Power of Compounding: How to Turn 10 to 20 Dollars Into More Money
A Parable About the Power of Compounding
I received a message from a small business owner who operated a Dairy Queen franchise. She insisted that someone in her situation could not become wealthy due to the nature of the business. The following is my response.
Imagine that in 1950, a family just like yours in the United States bought a Dairy Queen franchise. We will call this family the Smiths. They set up a tiny business called Smith Family Holdings to operate this franchise. Their small company provides a comfortable living.
Through years of hard work, it becomes ingrained within the fabric of the community, representing all that is good and right about small-town America. There never seems to be a lot of money left over, but it does put food on the table and provide employment, making it worth the trouble despite the accompanying headache of employees, insurance, and capital expenditures that are an inevitable part of owning a small business.
A Small Investment Grows Quietly
Mr. and Mrs. Smith decide they want to invest for their family's future but they don't know much about finance or the stock market. Following the advice of some of history's great investors, they look at what they understand. They began to poke around their business and research the companies that provided them with the products they resold to their own customers.
The Smiths realize that, in the ice cream industry, most of the candy toppings are produced either directly or indirectly by two firms: Mars Candy and Hershey Foods. Snickers, Reese's Peanut Butter Cups, M&M's, Butterfingers, Baby Ruth, and a whole host of related toppings provide the perfect flavor for their customers. These products also sell well in local supermarkets, movie theaters, and gas stations. Mr. Smith figures that if someone loves Snickers bars, he or she isn't going to suddenly stop eating them because they are an affordable luxury.
Unfortunately, Mr. Smith discovers that Mars has always been, and remains, a privately owned family business so he can't invest in it. Hershey Foods, however, is very much public. The Smith family decides to set aside $10 per week, which is all they can afford.
They create a small family retirement program and enroll in the Hershey Foods direct stock purchase plan, which allows them to buy shares for little or no commission directly from the company (virtually all major corporations have these programs, though most new investors don't know about them because brokers want to get the commission on trades). They always reinvested their dividends.
The Smith family goes about their business and upon the death of Mr. and Mrs. Smith, the family business gets passed on to their two children, a daughter named Susie Smith and a son named Walter Smith, who continue to run it.
The decades pass, children are born, family members die, fashions change, and the world keeps spinning. All the while, this tiny Dairy Queen franchise in the middle of America continues to provide a decent living for its owners, who are thoroughly proud, hardworking, honest folk.
Without fail, though, for all of those years, the original Mrs. Smith continued to write the $10 check each week to the Hershey Foods stock purchase plan. After her death, her daughter, Susie Smith, took over responsibility and wrote those checks. They never increased the amount saved each week, meaning that the $10 now represents less than the cost of a single movie ticket.
Since it was part of a retirement plan owned by the company, neither Susie nor Walter Smith paid much attention to the Hershey stock account their parents had originally set up all those years ago. They figured that $10 a week was small, so they hoped that any extra left over when they retired and sold the Dairy Queen would be a nice bonus; icing on the proverbial cake, providing a little extra security.
The Power of Compounding
One day, Susie and Walter, now middle age with their own kids, decide they can't run the restaurant anymore. The capital expenditures continue to increase, they don't want to commit to a new business loan, and they feel that it is time to move on and start anew. They meet with the accounting firm that worked with their parents for decades and begins the liquidation process.
After paying off their bills and debts, the two are left with a bit of money, $50,000, mostly representing the equity in the real estate. Other than the jobs the franchise provided the family members, there isn't a lot to show for years of effort and hard work. With a mix of sadness and relief, this chapter of the Smith family has come to a close. Walter and Susie figure they will split the $50,000, each taking $25,000, and be done with the restaurant business forever.
They go to meet with the accounting firm that handled their parents' estate and business since the very beginning. They take their $25,000 checks and get up to leave. As they stand to walk out of the office, the accountant looks confused. "Where are you going? We still haven't discussed the retirement plan!" he says to Susie and Walter. Thinking of the tiny weekly contributions, Susie responds, "Just sell everything, liquidate it, and send us a check for whatever is in there. It can't be much."
The accountant goes over to a file cabinet, pulls out a statement, and hands it to her. As Susie looks down at the page, she does a double-take. The Smith Family Holdings retirement program, which never received more than $10 a week in contributions, now contains 226,040 shares of Hershey Foods stock. At $47.20 per share, the value of the family's holdings is $10,669,088. Hershey pays an annual dividend of $1.28 per share, so the account is earning $289,331.20 pre-tax each year, or $24,110.93 per month, which is being plowed back into the plan to buy even more shares of Hershey.
"How could we not have known about this?" Walter demands. "Well, due to the fact the investments are held by your company, Smith Family Holdings, and it is a retirement plan, none of this income or wealth ever showed up on your tax returns. Your parents didn't want to liquidate the account because they would owe taxes on the withdrawals. They figured the longer the money was left undisturbed to grow, the better for the family."
The Moral of the Story
The point of this story is that, given enough time, small amounts can become great fortunes due to the power of compound interest. Stocks, bonds, mutual funds, real estate, options, original artwork, car washes...these are nothing more than vehicles that allow you to grow your money.
Any small business owner who has even a few dollars left over at the end of the week is holding the power to become wealthy in his or her hands. It just comes down to the rate of return he can earn or the length of time he can let the money grow, undisturbed. It isn't rocket science.
What I Would Do
If I were in the original position of Mr. and Mrs. Smith, I would have established accounts with several dozen companies that I understood—Hershey Foods, PepsiCo, The Coca-Cola Company, Tootsie Roll Industries, and H.J. Heinz, just to name a few. I would then treat the weekly savings as a bill that had to be paid. If necessary, I would pay it first and push the other bills (I'm not kidding—the electrician would just have to wait to get paid).
Imagine if the Smith family all had outside jobs and worked in the restaurant for free. They could have taken their salary and written a "paycheck" to their direct stock purchase plans. In that case, the family would have been worth more than $100 million.
This is one of the reasons that I have never taken a single penny in salary or wages out of the operating businesses I own. Everything gets reinvested and I live off royalties from projects I created back during my college days. We live in the greatest market-based economy in the history of human civilization. Anyone who wants to has the power to become rich. It may not be fast, but it is simple.