The Investing Gift That Keeps On Giving

Albert Einstein is often attributed with calling compound interest "the most powerful force in the universe. " Whether or not he actually said it, the stock market really gives an incredible gift to investors who invest with a simple, three-step formula:

1. Buy companies with a history of raising dividends and the potential to continue doing so.
2. Reinvest those dividends, either in the company that paid them or another one with a similar pattern of dividend behavior.
3. Repeat until you're generating enough income from your investments to comfortably retire.

It works in the real world
This isn't merely an academic exercise; the benefits are there for those willing to put real money on the line. On Aug. 14, 2003, I invested $4,107.80 to buy 110 shares of Kinder Morgan Management (NYSE: KMR), one of the securities associated with the giant Kinder Morgan (NYSE: KMI) pipeline family. As of yesterday, that same investment had grown to 179 shares, valued at $13,469.75. Along the way, I added no new cash, simply accepting the shares distributed in lieu of cash dividends.

That investment has more than tripled in value in just over eight years, with a significant portion of that gain driven by compounding. In fact, 69 of those shares -- worth $5,192.25, more than my entire initial investment -- came from compounding. If you look at the components of that investment's recent total value, the majority of the returns came from that compounding. This table shows the breakdown:

Source: Author's calculations.

Sure, the stock has risen quite nicely over the past eight years -- especially considering the roller-coaster market we've had over that time. Still, that growth lags behind the compounding in terms of driving total return.

The accidental compounder
Initially, I hadn't intended to buy Kinder Morgan Management, preferring instead its sister security, Kinder Morgan Energy Partners (NYSE: KMP). As a limited partnership, Kinder Morgan Energy Partners itself pays a substantial cash distribution that has a history of rising, even back then, which made it initially look like an attractive holding.

But fortunately, a fellow Fool pointed out the risks of holding such a partnership in an IRA that dissuaded me from that idea. Limited partnerships like Kinder Morgan Energy Partners can generate something called unrelated business taxable income, which in high enough quantities can cause IRAs to owe taxes. As that would largely defeat the purpose of investing in an IRA, I looked more closely at Kinder Morgan Management -- a security designed to be more IRA friendly -- and liked what I saw, enough to invest.

Kinder Morgan Management derives its value entirely from the Energy Partners' business, and given its cheaper valuation and IRA-friendlier structure, it seemed like a great alternative. The automatic compounding that came from receiving the distributions as additional shares of stock? That was essentially an afterthought -- until the compounding really started kicking in. At that point, I truly appreciated it as the investment gift that just kept on giving.

Build your own compounding dynamo
Of course, most companies don't pay meaningful stock dividends like Kinder Morgan Management does. Most stock dividends are merely splits -- the equivalent of making change by turning a $100 bill into two $50s. But when a company pays you a standard cash dividend, you can reinvest it, either directly in that company or in another company that looks to be worth buying. It's that act of reinvesting the dividends that lets the power of compounding work.

Indeed, over time, the gifts from compounding can be tremendous. The chart below shows the beneficial impact compounding has had for a few key stocks over the past 20 years:

Data from Yahoo! Finance as of Dec. 22, 2011.

Of course, hindsight is 20-20, and it's fairly easy to pick out companies that have compounded well over history. But what makes these companies different is that 20 years ago, they had all already established themselves as strong dividend-paying companies. Indeed, each stood among the few that had already been paying higher dividends annually for at least 15 years. While nothing is guaranteed in investing, there is nothing quite like a supported and growing dividend to confirm a company's strength.

If you're looking to harness the investing gift that keeps on giving, companies with such strong dividend histories are a great place to start looking. After all, that's the basis on which all great compounding starts.