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A technique more rewarding than compound interest

Oct 14, 2011

In this issue:
» What is going on in China?
» Fuel prices a cinch to go up in India
» RBI Governor to continue tightening if inflation remains high
» Euro slowdown will pose threat to Asian growth, feels IMF
» ...and more!
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00:00
 
Imagine one of our forefathers from around 1,500 years ago going to a goldsmith with a couple of grams of gold and entering into a pact. The pact being that the goldsmith and his descendants get to keep the gold provided they add 5% to the total quantity of gold every year in the form of interest for the next 1,500 years. Since 5% is not a very high rate of interest, the goldsmith readily agrees and signs the pact. His descendants though are in for a rude shock. As things stand today, that tiny piece of metal weighing 2 grams has turned into an astounding 1.22 X 10^32 grams. To put into perspective how big this number is, it is more than 20,000 times more than the entire mass of earth! Well, the goldsmith's descendants would have defaulted a long time back.

This in a nutshell is what the enormous power of compounding all about. And even we can make use of its strength by investing in such a way that interest earned in a year is added to the principle and this new total is considered for calculating future interest. Follow this pattern sincerely for a few years and you will be surprised at the amount of wealth you would have accumulated at the end of the period.

Is there a technique that is more powerful than the compound interest? Indeed. And this technique does not run contrary to compound investing but uses the same principle and takes it a step further. Some prefer calling it compound interest on steroids. It is called so because here, the interest rate does not remain constant but keeps on growing year after year. What we are talking about is nothing but a stock that is able to increase its dividends year after year. Such a stock can easily be an investor's dream come true. This since not only do the reinvested dividends fetch dividends the next year, they also fetch a higher overall dividend by virtue of the dividend growth rates. Hence, they are able to generate much more returns than any instrument that compounds money at a fixed rate.

Put differently, Rs 100 compounding at a fixed rate of 5% will yield Rs 5 in the first year, Rs 5.25 in the second year and Rs 6.1 by the time the fifth year comes to a close. In contrast, a stock priced at Rs 100 and yielding Rs 5 as dividends but growing at 10% every year, will pay out Rs 9.2 as dividends at the end of the fifth year, 50% greater than the first case. We would however like to add a caveat that very few stocks are able to increase dividends for an extended period of time. The investor thus has to be really cautious while putting his money with the hope of benefiting from this strategy. Clearly, if a right stock is unearthed, there is no beating the strategy of dividend compounding, provided the dividends grow year after year.

Do you think this is the best wealth enhancing strategy out there? Share your views with us or you can also comment on our Facebook page.

01:36
 Chart of the day
 
The RBI may be pulling out all stops to tame inflation. But the strategy of high interest rates that it is using could also be leading to some unintended consequences. Take capex for instance. As today's chart of the day shows, future capacity building in India grew at a very low rate in FY11. If this is not enough, the current year could actually see capex coming lower than the previous year. Of course, a lot of people could argue that it is much better to have low capital expenditures rather than have it grow at break neck speed only to see the underlying loans going bad in the future.

Data source: Mint

02:07
 
5 year plans may come and go, but India's infrastructure woes seem to have little recourse. After all, while making US$ 500 bn and US$ 1 trillion spending plans, the Planning Commission has conveniently forgotten to worry about policies to back them up. Policy inaction with regard to energy security will therefore continue to haunt India for many years to come. In fact, rarely in the past has India been in a bigger mess with regard to power shortage. Any realistic solution to the energy problem calls for higher tariff. The same will definitely push up inflation and slow down growth in the short run. Maharashtra's industry is facing 16-hour power cuts in some areas. Outside Kolkata, West Bengal faces power cuts of four to five hours daily. The situation isn't too different in many other states. The State Electricity Boards have become bankrupt and are deep in debt due to lack of pricing power in tariffs. The coal shortage is already 80 m tonnes annually and could rise to 600 m tonnes by 2017. The plight of oil marketing companies with subsidy burdens is well known and may not get resolved without stoking inflation. Hence the fact that power and fuel prices have nowhere to go but upwards is a truth that Indian have to live with in the coming months.

02:47
 
Given the influence of China on the global economy, it is pertinent to ask where the country is headed now. To get a proper perspective of what's going on now; we need to regress a bit into the past. In the aftermath of the 2008 global financial crisis, the Chinese government came up with massive stimulus packages amounting about US$ 2.1 trillion, which was about 33% of the GDP (Gross Domestic Product). The money was channelised into building cities, roads, malls, commercial and residential buildings and so on. It not only boosted the country's economic growth in the short run but also generated significant employment.

The problem becomes apparent when you visit some of the Chinese 'ghost' cities. These cities have excessive real estate such as residential towers, malls and roads that are totally unoccupied. Meaning, there are no buyers or users for these properties. Then why were such projects built in the first place? Well, because cheap money was available. But why did the banks lend to such risky lenders? Because the central authorities ordered to do so. All this hints towards impending turmoil in both the Chinese banking and real estate sector. With inflation high and growth slowing, it's difficult to guess whether China is heading towards a temporary correction or whether a big bubble is about to burst.

03:27
 
The worsening crisis in Europe may cause a crisis in Asia. This is the view of the IMF (International Monetary Fund). The IMF feels that if the crisis in Europe worsens then it would lead to the foreign funds pulling their money out of Asian assets. This in turn would trigger a massive selloff in Asian assets. Furthermore, the crisis in Europe would force foreign banks to cut down their lending to the Asian markets. This would disrupt the latter's investment plans and cause havoc for their currencies (as a large part of Asian companies rely on forex denominated debt to fund their investment plans).

As per IMF early signs of this effect are already visible in the slowing growth rates of the Asian economies. With most of them adopting hawkish monetary policies, growth would be further impacted. So would this mean that the Asian world would head into a Europe like crisis? We really do not think so. It is true that the growth for Asia would cool down. But it is still a growth. A lot depends on how the policy makers handle the situation. They have to remember that an overly tight monetary policy could lead to a massive slowdown. They have to allow some level of flexibility for capital flows to drive investments. And as long as they do this, Asian economies would be cushioned from a crisis.

04:09
 
For over 20 months the Indian consumer has been saddled with inflation rates in excess of 8%. Is this a new normal? Or will the central bank continue to fight the forces of inflation with its monetary policy tools? Well, we believe the RBI will choose to focus on the latter. Corporate India and leading bankers were hopeful that the tightening would be due for a pause in October.

However, RBI governor Duvvuri Subbarao reiterated that he would continue to tame inflation, even if it hurts growth in the country. Despite 12 rounds of rate hikes, inflation (WPI) stood as high as 9.8% at the end of August. Growth has also decelerated in the country over the past 2-3 quarters. But the RBI is now definitely trying to walk the tightrope. It needs to take into account the needs of the industry, which wants low interest rates. It also needs to look into the needs of the poor, who wants low inflation. Not an easy choice, but we believe that the RBI's focus will remain taming inflation.

04:41
 
Meanwhile, Indian stock market indices seem to be pressing the accelerator hard as the Sensex was trading higher by more than 150 points at the time of writing. Heavyweights like RIL and TCS were seen driving most of the gains. Most other Asian indices closed weak however. Europe on the other hand, has opened on a strong note.

04:54
 Today's investing mantra
"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it." - Albert Einstein

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Equitymaster requests your view! Post a comment on "A technique more rewarding than compound interest". Click here!

4 Responses to "A technique more rewarding than compound interest"

Yatin

Nov 4, 2011

With ref to your article on compound interest, we would like to see some examples and illustrations from your end, of stocks that give such compound interest on steroids !!! lets have less talk and more (positive)action from your recommendations.

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srinivas

Oct 15, 2011

bakwas karne ki hadh hoti hai... trading karo bas... returns will be better than compound interest & steroidal compound interest...

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Dr. Suhas Shah

Oct 14, 2011

If u choose ur stock well and as u say it goes up ur earnings can be many many times in capital gains in a short period, compared to all the compounded interest over years.

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anupam garg

Oct 14, 2011

Despite repeated warnings / pleadings by the RBI governor, there hardly has been any action taken in fiscal policy...however, the story of China is also worth looking into...until and unless there's adequate demand, surplus expenditure even in infra projects may not prove fruitful

But 1 thing is for sure, rate hikes can do only so much to tame inflation...the governor can't keep pushing against a wall while the rest of the house (IIP numbers) is crumbling

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