Einstein once said: "the strongest force in the universe… Compound Interest!"
(think about it!)
A lot of us know the formula for compound interest, but few understand it and even fewer actually see the force and use it to their advantage...
Let us look at Compounding more closely…
[A rate of 30% over 5 years expands the amount to: P * 1.3 * 1.3 * 1.3 * 1.3 * 1.3 = 3.7129 P]
Have you heard the phrase: "Money making Money!"
It is all about your interest bringing more interest and henceforth (growth over growth!)
In fact, Compounded Interest is also the single biggest force that drove me into the world of Investing and have my life committed to it.
In my career as an Investor, I simply focus on these 3 parameters:
Principal
Principal is the size of your kitty.
By the very nature of compound interest, your Principal is dynamic and keeps adjusting itself with the latest value of your kitty. The role of principal is simple. Had you started out with 2 instead of 1, you would have had twice as much today.
Rate
The rate of returns is a measure of your investing intellect/aptitude. By far, the single biggest factor of focus for an investor. Nearly everything you do as an investor is oriented towards maximizing this parameter.
Theoretically, no matter how small a Principal you start with, if you have a higher rate of return, you would eventually surpass anything however big. (Alternatively, if you are driving faster (and in the right direction :)), you would overtake any vehicle however ahead, if the race is long enough)
The difference between a 10% versus a 20% return stretched over 10 years is 140%
There is a crucial role of consistency here. For instance, if you aiming for 50% annual returns and fail to get any returns for an interim year, than you need to get 125% returns to make up for it the next year. (Imagine what it would take to cover up for a loss)
Time
Time is your tenure or longevity as an investor. Starting early is one advantage, not quitting is another and living longer is yet another. If you are healthy and live 3 extra years at 26% an annum, you would die/retire twice as wealthy :)
However, compound interest is not meant for gamblers or those willing to risk the life of their investments.
Over the years, a number of very smart people have learnt the hard way that a long string of impressive numbers multiplied by a single zero equals zero
Simple Interest: Unless the interest is paid back to the investor year after year, any calculation using simple interest is wrong, rather unfair.
Time and again, I have failed to understand the application of simple interest.
The world human population grew from 1 billion to 6 billion in the last century (1900 to 2000) at 1.8% compounded rate. If it was the simple interest at work, the same 1.8% rate of "simple" growth, would have resulted in a population of just 2.8 billion instead of 6 billion. So you see, it is never "simple" when it comes of application! Moreover, simple interest here would have meant that only the first generation reproduced.
While simple interest is addition, compound interest is multiplication.
Remember: Repeated multiplication always beats repeated addition!
Coming back to compound interest, here is a chart that will help you see the potential.
These are the returns with a one time investment of $ 100 or INR 100/-
Imagine the returns if you invested more or recurring monthly/annually through SIP.
I decided to limit the chart at 50% and 50 years as I neither aspire to get anything close to 50% compounded returns nor expect to live beyond 50 years from now. Moreover, I started having trouble with numbers beyond these.
Another example: If you consistently manage to double your money every 2 years:
- An amount of $ 100 K would be approximately $ 100 Million in 20 years after 10 doublings.
- And the same $ 100 K would be approximately $ 100 Billion in 40 years after 20 doublings.
However, it would be foolish to think only math's and continuous compounding in a limited real world…
That brings me back to an excerpt from Warren Buffet's 1989 letter to the shareholders of Berkshire Hathaway...
We face another obstacle: In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends: A high growth rate eventually forges its own anchor.
Carl Sagan has entertainingly described this phenomenon, musing about the destiny of bacteria that reproduce by dividing into two every 15 minutes. Says Sagan: "That means four doublings an hour, and 96 doublings a day. Although a bacterium weighs only about a trillionth of a gram, its descendants, after a day of wild asexual abandon, will collectively weigh as much as a mountain...in two days, more than the sun - and before very long, everything in the universe will be made of bacteria." Not to worry, says Sagan: Some obstacle always impedes this kind of exponential growth. "The bugs run out of food, or they poison each other, or they are shy about reproducing in public."
Coming back to the real world:
The good news is that compounding does work in the real world, even with smaller and more realistic rates of growth.
We often tend to limit our minds with the highest or the best that we have seen in the past. Think for yourself, how many times have you looked at the 'all time high' and fallen short of being able to see anything beyond... man, that's the highest it ever got to! And we draw the line…(this is like driving a car with eyes on rear view mirror!)
An old or a newer high can most certainly be a resistance (more so because we create it in our minds), but certainly not the end. These are just milestones after all.
The other day, I heard someone say…
"Man, I don’t think Dow will ever go beyond 14000 again…!"
Here is best reply, in the words of Warren Buffet:
"The Dow averaged 5.4% per year during the last century despite two world wars and a great depression. To get 5.4% of gains per year, the Dow will have to end this century around 2 million. So you better get used to announcing these little milestones"
Happy Investing and Happy Compounding!
Let us run through history of MNC's in Corporate India...
1970's: Most MNCs came to the Indian equity market as ‘unwilling guests’ following a government rule that made it mandatory for Indian arms of the MNCs to list on local stock exchanges.
A rule in 1973 directed foreign companies to sell majority holdings to locals.
What that meant for the parent MNC's was sharing equity, ownership and profits made from business done in India.
While some MNC's like Coca Cola and IBM exited Indian shores, unhappy with the regulation; Others like Nestle and Colgate chose to list (making millionaires out of investors who bought shares back then)
1991: In an effort to revive the industries and the economy, the government began to open various sectors and invited MNC's to India, what was until then a more or less closed economy.
In what was to follow, a lot more multi national companies entered Indian subcontinent mostly by way of fully owned (100%) subsidiaries and some through partnerships.
To name a few: Nike, Coke, Adidas, Puma, Vodaphone, Nestle, McDonalds, Dominoes, Pizza Hut, Toyota, Mercedes benz, Renault, Volkswagen, BMW, Sony, LG, Samsung, Microsoft, Apple, Google, Motorola, Nokia, Citibank, Bank of America, Wells Fargo, RBS, AIG, Shell and numerous others in the pipeline as you read...the list is HUGE
However, the MNC's that chose to enter India between 1973 and 1991 had to part with their stake in the Indian arms by having to list shares locally. They sure had the early mover advantage compared to those that entered post 1991, but it still looks unfair in some sense.
With an end motive of globalizing, expanding business and making more profits, there was a natural conflict of Interest between the MNC parents and the minority shareholders in the listed Indian arms. It wasn't long before most of these MNC's had their minds working on how to address this and get a larger share (rather full share) in the business done through their arms in India.
In the scope of the law, most public listed MNC's have done one or more of the following:
1. Royalties
Fair enough, MNC kids paid Royalties on Sales for technology, RnD, brand value to the MNC's parents. Since Royalties are paid on net sales and paid as expense (before tax), this was a good way for parent companies to take home some money. However, since the regulations capped Royalty payments at 5% on domestic sales and 8% on exports, this strategy alone did not solve the problem for high IP / high margin products.
2. Buy backs, Open offers and Delisting from exchanges
A lot of MNC's did buy backs, made open offers to increase stake in the Indian arms (Many were even successful in delisting which meant converting into a private ltd (100% sub) just like ones that started post 1991)
A lot of MNC's looking for delisting, in fact suppress financial performance to keep the stock price low, so as to make a cheaper open offer.
It isn't a coincidence that the profits of Reckitt Benckiser jumped 12 times from 21 crores to over 252 crores in just 4 years of delisting since 2002
The delisting of Cadbury India was attempted at 500/- per share back in 2003. After an appeal for fair pricing of shares by some retail investors, the company was forced to revise the price to 1340/- (EnY has now recommended 1742/- a share)
Don't confuse this with an exit from Indian markets: For almost all of the MNC's, globalizing business and expanding to India and other countries is beyond question. In fact, several of these Indian listed subs already contribute significantly to the overall business and profitability of the parent company.
3. Dividend Payouts
This is a very popular method of taking home profits. Depending on needs for fresh investments and taxation laws, several companies paid out heavy dividends (high dividend payout ratio), hence taking back profits home. However, dividend had to be shared between all shareholders. (So in principal it did not change anything)
4. Importing parts or products from parent MNC company
A lot of companies chose to source the products or parts from the parents companies, as only a limited part of the sales of products manufactured in India could be taken back as royalty and profits had to be shared with the local share holders. (This was particularly true for high IP or high margin products)
How about listing parallel 100% subsidiaries for doing selected businesses (sounds unfair?)
June 2009: The government made it mandatory for all listed companies to have atleast 25% float in 3 years.
…so these MNC kids that were stuck in a limbo had to decide fast whether to make open offers and delist fast or to give up and dilute stake to 75%
What more… Investors started taking stock prices for these listed MNC kids up.. up.. up.. speculating open offers and a host of delisting's to happen. (some of the names include Gillette, Foseco, BOC India, OFSS, Honeywell Automation, BlueDart Express, Novartis, 3M India, Thomas Cook and several more)
While delisting may bring immediate gains, Investors will lose a big opportunity of being able to share prosperity in the long term. Moreover, with the ever increasing role of MNC's in Indian economy, a large portion of Indian Business is out of reach for the domestic investors.
2010: The RBI removed the upper cap on the royalties paid by companies to their parents companies. (Earlier the royalty payments for import of technology was capped at 5% for domestic sales and 8% for exports, while the royalty for using trademark/brand name was capped at 1% of domestic sales and 2% of exports)
Does this mean that these companies can now pass all their potential profits to their MNC's parents as royalties, pre tax.
Looks scary and off course unfair for the retail investor. [Yet another way of milking the investors :) ]
Last week, Maruti announced lower than expected profits for the quarter on account of higher "royalty payments" to the parent company. So was the case with the quarterly results of Hindustan Unilever. So the bad news for the retail investors has already started to reflect.
Are Royalties Justified ?
Off course! I don't disagree with the fact that the original inventor deserves a royalty/pie in the sales. (think of it as sharing the cost for RnD, technology and brand value/marketing)
Did you know, even Tata Sons charges brand name royalty to several Tata group companies.
(Sounds fair, as long as it is a common pool of money from group companies, which will be spent on group advertisements)
In fact, I believe the Royalties paid to various parent MNC's offshore should be counted as Imports (of technology, RnD and Brand Value), if not already so.
My ask from the government is for the protection of the minority shareholders. To ensure that these companies don't do the obvious (increase royalties, suppress performance and then do an open offer) One way this could be taken care of is by making an open offer at say 20% premium to the stock price before increase of royalties, so that the minority shareholders get a chance to exit at a fair price.
There is a certain good that comes out of the removal of upper limit on royalty payments: (more so, in context of listed MNC's)
- Incentive to manufacture/export products from India.
- High IP products can now be sold/manufactured/exported from India.
Given that the MNC parents can now take a fair share of royalties from the revenues from Indian operations, the manufacturing can now happen in India instead of sourcing of parts/products through imports. Further, manufacturing in most cases should be more economical given lack of transportation/import and lower cost of production in India.
In fact, India can be seen becoming the manufacturing and export hub for several of these MNC companies.
Coming back to listed MNC kids in India:
The pain that I face as an Investor though, is the complexity in predicting profits and valuations for these listed subs in India... amid these unknowns, changing policies, conflict of interest and in absence of a definite "beneficiary" of the company's growth and profits... it just adds to the component of "speculation" in making Investment decisions...
