Compound Interest Phenomenon

General
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This compound interest phenomenon has been difficult for me to conceptualize. Exponential growth leads to problems with carrying capacity in the long run. For example, if a city’s population grows by 3% annually, the city’s population will double in 24 years. During that time, the capacity of the city’s housing, daycare centers, schools, and other facilities must double. The “Rule of 72” helps calculate the doubling time: divide 72 by your growth percentage to get the doubling time.

Stock investors are not content with 3% growth; instead, a bold 8% is often reported as growth. What company grows by 8%, especially in the long run? Let’s cherry-pick at this market peak. What is the company’s earnings per share growth rate over the last ten years (geometric growth)? I choose to look at earnings per share because it is the return received by the owner, independent of market speculation. For Kesko, it’s -1.12%. For Kemira, 0.85%. For Fortum, -5.58%. For Nokian Renkaat, 2.08%. For UPM, 8.58%. For Cramo, 1.21%. For Olvi, 6.58%. I won’t even mention the numerous companies where this compounding growth is double-digit negative. It seems that a company must consciously choose a strategy that increases shareholder value to achieve a good outcome. I understand that companies may have other ambitions. The purpose of a stock exchange listing may only be to increase stock liquidity or raise capital.

An important point is also that even if a phenomenon can be modeled as a geometric series, the nature of the phenomenon may not necessarily be this. Bacteria in a petri dish grow exponentially as long as the living conditions are suitable, but does it make sense, for example, to calculate the exponent of turnover as if past sales would generate more sales? I would like to ask, why is this compound interest phenomenon considered so significant by many, especially in stock investing?

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I’ve also been wondering why this is repeated so much. Fundamentally, it’s about larger capital growing more in absolute terms than smaller capital with the same relative growth. The compound interest effect itself doesn’t bring any added value to an investment. What’s essential is the growth rate and maintaining that growth rate.

If capital equal to the interest factor is removed from the investment as dividends, which is also praised, this effect completely loses its significance. What’s more essential is that all available capital has been invested to generate the best possible return and new capital.

Of course, it’s good to understand how growth is built, and an investment offering high growth will generate more in absolute terms in the future. Compound interest is just a theoretical model that models the significance of the growth rate for accumulating absolute capital.

A better absolute return can be obtained either with more capital or a higher growth rate. In the long run, the growth rate can be assumed to approach a certain value, so you get the best absolute return in the future by investing as much as possible.

Regarding growth figures, the most important factors for investments are company profits, and they can grow significantly faster than GDP growth. In addition, GDP per capita can grow considerably, so population size doesn’t have a direct correlation with stock returns. Of course, a larger population offers more potential. The most important factor in GDP growth is technology and the growth it enables.

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This was an interesting comparison. I see the situation where the bacterium is the stock, and the Petri dish is the entire market. If you look at one bacterium, its growth or contraction is not very significant when looking at the overall situation of the entire Petri dish. It would be absurd to claim that a single bacterium continues to grow indefinitely, as you described. The consumption of existing resources and technological advancements improve the situation of the Petri dish.

The great point of the compound interest phenomenon is that you only need to understand 1) buy 2) wait for growth 3) sell and back to step 1. Why wouldn’t there be growth in the future? I argue that it is purely human to want to grow and ensure a better life for future generations. There will always be temporary growth somewhere, but perhaps for fewer people in the future when resources and innovation are exhausted.

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One must also remember that growth is not always an end in itself for companies from an investor’s perspective. What is essential is how much return you get on invested capital. A zero-growth company can be a good investment if you acquire it cheaply. Growth should be examined in terms of how much an investor gets back from their investment. However, growing companies are often competitive and thus provide a good return on investment.

Innovations, however, cannot be exhausted as long as people’s intellectual capacity is maintained. Of course, there will be periods when innovations provide a better platform for growth and periods when no groundbreaking innovations occur. But development is constantly moving forward, creating better and more sophisticated products.

In economic growth, it is important to remember that it is a whole, and individual components cannot be viewed in isolation; they are linked to several other components. Additional money flows as a resource in the national economy, and for this reason, if added value is created somewhere, it accelerates the national economy everywhere.

For example: if you buy a bag of candy from a store, it indirectly accelerates China’s economy. It most affects the merchant’s paycheck, the manufacturer, raw material suppliers, and all employees involved in this chain. The increase in these participants’ monetary resources leads to additional consumption of other products. Through this, everything starts with consumption. If consumer demand can grow, then the economy will inevitably grow, and with it, companies.

If something were to happen that caused a permanent decline in consumption, the economy would not automatically grow. How many people do you know who wouldn’t want to consume more and who wouldn’t be willing to work for a better standard of living? Such people are quite few, so economic growth will remain on an upward trend in the long run, as will corporate earnings. It’s largely about the cycles in which growth occurs.

Capital, therefore, does not in itself bring more growth to a company. If the economic situation remains favorable, the generated additional capital flows through the national economy and creates additional demand for that particular company. A company’s growth also increases opportunities for investment, which in turn creates growth and eventually flows into the company’s demand. When such a similar cycle occurs throughout the economy, the economy grows and further fuels that growth.

Economic growth is, therefore, fundamentally about a positive cycle.

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Historically in the US at the index level:

Large cap ≈ 9–10% annual return
Small cap ≈ 11–12%
Quality small cap ≈ 12–14% (“high quality”, “high profitability”)

It sounds like a small difference.

But over nearly 100 years, an extra 2–4 percentage points of return leads to a massive difference due to the compound interest effect.

For example:

9% annual return for 98 years → approximately 4,700x capital
13% annual return for 98 years → approximately 160,000x capital.

In the US, supported by a nation of 340 million, small companies have the opportunity to grow into large ones quite quickly when they succeed. In Finland, unfortunately, small companies mostly remain small.

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A great, thought-provoking opening that I want to contribute to. I’ve waded through quite a lot of domestic investment literature and “bibles,” and similar thoughts have occurred to me. Firstly, it is quite difficult for people to understand and conceptualize potential growth; the brain somehow tends to function linearly.

You mentioned a few domestic listed companies in your text. Only a small fraction of stocks explains the bulk of the stock market’s returns. Furthermore, research shows a significant portion of returns is generated by reinvesting dividends back into the market. Kim Lindström wrote in one of his books that 20% of companies on the Helsinki Stock Exchange make a profit at all times. The remaining 80% post losses at some point, eating away at the compound interest effect and consuming capital for periods of time. In all honesty, there aren’t many high-quality companies on the Helsinki Stock Exchange, and if you add growth to the quality criteria, the options dwindle even further.

Stock market returns are not straightforward. You can get a return simply by selling at a higher price than you bought, and for that, all you really need is a buyer ready to pay more for the share than you did, for one reason or another. Usually, it’s enough that the future looks better than before. Another possibility is to estimate returns using the Gordon Growth Model to calculate the value of future dividends. If capital generates returns and is distributed as dividends, that also has value. One thing I feel people fail to understand is accounting for return on capital alongside growth. When you achieve high return on capital with high growth, the potential growth is staggering, earnings grow wildly, and the stock price will follow earnings sooner or later. Well, in the local market, there are few companies that consistently reach the “quality company” threshold of over 15% return on capital. Usually, people are digging through the “trash heap” below that level. Often, high return on capital is used more to defend one’s position rather than to grow aggressively and try to conquer the world. Quite frequently, return on capital is cyclical; a good return is only achieved during a favorable economic cycle.

Our domestic stock exchange is cyclical. The compound interest effect is best achieved by reading the cycle—buying at the onset of a cyclical recovery and selling when the trend begins to weaken—with the exception of just a few companies. But the advantage of cyclicals is that you can get multiple expansion, growth, and earnings improvement all at the same time.

In general, I think it’s interesting that when talking about the compound interest phenomenon and returns, people always talk about inflation-adjusted returns. Well, now inflation might be 3% in the future while you get 0.1-0.2% interest from a bank account. No value is given to that “non-disappearance” of inflation.

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The compound interest phenomenon occurs when you reinvest the annual returns you receive.
In other words, you have your initial capital plus the first year’s interest, which is then reinvested. Because the capital increases, the amount of interest earned also increases every year. You can plot how a €1,000 principal grows over 10 years with a 5% interest rate if you spend the annual interest, and then plot a scenario where that interest is reinvested every year at the same rate of return. The interest starts earning interest as well..