The greatest shortcoming of the human race

Many great investors have written extensively on the power of compound interest, yet it remains a difficult concept for investors to grasp and the majority of us fail to reap its long-term rewards.

Albert Bartlett might bring to mind the weekly shop and roast dinners for UK readers, but the nation’s leading potato supplier shares its name with a US academic whose work on compound growth has far-reaching implications for the investment community. A renowned professor in nuclear physics at the University of Colorado, the late Albert Bartlett stated that “the greatest shortcoming of the human race is our inability to understand the exponential function” and innovatively illustrated this through his lessons on population growth, as opposed to investment returns. The following chart amply demonstrates the power of compounding in the remarkable growth in the world’s population over 1000 years. Bear in mind, this is what 1.5-2% population growth since 1950 actually looks like.

compounding-interest-blog-chart

Bartlett’s lecture ‘Arithmetic, Population, Energy’, which is still available online today, sets out several examples. A local paper in Boulder, Colorado asked council members for their view on what rate of population growth they’d like to see in the town over the coming 70 years.  Members provided a range of answers from 1% (the rate of US population growth) to 5%. A 5% annual growth rate might sound reasonable until you realise that this would constitute a 32-fold increase in the town’s population.

In another Bartlett example, a skier is told the price of their season ski pass in Vail, Colorado has doubled in ten years. They are shocked, despite this constituting only a 7% rise each year. This growth rate is hardly worthy of protest and would likely evade the attention of an avid skier considering their annual ski pass renewal. It takes patience to feel truly ripped off. And it takes patience to truly benefit from investment in income stocks.

Consider a company that grows the dividend paid to shareholders by 7% every year. Every ten years that dividend doubles. If the market agrees the company is fundamentally strong enough to continue to grow its dividend in this manner, and nothing else changes with respect to the way the market values that company, then share-price appreciation should mirror the dividend increase. In this scenario, the share price could be seven times higher in 30 years. And that is before we introduce the power of reinvested dividends into the equation.

History has taught us that consistent dividend growers are few and far between. A company able to grow its dividend every year for more than 50 years will almost certainly have shown exemplary capital allocation, with enduring brands and specialised products or services that competitors have never managed to replicate. The challenge is to identify such companies, understand their intrinsic potential and be patient enough to give them sufficient time to show the value of long-term compound growth.

The US industrial conglomerate 3M, famous for founding the ‘Post-It®’ note, is one such company, growing dividends in each of the past 57 years and paying some form of dividend to its investors for the past 99 years. Since 1980, the company has grown its dividend stream at a compound rate of 7.3% per annum. While this already sounds like a pretty good investment, it sounds even better when you realise that 3M’s 2015 dividend payment is more than 57% of your initial purchase price in 1980 and the cumulative value of the dividend stream since 1980 is more than five times your original investment. As impressive as all of this is, if you had reinvested all the dividends received, the results would be even more compelling. An initial investment in 1980 of $100 would today be worth in the region of $6,000!

None of us are blessed with perfect foresight, but if we remain patient the exponential function can create a powerful tailwind. Our job is to identify companies capable of long-term compound growth, the future 3Ms of this world, and then let time do its work to generate exceptional returns.