The Eighth Wonder of the World

Albert Einstein is alleged to have called compound interest one of the most powerful forces in the universe. Charlie Munger considered compound interest as one of the key models in our tool kit.

I found an interesting blog from Michael Moe, posted in May 2005 (ThinkEquity Blog) about compound interest. Below is a portion of his post...

"...we can benefit from the magic of compounding identifying companies that will grow their earnings at a high rate for a long time and hold on for the ride.

An important concept to appreciate as a growth investor is the power of compounding growth. While when it comes to growth companies, where the bulk of their future earnings lie ahead of them, the perception of valuation risk crowds out investor interest in future earnings potential. This said, a few simple math examples may help to underscore the power of growth.

The Power of Long-term Compounding

In 1626, Dutchman Peter Minuit purchased the entire island of Manhattan for $24 from the Wappinger Indians. In other words, for what it would cost to order a bagel and cafe latte at a midtown hotel today, Monsieur Minuit owned the entire Big Apple.

While there are many outside of Gotham that would look at neither as a bargain, our point is to demonstrate the power of compound interest over time. Compound interest has been called the "eighth wonder of the world" and, with the help of the "ninth wonder of the world," the HP 12C, we can calculate whether Peter Minuit got a good deal or not.

Obviously, the key variable to determine the answer is interest rate that we apply to the $24. Or what we could have earned in an alternative investment.

The difference between a 5% return and a 10% return isn't a simple doubling but a compounding that becomes staggering over time. If the $24 was invested at 5% interest over the past 377 years it would have grown to $2.3 billion today, implying a good price given Rockefeller Center sold for $1.9 billion in 2000.

At a 10% return however, the $24 doesn't just double the 5% return, or to $4.2 billion, but magnifies it to $97 quadrillion!

At the foundation of our investment philosophy is that over time, share prices are nearly 100% correlated with earnings. Hence, our objective is to identify companies that can grow their earnings at a high and sustainable rate and hold on for the ride.

In the world of investing, few stocks have accomplished the returns of Peter Minuit, yet, consider that Microsoft went from a $500 million market cap company at the time of its IPO to nearly $400 billion today by growing its earnings at approximately a 40% compound annual growth rate over the past 17 years.

The trick, of course, is that it is almost impossible to grow at a rate that high, for that long of a period, as the laws of compounding cause growth to diminish with size. Bearing this out is the fact that there are fewer than 30 companies that managed to grow their earnings in excess of 20% annually during the past 10 years out of a universe of more than 12,000 companies!

1¢ Doubling Every Day or $10,000 per Week

To illustrate the power of the doubling effect, suppose you were offered a job as a consultant for a month and you had your choice of being paid $10,000 per week or a penny the first day, and having it double every day for the remainder of the month. Easy choice right?

At $10,000 per week, you would make $40,000 for the month. On the other hand, making a penny the first day, two cents the second, four cents the third, eight cents the fourth, and so on, you actually end up making over $10 million by the 31st day."

He also give us a model to use called the "rule of 72"; where if you divide 72 by the interest rate you will find the number of years that your investment will take to double. i.e. If your interest rate is 15% it will take you 5 years to double your investment.

Now our challenge is to get this model in our head and try to applied it to the real world. Remember what Julian Huxley (biologist) said "Life is just one relatedness after another".