Joshua Kennon » warren buffett

Coco Chanel Only Owned 10% of Her Business – Intelligent or Stupid?

Joshua Kennon — Thu, 22 Jul 2010 04:48:58 +0000

As she grew more successful, Chanel resented the deal she had struck with Pierre Wertheimer, so following a dispute in the perfume business, he increased her equity in the House of Chanel.

I am going to start reading several biographies of Coco Chanel before long, so I made a run to a department store today to pick up some Chanel products (I have a habit of wanting tangible representations of whatever I’m studying around the office, which is why we need “investing cabinets”, which contain things like miniature Hershey Chocolate trucks and replicas of Wal-Mart Supercenters from whenever we were buying shares in those companies years ago … it is a way I make the money “real”).

Turns out, Coco Chanel only owned 10% of her business! She was backed by financier Pierre Wertheimer, who was in-law to the famous Lazard family of bankers. An unknown seamstress, Coco needed Wertheimer’s expertise, American business connections, and capital so the Chanel company partnership equity was owned 70% by Wertheimer, 10% by Chanel herself, and 20% by Chanel’s friend, Théophile Bader.

Today, the business remains privately owned and firmly in the hands of Alain Wertheimer and Gerard Wertheimer, the great-grandsons of Pierre Wertheimer. Both are listed on the Forbes 400 list of global billionaires.

Should Coco Chanel Have Given Up 90% of Her Stock?

It is easy to criticize Chanel for giving up so much of the equity in her firm, but at the same time:

She maintained exclusive creative control, which was what mattered to her.
Without the Wertheimer money and network, it is likely she would have died in obscurity, the name Chanel never coming into the lexicon as the embodiment of haute couture.
She also ended up wealthy herself, and got to do what she loved.

Diamonds vs. Rhinestones

Sometimes, it is better to own 10% of a diamond than 100% of a rhinestone, as Buffett has said.

Today, by partnering with the right people, the House of Chanel dominates fashion, perfume, watches, and more.

My father once worked for a sporting goods company that, I know for a fact had they given him equity, he would have focused on building for the rest of his life. When the existing owners didn’t, he quit and started his own firm. The cash that flows through his business now would have been part of the sporting goods store and everyone would have benefited and grown very rich.

Instead, because they didn’t want to grant him a 1/3 of the business ownership, he went off on his own with my mom and they now own 100% of their own corporation. In that case, the owners of the sporting goods store would have been better off diluting their equity stake but they didn’t.

That single decision has cost the sporting goods store owners millions upon millions of dollars over the past ten years (and I don’t even want to speculate about the next 10 years!).

On the other hand, Rockefeller, Gates, Buffett, Ford, Carnegie, and others grow obscenely rich because they wouldn’t part with shares under any condition during the early years of the business.

What, exactly, is an entrepreneur to do?

I say the general rule is: Keep as much equity as you can. Fight for every percentage point. But be smart enough to know when to bring the right people on board because a business is the people who run it. Management is the ultimate talent. Your company will only be as successful as the people who are behind the wheel making the decisions about where to drive and what to avoid.

In this case, I think Coco Chanel was probably doing the right thing. She achieved everything she desired and lived the life about which she dreamed, getting very rich in the progress. Should she really be concerned someone else got richer by helping her? Envy just doesn’t make sense.

Limited Liability Companies LLCs vs. Limited Partnerships LPs

Joshua Kennon — Sat, 26 Jun 2010 18:29:59 +0000

I am in the process of publishing several dozen new investing articles about limited liability companies and limited partnerships over at About.com, a division of The New York Times.

The idea came to me a few weeks ago when a reader wrote and pointed out that millions upon millions of people will never own a share of stock or a bond but they will invest with their families in a small business, a hedge fund, a private equity fund, or a pooled investment account. From a tiny corner drugstore to a special real estate project, limited liability companies and limited partnerships are the legal structures through which those investments should be held, in most cases. When families opt for them, they can enjoy tremendous tax benefits, legal protections, asset secrecy provisions, and more, especially if using a so-called Nevada LLC or Delaware LLC.

After all, Warren Buffett used a limited partnership when he pooled money from friends and family back in the 1950’s in Omaha, Nebraska. His limited partnership agreement called for a percentage of the profits over a certain hurdle rate to be counted toward his account. It really wasn’t as complicated as people think. In fact, with the right attorney and accountant, it would be theoretically possible for a family to pool its money in a matter of weeks and be fully operational, acting from a single, consolidated entity.

In my own life, I tend to use limited liability companies that are manager-managed (as opposed to member-managed, which I explain in the new investing articles). That is because as most of you know, I don’t have any day-to-day role in the companies because I am an investor, not an operator. I can identify great prospects and fund them, but as for running the businesses, that isn’t where my heart or desire are. I could have just as easily have used limited partnerships but for the types of assets I hold right now at this juncture in my career, the limited liability companies made more sense for a variety of reasons.

For more information, head on over and check out the content, which I’ve linked to throughout this blog post.

Thanks a Lot, Greece … Bought Some More Berkshire Hathaway

Joshua Kennon — Tue, 04 May 2010 17:55:29 +0000

As a result of the Greece debt crisis, stocks crashed today. The accounts are down roughly 3% to 4% and it’s only noon in the Midwest.

We went back for another round, purchasing more shares of Berkshire Hathaway this morning for the reserve portfolio, which comes on the heels of our acquisition last Friday. I’m going to be genuinely surprised if 10 to 15 years from now, when/if Buffett is gone (God willing, that won’t happen for a long time), the company hasn’t gone into full maturity mode and begun distributing substantial cash dividends. In other words, I expect the money we are allocating to Berkshire today to end up being a big cash income dividend producer in my 40’s.

The reason is fairly simple: Berkshire generates $9 to $10 billion in net cash per year, even after its reinvestment needs. Now, Burlington Northern Santa Fe is going to provide a home for some of that money, but let’s say cash flow grows at a 10% steady rate for the next 20 years. The company will then be generating $60 billion to $70 billion in annual net cash. There aren’t enough businesses in the world to absorb that kind of earnings power unless you want to park it all in Treasury bills, which isn’t going to happen. Berkshire could either devote itself completely to stock repurchases (which would be fine) or cash dividends.

As a general rule, when we buy Berkshire Hathaway shares, we tend not to sell them unless there is something that is really attractive in the actively managed portfolio and we need more cash. It will be fun to see how much we’ve acquired decades from now. I rather like the idea of huge dividend checks providing me a stream of earnings for redeployment coming from the conglomerate I admired as a child.

The Success of the iPad Will Come Down to App Development

Joshua Kennon — Thu, 08 Apr 2010 01:57:06 +0000

After 5 days with the iPad, I can tell you it is not hyperbole ... the iPad is going to revolutionize business and personal computing. Those who point out there are more powerful tablet PCs are making the same mistake Steve Balmer did when he said the iPhone would fail because it lacked a keyboard. They are missing the point. I have a maxed-out Power Mac with two (2) 30" High Definition monitors that could process videos for Pixar and yet I still have switched to the iPad for all of my reading needs. And I love paper and pen ...

Five days or so into my experience with the iPad and it continues to exceed expectations (by far). I’ve spent somewhere between $120 and $150 in the Apple iTunes App store, which compared to my previous purchases of apps (read: $0), means there is more cash flowing into Steve Jobs’ coffers. The overwhelming indication continues to be that the success of the iPad will come down to the applications that software companies develop for it. We bought our iPads for business purposes. As an Internet company, the easier we can access data, the better we can respond to customer needs.

Business Productivity on the iPad

The main benefit of the iPad is it allows us to monitor profits, costs, bills, and customer messages in real-time across all of our businesses. I can see, quite literally, sales flow into our sporting goods business or baby retailer as I sit on the balcony drinking coffee and listening to Coldplay’s Viva la Vida (which I’ve had on repeat all day). I can monitor our investment positions and submit complex options positions with a few clicks (er… taps). It has allowed me to get up from my desk and spend time elsewhere, greatly improving the quality of life.

If I’m already using the iPad to revolutionize our trading and investing positions, can you imagine when software companies develop high-end apps that allows medical records to be wirelessly access by doctors or nurses? What about lawyers that can access case law databases?

Books on the iPad

The Apple iBook store can be great. It’s just not there, yet. There isn’t nearly enough selection, especially when compared to the Amazon Kindle (which explains why I use the Kindle app and buy books from Amazon for the iPad). I should have the ability to print directly from the iPad any page I’ve noted, complete with my markups. Imagine what that would do for business productivity.

Games on the iPad

On the gaming front, there are a lot of things that could make the iPad a game changer. For example, if Square-Enix were to release the Final Fantasy games up through FFIX, I’d buy them in a heartbeat, no questions asked. If I can play Monopoly with my family members wireless over a network connection, regardless of physical distance, I’d be thrilled because it would be another way to spend time together.

Why would they create for the iPad instead of sticking to an existing gaming console? Because the iPad will be with me for business purposes all the time. That means I can take a break and play a game of Peggle without taking out a separate machine. No one would think twice about a guy in a suit on an iPad but they would do a double take on a PSP or a Nintendo DS. It is a chance to access a much larger audience that has the ability to make impulse purchases.

Only a Fool Would Think the iPhone Makes the iPad Redundant

After only a few days with the iPad, I can tell you it is nothing like the iPhone. I’m not going to type on an iPhone or use it for apps. I didn’t buy very many games. I can actually work on the iPad. I can read the blogs, check the news, and monitor stock prices. I can update my calendar, watch videos, or send email.

The iPad is used most often where a MacBook Pro would have been but wasn’t convenient. I’ll still keep the MacBook Pro (in fact, Apple is supposed to be releasing an update to the MacBook Pro line this year), but the iPad is what I want to grab if I’m running to Panera for lunch or going to go out to dinner and want to be able to read through 10K reports. Now, instead of taking a briefcase with me, I can just bring the iPad.

In fact, I’ve already begun the process of organizing and updating my rare PDF files, including copies of Buffett’s partnership letters (which aren’t publicly available) and Ben Graham’s reports to his stockholders. As soon as someone gives me a PDF reader with strong highlighting abilities, note taking, underlying, and printing capabilities, I can get rid of most of the office. Imagine having 20+ years of annual reports on demand, with a click of the button.

The Best Habit I Have …

Joshua Kennon — Tue, 30 Mar 2010 22:58:29 +0000

Charlie Munger said that he has never known a wise or success man that has stayed that way for very long unless he or she was a voracious reader and synthesizer of knowledge.

Another batch of books arrived from Amazon.com following my book buying binge at Borders the other night. That’s typically how it goes, though … I buy a few dozen books at a time, mostly in business, philosophy, psychology, investing, finance, history, and biography (all non-fiction – I’m not a big fiction reader).

Early in my career, books were my biggest expense. When my first business was making only $500 a month in profit, I probably spent $250 of it on buying books to learn. Today, I still try to buy a copy of anything that I think could teach me something or present a different opinion on a topic such as a political issue. I never presume that I am always correct and I attempt to “destroy my own best ideas”. By arguing against what I believe, and finding problems with a given thesis, I can better understand if my beliefs are rational and the best available option.

It could have to do with the fact that when I was much younger, I wrote a letter to Warren Buffett asking him a question. He emailed back through his secretary, Debbie Bosnak, explaining that most everything he knew came from self-taught reading and study. Even today, a single good idea from a book can help make huge profits for us because we look at the problem a different way.

The whole company is designed so I can sit in a room and read, drink coffee, play video games, or do whatever I feel like at the time. To this day, opening these packages feels like Christmas morning, even years after I can afford almost anything I want. It just doesn’t get old.

(Thank God my habits are relatively cheap … some people are addicted to cocaine and hookers.)

Precious (Based on the Novel Push) vs. The Blind Side

Joshua Kennon — Fri, 26 Mar 2010 20:01:29 +0000

Mo'Nique was nothing short of genius. She made you believe that she was this character, twisted and sadistic, just as Anthony Hopkins does as Hannibal or Meryl Streep does in her films. It was a privilege to see her play the role. I cannot praise her highly enough. It was just ... remarkable and excellent. She is the only reason to see the movie. You have to watch it just to admire her work. Few people can call themselves actors or actresses (most are cheap entertainers). Mo'Nique is an actress, practicing a craft. I had no idea the depth of her talent.

Tonight, as I worked, I rented and watched both The Blind Side with Sandra Bullock and Precious on iTunes due, in part, to the Oscars that I watched with Ruby a few weeks ago. There is no question that the Academy got the votes right. Sandra Bullock deserved to beat Gabourey Sidibe who, to be honest, only gave one great scene (the final one in the classroom). As a supporting actress, Mo’Nique was brilliant. I mean, absolutely, unbelievably genius (and I don’t use that word lightly). We’re talking Meryl-Streep-good. You believed that she was a sadistic, sexually abusive, pathetic, twisted bitch of a mother that was not only mercurial and tempestuous, but devoid of virtually any good. She unquestionably deserved to win an Academy Award and it was a privilege just to watch the performance. She created art.

As for the narrative itself … it sucked. I expected far more, especially with the work normally put out by Oprah Winfrey (The Color Purple) and Tyler Perry (I generally like anything he does). The directing style of Precious resulted in you feeling almost no emotional connection or empathy for this character. About twenty minutes into the film, I realized why the lead actress didn’t win the Oscar, instead bowing to Sandra Bullock, who you could not help but love (she also has the regional accent down and it made me feel at home!).

We Always View Literature, Art, and Film Through Our Own Experiences

There is no doubt that my own background influenced how I saw the film. I mean, you have to remember that as a child, I was wired differently. When I realized that I wanted to become rich and successful, I walked to the library and taught myself finance, investing, web coding, and a host of other skills over the years, which cost me most of my youth. I was built to “do it myself” if no one would help me, as the Little Red Hen would say, so it is incomprehensible to me as to how someone could take that kind of pain for so long.

As we watched Sandra Bullock in The Blind Side, the most repeated comment was that her personality was me in a dress (especially when she walks to the front of the line in the social services office and asks who is in charge before her speech). She just takes control of life and (to borrow from the Nike slogan), just does it. You could take everything away from her and within a few years, she'd have it back through hard work, relentless drive, and an almost titanium will.

Part of this could be genetic. It was one of the greatest gifts I was given from birth – a mix of megalomaniacal self-confidence tempered by the Fear of God. Here’s a story to illustrate: When I was a child, my parents and brother once asked me, “If your hero, Warren Buffett, looked at you and said that you would never be successful in finance, wouldn’t that crush you?”

And without hesitating, somewhere deep inside of me, I looked back at them and said, “I would think, ‘You’re a f*cking idiot, Warren. You’re my hero but your expertise does not extend so far as to tell me what I am capable of achieving.’”

My family didn’t use that kind of language, so a sentiment that strong was almost like a chemical reaction. I fundamentally believed in betting on myself, even against the opinions of people that I practically idolized. That’s why I say I cannot take full credit for what I have in my life. Part of it was the personality that God gave me, over which I had no control. It was an asset on my intellectual balance sheet that I leveraged to achieve a lot of other things. I never had low expectations for myself. It all goes back to the swing set on the playground in third grade (those of you who know me know what I’m talking about … it was a life changing moment).

That is why, as I’m sitting there watching this movie, I’m thinking, “Dreams don’t do it. Dreams won’t get you out of there. Get off your ass and go DO something. Run. Don’t look back, just run.” I mean, DEAR GOD, she lived in the middle of a major city. She could have secretly dropped out of school, got her GED part time, worked as a cashier, and put aside at least a few thousand dollars at a hidden bank account halfway across town that no one knew about … or better yet, a safe deposit box.

An Honest Reflection of My Feelings

And I’m going to be honest about something that won’t be popular to admit (but the truth is the truth). As the movie went on, I began to feel disgust at the eponymous Precious for just sitting there and taking it. Joan of Arc conquered Europe at 14 years old despite being just as poor, brutalized, and called a witch … Precious was two years older! As the film progressed, I felt more and more disgust. I began to loathe her, her family, her community, and her life.

It was the exact opposite feeling I had about Michael Oher in The Blind Side, who was this remarkably virtuous character that had managed to stay good despite a horrific childhood.

These two people were night and day. You look at Precious and you want nothing to do with her, her life, her choices, her pain … you look at Michael and you feel this sense of conviction – if he can persevere, and overcome, what excuse do I have? Michael made you want to be a better person. Precious made you want to build a wall her neighborhood, cut off the tax-funded food stamps, throw your hands up and leave. I’d be lying if I said otherwise, and I don’t lie. It’s just not something I do.

Michael Oher made me want to change the world. Precious made me want to give up on humanity, surround myself with other highly educated, wealthy people, and make sure our children are better off and never suffer that fate. They could not have elicited more dichotomous reactions.

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I Finally Understand Buffett’s Comment …

Joshua Kennon — Wed, 17 Mar 2010 23:50:27 +0000

This is what I do all day. This is also what I do on vacation. I love learning so my life has been arranged around having as much time as possible to read, study, think, and invest.

When I was a kid, I recall watching a recording of a speech Warren Buffett gave to a college group and he said it would be incredibly boring to watch him work if you had the opportunity to observe Berkshire Hathaway for a day. When I began building my company, Aaron and I wanted a system put in place so that we could do nothing but read, study, invest, and play video games as we earned ever-increasing sums of cash from our holdings. That was the mandate.

A few minutes ago, I was having an absolute blast reading a survey on the spending habits of America’s ultra-elite and found it amusing because, true to form, 43% of those with $5 million or more in liquid assets say their favorite store is a tie between Costco and Nordstrom’s. Yes!

So, anyway, I’m having the intellectual equivalent of a rave party here and I realize, this is what it looks like to the outside world …

Buffett was right, yet again.

The point is, you need to arrange your life. Don’t do what other people tell you should make you happy, focus on finding something you love – a process that makes you want to jump out of bed in the morning – and then figure out how to make it pay well. There are people who are paid to bake cupcakes, people who are paid to have sex, people who are paid to test roller coasters, people who are paid to design dresses, people who are paid to build houses, people who are paid to help children learn to read, and people who are paid to play sports.

Money alone cannot be your primary motivator because your inner drive will be worn out by the day-to-day grind. If you were to offer me a $40 million contract to play in the NFL for a year, it would take less than a nono-second for me to tell you there isn’t a snowball’s chance in hell of that happening. I would literally shove the contract back in your face. I know myself well enough to know 1.) that’s not where my talents lie, 2.) I like being the best in my field, which isn’t going to happen in football, and 3.) I’d be much happier doing something like being a professor of finance at a respected college for $85,000 per year, taking the salary and investing it in hotels or stocks or car washes so that decades from now, I’d have the $40 million, anyway.

Know thyself. Life is too short to spend time doing things you hate.

We’ve Finally Settled on a Course of Action for Kennon, Green & Company

The Housing Crisis Isn’t All Bad …

Joshua Kennon — Tue, 09 Mar 2010 19:26:42 +0000

For every $1 in home value lost by a seller, there is $1 saved by the buyer. No one is talking about this, but the housing crisis represents a massive transfer of wealth to the younger generation (35 years and under) from the older generation.

As Warren Buffett pointed out in this year’s letter to Berkshire Hathaway shareholders, for every house that falls in value and pushes one family into bankruptcy, another American family benefits from the lower prices as new households are created due to the younger generation graduating from college, settling down, and moving out of their parents’ houses.

So, the 50 year old that lost all of their home equity is in trouble, but the 22 year old getting married now has much more affordable housing options available, resulting in more cash in his or her wallet each month. As Buffett put it:

Prices will remain far below “bubble” levels, of course, but for every seller (or lender) hurt by this there will be a buyer who benefits. Indeed, many families that couldn’t afford to buy an appropriate home a few years ago now find it well within their means because the bubble burst.

No one is talking about that, though, because it’s somewhat harder to measure. This is my point when people talk about being at the mercy of the economy … I don’t buy it because there are always intelligent things to do. If you thought housing was going to fall years ago, you could have shorted the housing market index or construction companies. I read one account the other day where some of the nation’s top home builders sold everything they owned, approached the private wealth management division of UBS, and put their entire net worth in high-grade bonds. The newspapers were full every day of headlines screaming, “Housing hits new high!” How many people took advantage of it?

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Our Investment Research Process

Joshua Kennon — Mon, 08 Mar 2010 21:58:30 +0000

A week or two ago, I wrote an article called Understanding Stock Repurchase Plans for About.com, a division of The New York Times, which discussed Sonic Restaurant and the massive stock buy back program that had taken place over the past few years. I walked the readers through a lot of the math and explained that I had purchased a couple hundred shares to watch and monitor the stock through one of my companies, Mount Olympus Awards, LLC. (I’ve since increased it to about 500 shares to continue watching and waiting to see how events unfold).

Here's a shot from my iPhone of a typical investor packet cover sheet, in this case the one for Sonic Corporation that was used when I wrote my report on the share repurchase program for About.com.

Some of the readers wanted to know how I read a stock report or analyze a company. Buffett often jokes, “Well, I start at the beginning and work my way through the end.” There is a lot of truth in that. Still, I thought it might be helpful to include some details on the process by which I put together our research.

How I Structure the Investment Files or Packets for Each Company

In terms of specifics, I often have an what we call in-house an “investment packet” or an “investment file” constructed on companies that have passed an initial screen or have piqued my interest somehow. (The initial screen consists of things that I look for in potential investments such as low valuation relative to historically high returns on non-leveraged assets).

This packet contains several things:

A full version of the most recent 10K filed with the Securities and Exchange Commission
A full version of the most recent proxy statement
A full version of the most recent two or three annual reports
A written transcript of the most recent few conference calls with Wall Street management has given
A copy of reports regarding the company from Value Line, Morningstar, and S&P; typically, the value line report gets bound or stapled on top of the entire packet and used as a cover sheet.

Sometimes, I know I’m not interested in a company as an investment within a few minutes. There have been firms in the past where I threw the report across the room because it was so offensive in terms of how management was handling shareholder capital or the risks that were buried in the 10K.

I’m Looking for Returns on Capital, Valuation, and Lurking Risks

One of the main purposes of investment research is to uncover lurking risks. A lurking risk, as I call it, can come from anywhere. For instance, some companies have their debt insured and if the third-party insurer is downgraded, the company itself would face a default event and be forced to pay back all of its long-term debt immediately, potentially causing bankruptcy. You clearly need to know about the health of the third-party insurer, in this case, before you could make a decision on the valuation of the stock you are analyzing. Sonic Restaurant is one of these.

If a company still interests me, I may read 200 to 300 pages on it. My work is made much easier if it’s an industry I understand thoroughly (like property and casualty insurance where reading loss development tables and studying deferred acquisition costs for GAAP accounting vs. statutory accounting doesn’t require a lot of mental lifting because of my background). I tread much more carefully if I do not have a detailed history with an industry, such as a company that manages a fleet of ocean liners and shipping boats I read a few years past.

We have rows of file cabinets filled with stock reports, 10K filings, proxy statements, conference call transcripts, and other data for us to pull on the companies we monitor. It makes it easy to go back and see what we had written and concluded about a company years before to provide a narrative in historical context.

Once a decision is made, we typically move quickly. We have a system that allows me to monitor most of the family’s accounts across the board and with a few clicks from a secure terminal, we enter orders and trades are executed. Back when General Electric was at $6 per share and we were buying it by the bucketful, it took under a few minutes to have the system executive trades for our business accounts, personal brokerage accounts, and retirement funds, with the shares allocated appropriately. The same goes for building options positions such as LEAPs, which we used extensively during the crash.

As you read the article, please keep one thing in mind: I absolutely am not recommending any individual stock and my personal exposure to Sonic, as I mention early on in the piece, is thus far limited to a small five hundred shares so I can watch, and wait, for further developments to unfold. This merely provided me with the perfect real-world case so I could point out how these things look when they actually come across your desk, instead of being in a textbook or theoretical. If you are just starting out as a new investor, it should help you understand the concept of stock repurchases better. I may sell those shares a few months from now, or buy massive blocks of additional shares to create a real position of consequence. Either way, I’m not going to update what I’m doing with it because it is merely the vehicle through which I want to explain this important concept to you. Don’t get hung up on the business itself.

The 5 Levels of Building Wealth

Joshua Kennon — Tue, 02 Mar 2010 19:07:53 +0000

When I was a child, I would read Scrooge McDuck comics by Carl Barks and Don Rosa. I realized that, while everyone else worked, Scrooge owned everything from the banks to the ice cream factory and the profits kept rolling into his money bin day and night. I realized that's how I wanted my life to be so I could focus on doing the things I enjoy and can give a lot of money away later in life.

Early in life, I developed a theory that there were five levels of building wealth that most self-made men (and women) go through to reach financial independence. It was started by my love for Carl Barks Scrooge McDuck comics. When I started reading the Federal Reserve reports of consumer wealth, empirical studies, and other sources of data, and discovered that 90% of those in the United States who are millionaires made the money on their own - that is, they did not inherit it – I started refining my theory. It helped guide me when I lived in a series of small towns throughout my childhood, saving nearly every penny I could from working after school and pouring it into my investments.

Level 1. A hard working man gets a job in construction and is paid by the hour. In effect, he sells his time in exchange for a set rate. When he is done, he collects his wage and that is it. He will never again receive a penny unless he agrees to sell more time to someone else in the future. He is always at the whim of the economy and an employer.

Almost all millionaires started here because 90% of high net worth individuals in the United States came from those who inherited little or no money. The only way to ever make a decent living from this level is to increase the rate at which you can charge for your labor. By going to law school, medical school, or business school, someone can demand $100 per hour instead of $9 per hour working at a discount store because their skills are harder to find (rarer) and in demand by the public. The term “wage slave” has been used to describe this level.

Level 2. The hard working man takes some of his savings, built up by spending less than he earned over several years, and starts a new limited liability company to hold his investments. He contributes the money to purchase the materials to build a house. He works on it himself to lower costs or, if he doesn’t know construction, hires someone. He rents the property out to tenants. Whereas at Level 1, he could only hope to make money from the time he spent on the project, he will now begin collecting rental income that will flow into his household’s income statement every month for years, if not decades, into the future barring some unforeseen disaster. That is, he is collecting cash each month even if he doesn’t get out of bed in the morning.

Most people never get to this stage because it is difficult to have the discipline to save money and come up with enough money to get off the ground. It’s a painful, slow process that can cause a lot of burnout, especially if you have no one to guide you and show you how easy it can be. Instead, they give up and stay at Level 1 forever, always worried about hanging on to employment or making enough to cover the monthly bills.

There is a "tipping point" that is reached when you're building wealth. The first $100,000 in savings is the most difficult, painful, horrible experience for most people because your money isn't big enough to start earning money for you. If you can get beyond that threshold and start collecting cash generating assets, no different than someone collects stamps or baseball cards, the rest will take care of itself. Your job then becomes risk management.

Level 3. The tipping point is reached when the hard working man no longer needs to live off the rental income generated from the property. This means that he is contributing savings from his job as a construction worker plus the after-tax earnings from his rental house to his limited liability company. Before long, he is able to construct or purchase a second property. Suddenly, like a tree planted in a field, the first young oak tree, which began as a sapling, begins to throw off acorns. The wealth is still small, but it’s becoming self-generating and that is the key.

Level 4. Through years of reinvestment, pouring more money into his investments, and intelligently putting money to work at the highest risk-adjusted rates of return, the small limited liability company our hard working man founded now generates so much money that he can write checks for new properties, hotels, car washes, or whatever else he believes will generate a decent return out of the annual after-tax profit. Should he choose, he could live off the income generated from these investments without ever working another day in his life (that hardly ever happens because, as I told you yesterday, once you get to this stage, business should be fun or you’re doing something very, very wrong).

Financial independence has finally been reached. The hard working man can give shares of the company to his children or grandchildren, or he can donate them to a family foundation, using the dividends each year to support charitable causes that are important to him.

According to the Federal Reserve survey of consumer finances, this represents the top 0.9% of wealth in the United States and typically requires a household income of $400,000 to $600,000 per year (that’s a monthly income ranging from $33,333 to $50,000). I wrote an article about this in 10 Secrets of the Capitalist Class at my Investing for Beginners site at About.com, a division of The New York Times.

Charlie Munger said it best when he opined about Berkshire Hathaway, "We want to own businesses that drown us in cash." Once you get enough of them under your belt, compounding starts to take over and suddenly your businesses generate enough money for you to buy more businesses.

Working for the money by selling your labor doesn’t really count, in my opinion. It has to be passive income from assets that you own. Otherwise, you can’t pass it on to your family or support charitable causes after your death.

Level 5. This is simply Level 4 on steroids. By most empirical evidence, it begins at roughly $20 million in net worth, which generates roughly $2 million a year in household income. That’s nearly $167,000 per month. This is the kind of money that you can begin saving up to develop hotels, endow chairs at universities, travel comfortably in private jets, or (as many of them do) continue to live the same way you always have and continue to expand the investments. Warren Buffett still lives in the same house he bought when he was in his 20’s. Back then, he had a few thousand dollars. Today, he’s worth more than $60 billion.

Summary. As a kid, I’d study wealthy people and classify them by how they generated their money. Even a musician follows the same path as an industrialist. Take Elton John. He is estimated to make $40 million per year by Forbes. Of this, approximately 50% comes from selling his time in the form of concerts. The other 50% comes from his ownership of the song rights on the music he composed. That is, every time someone plays “Bennie and the Jets” on television or in a movie, he gets a check. Every time someone covers one of his songs, he gets a check. Every time it sells on iTunes, he gets a check.

Elton never graduated beyond Stages 1 and 2 but Oprah Winfrey, on the other hand, used her money to buy up local cable television businesses. Most people don’t realize that her “investment company, Harpo, now owns countless local stations and it’s possible you are paying part of your cable bill directly to Ms. Winfrey. Her money makes money for her now, so even if she never recorded another show, the stream of earnings would keep on rolling into headquarters. That’s why she earned $250 million versus Elton’s $40 million. That’s a big difference.

Business Should Be Fun … If It’s Not, You’re Doing Something Wrong

Joshua Kennon — Tue, 02 Mar 2010 06:55:49 +0000

When I talk about the idea of tap dancing to work, in the words of Warren Buffett, I’m not kidding or making a joke. You should wake up every morning and jump out of bed because you can’t wait to spend your time focusing on something that makes every part of you – physically, mentally, emotionally, and spiritually – satisfied. This is going to be different for everyone.

Building a financial net worth that allows you to live any way you wish and enjoying your life are not mutually exclusive. You can make money following your passion if you are wise and intelligent about it. There is a man working for a major ice cream company that is paid, literally, hundreds of thousands of dollars as the head ice cream taster. There are people who test roller coasters for a living. I have arranged my whole life to allow me to sit in a beautiful office, read all day, and acquire stuff because that’s what I enjoy. Something in me is satisfied when I pass a building and know I own that, or shop in a store and know I have a few thousand shares parked in some operating company somewhere that no one knows about but Aaron.

In fact, this philosophy is terrifyingly close to the one espoused by Molly throughout high school: Follow your bliss. There are people who have built fortunes making bow ties by hand and selling them from the trunk of their car (seriously). There are people who travel the world and get paid to write about it. Find your bliss. Follow it. And find a way to make it self-sustaining. Money isn’t the goal, it’s the by product.

In other words, don’t work for someone else doing something you hate so you can “someday” be financially independent. You may need to do that for a few years as you figure out the details, but instead map out a plan to make money as you do something about which you are deeply passionate.

In my office, I keep an ever-expanding collection of Monopoly collectibles to remind me that building a company, generating profit, enriching my shareholders, and creating jobs should be fun. It is a real-life version of Monopoly. If we want, we should go buy houses and rent them out to tenants. Or hotels. Or water utilities. The point is, if you focus on risk-adjusted return on capital, in an industry you love that is lucrative, and you don’t take yourself too seriously, you’re going to do well over time.

Business should be fun. Growing an empire is like a real-life game of Monopoly. If you like it, why not buy real houses or hotels? Why not acquire shares of power utilities or water companies? Don't take the game too seriously. I'm convinced that by remembering that money is an illusion - you can always get it if you provide a solution to someone - life is far less stressful. Here's a picture of some of the Monopoly collectibles on the fireplace mantel in my office to remind me of this.

Why Income Inequality Will Always Exist as Part of the Post-Industrial Revolution Global Economy

Joshua Kennon — Fri, 23 Oct 2009 16:04:56 +0000

First: Before we begin, the education system in the United States over the past few decades has done such a poor job teaching basic logic that by virtue of the headline alone, it is statistically likely that you have already made a decision about whether or not this short essay on pay inequality is “good” or “bad”. You’ve done this without considering any of the factual data or evidence I’m going to offer by virtue of my own experiences in finance, based nothing more on your own political meme. Regardless of whether or not someone agrees with my facts, this inability for a citizen to carefully consider evidence instead of feeling is part of what is wrong with our Republic. As a civilization, we have to get away from fear mongering and sound bites.

Reasons Goldman Sachs Deserves the Bonus (No, Really … )

Businesses, like people, are different. Some people are tall, some are short. Some are black, some Asian. It’s the nature of the world. In the same way, some businesses require more employees than others as a result of the business model and industry in which a company operates.

Whether or not a business can lavish employees and owners with huge bonuses, paychecks, dividend checks, and profits depends upon one metric and one metric only: operating profit per employee.

For instance, Goldman Sachs has 34,738 full-time employees. Over the past 36 months, as the world has fallen apart and some of the biggest names in finance have collapsed, Goldman’s pre-tax profit from continuing operations was a staggering $34,500,000,000. In other words, after paying these huge bonuses, Goldman Sachs has earned an average operating profit of $331,050 per employee, per year, over the past three years. It’s amazing performance is evidenced by the fact that the stock is trading near the all-time high set before the market crash several years ago. Thanks to the management team, shareholders have emerged virtually unscathed as those around them have lost everything.

Wal-Mart Stores, on the other hand, has 2,100,000 employees. Over the past 36 months, it has earned pre-tax profits of $60,064,000,000. That works out to an average of only $9,534 in operating profits per employee, per year, over the past three years.

Put another way: On a per employee basis, after paying all compensation and these huge, “excessive” benefits, Goldman Sachs is 34.723 times more profitable than Wal-Mart on a per-employee basis. This explains why it’s able to offer far better pay and benefits for its employees. In fact, Goldman could give each one of its workers a $3,000 Christmas gift and it would shave just 1% off operating earnings. If Wal-Mart did the same by adding, say, $75 to everyone’s paycheck each week, it would cause a 31%+ drop in operating profit. People need to understand the numbers that drive these economics. Given that the company has a $200 billion market capitalization, that 31% drop in operating profits would result in a loss of $62 billion in stock market value as the lower earnings resulted in a lower valuation put on the company’s shares by pension funds, 401(k) investors, and mutual fund managers. The “loss” to the owners of Wal-Mart would be $29,524 in market value for this $3,000 per employee bonus. It would actually be much higher because of the additional payroll taxes and other factors that businesses pay on top of wages.

In fact, even if you own no stocks directly, you probably have a large chunk of your retirement invested in Wal-Mart if you have any sort of pension benefits at all, or you own any type of mutual fund or equity-based annuity. If you are a retired nurse with $500,000 in your 401(k) and you own an S&P 500 index fund, roughly 1.13% of your assets will be in Wal-Mart so your personal loss would be $1,751.50. If your pension pays you $1,800 per month, the plan likely has the same assets set aside to cover your distributions (it would take about $500,000 in earnings to generate a sustainable $1,800 per month pension payout) so its loss would be the same; although you wouldn’t need to worry about it because your old employer is on the hook for the money, the company has to make up the unfunded pension assets so it’s less money in their bank account for hiring new employees or offering their own bonuses.

Before the rise of our modern economy, it was virtually impossible for firms to earn high operating earnings per employee because of the huge investment in equipment, machinery, and physical labor (the exceptions were businesses such as commodity brokers, which were able to earn a profit without tying up their own capital).

An apple orchard, for instance, would have massive investments in land, dozens (if not hundreds) of hired men and women to walk the field and physically pick the apples, and a warehouse of people to prepare them for shipment. Today, much of that work has been replaced by machines but the savings went to the customer in the form of lower food prices, rather than to the business owner, because apples are a fungible product (you can’t tell an apple grown on one farm versus another if they are of comparable quality). The result is that apple farmers aren’t able to offer great medical benefits, new Mercedes, and signing bonuses. In banking, talent is anything but fungible. Someone like Warren Buffett, Charlie Munger, or Philip Fisher is exceedingly rare. If you could get Warren Buffett to work for you, paying him $1 billion a year would be a bargain because he’d likely earn that for your firm on a single transaction.

The moment our society moved beyond capital intensive industries, the fundamental laws of mathematics show that the pay difference between the richest and poorest (in terms of income) was going to widen because the new firms that arose such as advertising agencies, accounting practices, legal partnerships, and dentistry, earn high operating profits per employee. Old firms, such as steel manufacturing, garment production, and railroads do not. As a country moves from third world to second world, and later from second world to first world, a larger percentage of the population finds itself employed by these “high” return businesses because the needs of the population change. The result is an ever-widening increase in the pay differences between the bottom tier, which consists mostly of those without a high school diploma, and the top tier, which statistically contains those with advanced degrees and PhD’s in specialized fields such as medicine.

As a society, our concern should not be pay differential but rather, the absolute standard of living for the bottom 10% of the population. I’ve said it a million times and I’ll continue to say it: If we could double the gap between the rich and the poor but, in doing so, double the real, after-inflation income of the poorest 10% of Americans, I’d do it in a heartbeat. What matters is how they and their families are able to live.

As a society, we have a long way to go but I’m encouraged by our progress. Why? Because in the United States alone, changes in productivity and real standards of living over the past century have exceeded the sum of all recorded human history prior.

Being poor used to mean having no running water, no air conditioning, no central heating, not being able to buy clothes, or own a car. Today, the poverty line in the United States is high enough that those on it have all of those things – according to one study that examined the European Union to the United States (see EU vs. United States by Fredrik Bergström & Robert Gidehag), in 2007, 46% of poor households in the US owned their own homes, 30% had two or more cars, and 63% received cable or satellite TV.

Yes, there is still a lot of work to do but we cannot forget that in the macro-economic scheme of things, our grandparents, parents, and now us, have done an amazing job of building an economic engine that has better opportunities than virtually anywhere else in the world. I’m sorry, but if you own two (2!) or more cars, you can’t call yourself impoverished. I didn’t buy my first car – a Jaguar X-Type – until I was in my early twenties and had built up my savings and investments to very respectable levels because I knew that an automobile is one of the single biggest hurdles to achieving financial independence when you factor in all of the incremental costs. Do you think I wanted to wait that long? Do you think it was convenient to get around places without transportation? No, but I wanted to be independent and have enough money to not have to worry about a job. That takes sacrifice. You can’t have it both ways.

My hope for you, the reader, is you will now stop and remember, each time you read the news or hear an interview with a company or labor union, that the first metric you should check to determine which side likely has the better argument is operating profit per employee.