The power of compound interest. Everybody likes to talk about it, but much like the weather, nobody seems to do anything about it.

Einstein was once asked what the most powerful force in the universe was. “Compound interest.”
I love that. I mean, I just love it that Einstein, the poster-boy for supreme brain power, a
guy who as far as I know never got heavily involved in the markets, pointed to a financial
phenomenon rather than a quark or quasar or gravity or something to answer that question.


Just picture it – that goofy looking bastard has all these ideas about curved space and moving trains floating around his head and “compound interest” pops out.

Compound interest is very powerful. Seriously. I know, because I spent a whole semester in grad school studying it. Sounds dumb, I know, and boring to boot, but believe me when I tell you that it was well worth the trouble. I graduated with a degree in actuarial science, and to understand that stuff you really need to know compounding. So I learned about it.

I said that “nobody seems to do anything about it” because nobody is buying yield any more. Have you noticed that? I mean, look at the yield on any of the major indexes. The returns that contemporary equity investors have enjoyed have consisted almost entirely of capital appreciation. That is wonderful, when it occurs, but it simply cannot last forever.

I’ll tell you a secret: stock prices don’t compound. Ever. Stock prices are a random walk. Not that I’m a random walker, but the price of a stock isn’t determined by any kind of growth process. The price of a stock is determined by the interaction of supply and demand. This is why stocks like Ely Lilly (LLY) can see 1/3 of their value vaporized in an instant. This is why stocks go down so much faster than they go up. This is why some stocks go to zero.

The compounding that occurs in stock world is a loose reflection of the compounding that can occur in business world. Certain businesses with the right kind of economics are able to grow consistently over time. The whole Buffett thing, you know? Like Dairy Queen. I just went to Dairy Queen for the first time. Got a Blizzard. I’m going to get hungry again tomorrow, and the day after, and every day after. And people will be born. And people will move to the Chicago area near that Dairy Queen….growth will happen, based on growth and flows of human population, and Dairy Queen is able to grow right along with it. Unless, by some strange development, people lose their sweet tooth or Dairy Queen changes its product line for the worse.

Same for Coke. Same for McDonald’s. Same for a lot of businesses.

So what compounds? Earnings. Earnings grow over time, because the size of the market grows and companies scale up with it. Hopefully it costs less than $1 to scale into another $1 of sales. Like Peter Lynch says, stock prices more or less track corporate earnings.

So they more or less compound.

Except for that “random walk” supply, demand thing.

So what compounds?

Dividends. Asset values. Income streams. But income streams are meaningless to stockowners unless they go into cash payments or investments in assets that increase shareowner asset value.

So back to compounding, and nobody doing anything about it. The very low, unbelievably meager level of dividend yields, confirmed by a rather chincey level of earnings yields, double confirmed by sky-high price to asset valuation levels, suggests that people don’t care about compounding. They are focused on being there for the plentiful capital appreciation that has occurred.

So what do you do?

I am all for playing the game that is being played. You can’t forego the kind of huge gains
that stocks have offered, even if you know for certain some of those stocks may not even trade five or ten years from now. But don’t ignore dividends. Don’t overlook compounding. And don’t be afraid to appreciate stable over sexy. Although it may seem much more fulfilling to own a flashy tech name that goes up 50% a year like clockwork, it will probably be better in the long run to own sexless, moo-moo stocks in companies with a tap into the real economy.

And that, dear reader, is all I have to say about that.

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