My Economics professor in college actually presented me with two “aha” moments that got me fascinated with investing. The first was a historical graph created by Pershing & Co. that showed a 60 year history of the S&P 500 where earnings and price were correlated. When showing us this graph, my professor used to literally pound his fist on his desk and screech at us “earnings determine market price.” You might say this was the mother of our F.A.S.T. Graphs™, the fundamentals analyzer software tool. Although simple in form, the Pershing & Co. graph showing that price followed earnings captivated my imagination. Little did I know at the time that validating the relation between earnings and the market price of a stock would go on to become my life’s work.
The same professor provided me with my second aha moment by doing a simple napkin presentation that highlighted the power of compounding. He presented the following statement and then followed it with a question: If you invested $.67 a day, or approximately $20 a month and did it every day for 36 years (which he defined as the average persons working lifetime) while earning 10% on your money, you would accumulate approximately $80,000.Therefore, if you invested the same amount of money over the same time frame and earned 20% versus 10%, or double the rate, then how much money would you accumulate? Of course we all answered $160,000 or twice as much money by earning twice the rate of return (20% versus 10%).
Of course the real answer was many times more than that which he expressed by showing us the following dynamics of compounding by using the rule of 72. We also learned that he carefully picked the parameters of his statement and question in order to make his point. First of all, using the rule of 72 he pointed out that if you take the number 72 divided by 10% you find it takes 7.2 years to double your money. If your money doubles every 7.2 years, then it will double five times in 36 years (36 divided by 7.2 equals 5). Therefore, one dollar would double five times as follows: $2.00, $4.00, $8.00, $16.00, and finally $32.00.
However, if you double the return to 20% and divide it into 72, you discover that it only takes 3.6 years to double your money at 20%. Therefore, if you double your money every 3.6 years for 36 years you get 10 doubles instead of five(36 divided by 3.6 =10), or double the doubles. Consequently, instead of stopping at $32 you end up getting five more doubles as follows: $64, $128, $256, $512, and finally $1024. So instead of growing a dollar to $32 in 36 years at 10%, you grow that same dollar to $1024 at a20% rate over the same 36 year time period. Not only was the power of compounding an “aha” moment, it literally blew my mind. From that moment on I saw investing as geometry rather than linear mathematics. Once I understood the magic beneath that investing was truly all about compounding, I was forever hooked.
The first stock I ever bought was Phillip Morris, because my same economics professor convinced me that this was a powerful marketing machine that charged their customers more by giving them less, and because their product was addictive. In other words, they were selling nicotine addiction and then by placing filters on their cigarettes delivered less nicotine causing their current customers to smoke more and therefore by more in order to meet their addictions. Consequently, it was growing earnings excess of 15% per annum and paid a dividend that was also growing with earnings. The end result was a very reliable investment that was capable of generating returns in excess of 20% per year. Of course, tobacco did not have the stigma back then that it does today.