A 40-year comparison of two investors holding shares in The Mercantile Investment Trust highlights the dramatic impact compounding can have on a portfolio.
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If you start your investment journey while you’re working and earning a decent salary, the chances are that you won’t need to supplement your earnings with dividend income from your investments.
You might therefore opt for a growth-focused investment (a smaller companies investment trust, perhaps) that over the long term should deliver robust share price increases as the underlying companies prosper and grow.
Alternatively, if you choose a dividend-producing investment and reinvest the payouts as you go, you may well see the advantages of compounding at work over the decades.
How does compounding work?
Compounding is a simple but very potent phenomenon, and it kicks in when you set up your investment so that its regular dividend payouts are automatically ploughed back into the market and used to buy more shares, rather than being paid out as cash.
Those shares in turn generate additional dividend payments, which are themselves reinvested into further shares that produce further dividends; and so the compounding cogs turn quietly but powerfully through the years.
A real-life example
The best way to appreciate the power of compounding is to compare the long-term performances of a real-life income-producing investment with and without dividends reinvested, though it’s always important to remember that past performance is no guarantee of future returns.
In this example, we’re looking at the returns over 40 years of two investors, each of whom bought £1,000 of shares in The Mercantile Investment Trust (MRC) on 30 September 1984.
The Mercantile’s focus on high-quality medium-sized and smaller companies that have the potential to become tomorrow’s market leaders is a significant part of this story, because that’s the part of the market where the best long-term growth prospects tend to lie.
The Trust's managers are also looking for businesses with the capacity to generate strong cash flow, with the aim of paying inflation-beating dividends. That, of course, is where the potential for compounding comes in.
The yellow bars on the graph of MRC’s 40-year fortunes represent returns for Yasmin, who withdrew all the dividends she received over that 40-year period, while the blue bars show the value of Ben’s investment, with payouts reinvested (disregarding management charges).
Over the early years, there’s relatively little to get excited about as far as the reinvested dividends are concerned. In the first five years, Ben’s fund has inched ahead in value by just over £200; but against that, Yasmin will have had a roughly similar amount of extra cash to spend.
After 10 years, the gap opens up more noticeably. Yasmin’s investment is worth £1,714, a gain of over 70% in terms of capital growth – but Ben’s is up more than 130% at £2,336, simply as a result of reinvesting dividends and allowing them to compound.
As the decades pass, repeated compounding means that the differential widens quite dramatically. Ben’s holding is worth around 35% more than Yasmin’s after 10 years; after 20 years, it is getting on for 90% ahead, at almost £7,500 compared with £4,000.
On the 30th anniversary, the value of Ben’s shares is nearly two and a half times that of Yasmin’s investment. And by the 40th it is well over three times more.
In terms of hard cash, the differential is truly startling. Over 40 years, Yasmin’s £1,000 holding in MRC has grown to £23,500 – a 2350% rise.
That is a very respectable share price gain, reflecting real historical performance. It also reflects the potential of small and mid-cap businesses to grow, and the advantage of canny stock-picking in this less extensively researched part of the market.
But Ben’s £1,000 nest egg is now worth more than £75,000 – and that £50,000-plus difference is entirely attributable to 40 years of dividends being ploughed back into additional income-generating shares in MRC.
Of course, it is worth noting that this example assumes Yasmin and Ben held on to their shares for 40 years which may be longer than the typical holding period of such a Trust.
Dividend consistency counts
Of course, wildly fluctuating dividends from year to year will make compounding an altogether more unpredictable aspect of expected returns.
Conversely, the more reliable an investment’s dividend payouts are, the more secure investors can feel about the power of compounding to work its magic over the long term.
Investment trusts have an inherent advantage over open-ended funds in that respect, in that their structure allows them to hold back a portion of dividends received from the companies in which they invest, keeping them in reserve to top up payouts to shareholders in leaner years.
The Association of Investment Companies (AIC) recognises the importance of dividend consistency for investors, charting a select group of Dividend Hero investment trusts that have chalked up more than 20 consecutive years of dividend growth.
More recently, the AIC has started highlighting the ‘next generation’ Dividend Heroes with between 10 and 20 years of increasing payouts. That list includes The Mercantile, with 11 consecutive years of dividend growth under its belt¹.
When cash could be king
Of course, there are situations where ploughing payouts back into the market may make less sense.
People nearing retirement or approaching another major financial goal who don’t want the risk of short-term market volatility may well prefer to take dividends as cash, for example.
Even investors with a long-term perspective might choose cash distributions if they are keen to rebalance their portfolio because that holding has been particularly successful.
Conversely, if the Trust has chronically underperformed, dividend reinvestment might feel like throwing good money after bad; taking cash opens opportunities to invest in more attractive alternatives without chucking the towel in altogether.
The bottom line, though, is that for most long-term investors who don’t currently need the income and are happy with performance, it makes a lot of sense to reinvest dividend payouts into their chosen trust and let compounding get to work.
And if that trust has a record of robust long-term capital growth as well as reliable distributions, they should be particularly well placed to feel some considerable benefit in decades to come.