The Joy of Cash Dividends

Over the years, I’ve written a lot about dividends on the Investing for Beginners site at About.com.  In fact, over the past few years it has been one of my absolute favorite topics to cover because through the Great Recession of 2007-2009, those who owned a collection of high quality dividends stocks were better able to ignore market fluctuations and avoid selling their ownership to pay their household bills.

It isn’t an infrequent thing I’ll hear people opine, “yeah, but who has money sitting around to invest enough to matter?”  It’s then that I realize the wisdom of Solomon when he said, “Do not despise the day of small beginnings.”  Most people don’t even try to begin collecting assets because the dividend checks start out at only a few dollars each quarter.  But money is like a farmer growing a crop.  It only takes a few seasons for the seeds you planted to begin to throw off enough seeds of their own for you to drastically increase your yield per acre.

Hard Work Isn’t Enough – You Need to Own Cash Generating Assets

It is almost exhausting reiterating this point, but let’s imagine that you owned $2,000,000 worth of Campbell Soup Company common stock.  Regardless of what the stock price did, you would receive $64,000 a year in cash dividends mailed to your home or office, or directly deposited into your bank account depending upon your preference.  That works out to $5,333 per month.  Dividends are taxed at 15%, meaning you would only pay $800 to the government, resulting in $4,533 per month in cash income.

This money should come as long as Campbell’s products are still popular and generating profits, even if you don’t get out of bed in the morning.  It is your reward for not spending the money and instead investing it in companies that create jobs and grow the economy.  (After all, you could have taken the whole investment and gone to Vegas, or redecorated your kitchen, or bought new cars, installed a swimming pool, etc.)

Since We Know That Most Wealth Isn’t Inherited, How Do You Get the Money to Invest?

We know, from virtually every study ever done on wealth in the United States, that 90% of American millionaires did not inherit their money.  They are first generation rich, with a vast majority coming from the middle class or lower class.  Most put themselves through college, and most are married.  Since they all started out exactly like you, how did they get the money to buy the $2,000,000 worth of Campbell stock?  It isn’t like the tooth fairy just showed up and dumped a pile of cash on their doorstep.

The Millionaire Next Door Method (Good Defense)

The most popular way is the so-called “millionaire next door” that Dr. Thomas J. Stanley discussed in his books.  These are people that never made a lot of money but played good defense – that is, they spent less than they earned and invested the surplus in stocks, bonds, mutual funds, and real estate.  This route can certainly make you rich (but not super-rich, which we will discuss in a moment).  It’s relatively easy, it just takes a long time to achieve financial independence this way.  If you are doing what you love for a living, this won’t matter because you’re happy anyway and one day you wake up to find you are loaded.

Take someone who is 27 years old.  If he were to cut expenses and save $1,000 per month (I have family members who are not college educated, in their twenties, and single parents that are capable of doing this so I don’t want to hear it isn’t possible – they are no better than you are, they are just making better choices), by the time he reached 65 and retired, he’d have $4,368,521 at a 10% rate of return.  At a 4% withdrawal rate (this is the level most academic research shows allows you to never run out of money, even if we were to go through another Great Depression), this would bring in $174,741 in annual household income, or $14,562 per month.  That’s an after-tax figure, by the way.  If inflation runs 3%, this would have the same purchasing power as earning $4,736 after taxes each month today.  You’d be in the same position as our Campbell Soup investor, plus you’d still have another couple of decades to live, statistically, and you’d have a huge pile of wealth to give to your children, grandchildren, or charity when you leave this world.

The High Earning Method (Good Offense)

Those with specialty degrees in medicine, law, engineering, or finance are often able to earn six-figure salaries (or better depending upon their skill and career path), allowing them to spend large sums of money, while still putting aside money for saving and investments.  An interesting fact, though, is that very few high earnings show up in the millionaire rankings where they should.  That is, they have far less wealth than one would expect.

The general consensus among those who study the affluent is this is the result of the psychological concept of social proof.  Doctors, for example, very rarely have the emotional strength to drive a ten year old Honda.  Instead, they feel pressure to drive what the other doctors are driving so as not to stand out from the crowd.  (Hence my note that most people would rather fit in than be exceptional.)

The Business Owner Method

The biggest percentage of millionaires comes from those who own businesses and the vast majority of super-rich and billionaires also own businesses.  The reason is something called earnings capitalization.  If you are a doctor and you earn $1,000,000 a year, that’s it.  You pay your taxes, you’re lucky to be left with $600,000 net, and if you die tomorrow, your family is out of luck.

If, however, you had built a plumbing business that generated the very same $1,000,000 per year in operating profit, you could sell it to investors or private equity groups.  If the company has modest growth, you may expect a 10x multiple.  In other words, these investors would be willing to pay you $10,000,000 for your company (as the founder, you own 100% of the stock), because that generates a 10% pre-tax earnings yield.  If they think they can use their marketing skills or other holdings to increase profits further, they can make a lot of money themselves.

The same income, in other words, results in $0 in net worth for the doctor and $10,000,000 in net worth for the business owner (to be fair, let’s say $8,000,000 because you have to pay capital gains taxes).  Same income, vastly different wealth.

This is precisely the reason that I chose to go into business ownership rather than law or medicine.  God blessed me with an extraordinarily high intellect (for which I can take no credit), just like he blessed others with different abilities – some are athletic, some are extremely patient, some are natural leaders.  I wanted to know how to get the most benefit for each unit of “work” I put in (as measured by total hours invested) and that would allow me to live the lifestyle I want – no demands on my time, total freedom to do what I want when I want, and still be able to afford the things I like.

The Super Rich Are Usually a Combination of the Three Methods

Take someone like Warren Buffett.  He owned the general partner equity of his partnership, which entitled him to a big cut of the investing profits.  This made him a de facto business owner.  He rarely spent money, meaning he played great defense.  As his stature rose, he sat on multiple boards of directors, earning millions of dollars a year in director fees and income, making him a good offensive player, as well.  If you look closely, most of the super-rich combined all three methods into a hybrid that fit their personality.  Even if they drop $10 million on a yacht, it represents a fraction of their net worth and is like you going out and buying a new Playstation 3.

In our case, we own businesses.  When opportunities are attractive, we take the profits from the businesses and buy stocks.  When stocks are overpriced, we’re open to selling them and buying real estate.  We may take the cash dividends from our stocks to expand our wholly owned businesses.  We are an integrated investment vehicle designed to grow our shareholders’ wealth.  It just happens that right now, all of the shareholders are members of the Kennon and Green families, respectively.

Related posts:

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2. Oil, Tobacco, Pharmaceuticals, Detergent, Discount Retail and Light Bulb Dividends … Oh, My!
3. A Perfect Example of Acquiring Cash Generating Assets from Charlie Munger
4. Where Do Millionaires Invest Their Cash to Keep It Safe?
5. New Stocks and Cash Added to The Kennon Retirement Insurance Fund (or “Stupid Fund”)
6. Stock Dividends Are Not Income – They Are a Balance Sheet Reclassification for Accounting Purposes
7. Using Cash to Increase Your Value Investing Returns
8. Dividends, Dividends Everywhere
9. Scared of Stocks, Young Investors Park Money in Cash