces exponential returns, not linear returns
Traditionally, when people invest in stocks, they expect the stock’s price to rise after they buy it. The value of a stock is directly correlated to the stock’s price such that a rise in the price will cause a rise in value and vice versa. This increase, which a stock’s value experiences relative to its price, also has a linear relationship where any given increase in price produces a constant increase in the value of the stock.
The key to compounding is reinvesting the returns earned on the investment. By compounding a stock investment, the investor accumulates more shares every time a dividend is paid. If you reinvest these dividends into the company, your initial investment, plus the newly acquired shares, continues to earn. Those extra shares keep earning as well. As you increase the number of shares you own (by buying new shares every time you receive a dividend), the power of compounding will play out to make the total return on the stock to grow at exponential rates, not linear rates.
How compounding works
The key principle that powers compound investing is that an initial seed will reproduce, by earning interests at the next interest payment date. In the subsequent payment period, the initial seed and its reproduced offspring will both reproduce. This process continues for as long as the investment pays dividends and the investor reinvests those dividends. To explain this better, let us look at the table below which shows how a ₦1 million investment could grow by over 1,000% over a 25 year period if the company pays 5% dividends twice a year.
When you make a ₦1 million investment in stocks, at the beginning of period 1, we can infer that your investment (mommy) just got pregnant. That pregnancy has a 6-month term before delivery and the baby, which will be born (dividend to be received), will be a bouncing 5% of mommy’s value. Fast forward to six months (end of period 1 and beginning of period 2) and mommy is delivered of a bouncing baby (₦50,000 dividends received). This is where we get to the plot twist.
Unlike biological beings that need time to develop reproductive capabilities, special baby can get pregnant as soon as it takes its breath. Mommy gets pregnant again, at the beginning of period 2, but so does baby too. By the end of period 2 (and the beginning of period 3), mommy and baby are delivered of their babies. Mommy reproduces a second bouncing baby (₦50,000 dividends received) while baby reproduces for the first time (₦2,500 dividends received). The combined reproduction (dividends received) by your initial ₦1 million at the end of period 2 will be ₦102,500 created by:
Mommy’s firstborn, ₦50,000 during period 1
Her second-born, ₦50,000 during period 2 and
Baby’s firstborn, ₦2,500 during period 2.
This process continues on and on until the investor puts a stop to it. More dividends will be received during every subsequent investment period, than was received in the preceding period if the investor reinvests the dividends, by buying more stocks. Therein lies the key. This process will continue and will cause the exponential growth described earlier.
There are a few things that an investor, who wants to build a stock portfolio for the purpose of compounding, needs to monitor.
Look for companies that are fundamentally sound
That’s right, you need to pay attention to the overall performance of the company. That a company pays dividends with high yields, or that it has been a consistent payer does not mean that it can sustain those payments. We have a post that somewhat touches on this topic. If you would like to learn more about that, you could read our post on the quality of earnings.
You need to find companies that are properly managed and have good prospects for sustaining their raison d’être. There are qualitative and quantitative measures with which an investor can monitor a company’s health. For the qualitative measures, you need to pay attention to news about the company, its industry, its competitors, its management, etc. For qualitative measures, just head over to the Investor Hangout data hub and you can access tools that simply company health checks.
Look for companies that have a track record of consistently paying dividends
When you complete the first step of identifying fundamentally sound companies, you need to weed out those that do not pay at all (growth companies) or those that pay but are inconsistent. A screener will be of great use to you here. Run a scan for companies whose annual dividends, every year, were greater than zero. We have run this scan and the result is presented below.
Ideally, we would like to see only companies that have paid dividends every year. We understand that Nigerian companies are not *there yet* so we can make a bit of concession. What about companies that have paid dividends 9 out of the last 10 years? Do you think there would be some value there? I think so. So, let us identify companies that have a 9/10 score in this context. The Nigerian companies that have paid dividends in 9 of the last 10 years are:
Look for companies that have the best dividends yield.
The table above shows us Nigerian companies that have paid dividends consistently in the last 10 years. This list is close to what you can call a Nigerian Dividend Aristocrat list; it’s not ideal but it’s also not a bad start either.
Next, we need to look at those companies and identify which of them generated the most yields from the dividends they paid. To do this, we calculate the dividend yield for all the companies on this list. This requires making some assumptions and they include:
Dividends are annual dividends (a sum of all the dividends that the company paid during the fiscal year).
The price used to calculate the yield is the stock’s price at the end of the company’s fiscal year, not the date the dividend was paid.
Yield is calculated by dividing the annual dividend by the company’s stock price.
We applied these rules to calculate the yields for all the companies that were on the previous list. What we got was a list of the yields for each year that the dividends were paid. We averaged those yields to identify the average yield of those companies over the period covered. The result is presented in the table below.
It must be emphasized that there are several other conditions that could affect a compound investment strategy. Some of these issues include:
Does the dividend grow at a predictable rate or does it not grow?
Does the stock’s price rise or fall?
Does the company still meet all the conditions identified? etc.
I also need to emphasize that this post is not a recommendation to buy or sell shares. It is educational only.
We have set out to explain what compound investing is and how you can achieve the benefits of compound investing with a stock portfolio. Will you be trying your hands on a few new stocks with this new information that you have? If yes, you might need some tools to simplify the process. Some of these tools include a screener for identifying companies that meet the requirements, a stock health checker to know whether the companies are fundamentally sound, etc. You might want to try your hands on one of our subscription plans if you want even more resources than the free Investor Hangout data-hub provides. If you do, please head over to our membership page and try any plan you think will suit you best.
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Taiwo Megbope is the Co-founder and Chief Growth Officer at Investor Hangout.
He is tasked with ensuring and managing the growth of the Investor Hangout project. His responsibilities include creating and implementing the project's vision as well as executing growth-generating strategies.
Taiwo is an avid researcher and autodidact. In his spare time, he enjoys spending time with his family and friends.