The Quartet of Financial Independence
Cash Flow, Liquidity, Profitability, and Net Worth
Most of you are familiar enough with my background starting and running operating businesses as a private owner as well as my personality and life history to know that I don’t care about the stock market per se. In truth, I detest everything about stock picking culture and have no desire to ever participate in it; people having frantic discussions over shares of some firm being up or down a percentage or two percent in any given trading day. There’s an element of inherent speculation and unrestrained emotion that make me uncomfortable; equity owners acting little different than the folks at the roulette wheel after putting a bet on the table but before the wheel has been spun. I don’t understand it. I’m not wired to understand it.
Rather, it’s businesses that I love. The stock market is one way to get my hands on ownership of certain businesses I want added to my collection, nothing more, nothing less. I want to find ownership stakes that I can sit on for years, decades even, and that offer me what I consider an acceptably high probability of a satisfactory outcome. I don’t care about volatility because I generally prefer to pay for equities in full without borrowed money. Unless something truly exceptional is happening, I typically don’t care about quarter-to-quarter earnings guidance provided it is still in-line with the assumptions I used when valuing a company. I care about what I pay relative to the core, long-term economic engine. What I’m doing is arbitraging everyone else’s impatience, action bias, and emotional instability (it still amazes me, though no longer surprises me, how many people treat their portfolio as a source of excitement rather than a way to make money.) It’s the reason I adore passivity so much over what many people think of when they talk about active management. In my view, the work should go into becoming adept at identifying what to buy and under what conditions to buy it, then letting time do the rest. I hate stock picking. I hate everything about it. I want to own businesses. I don’t view my ownership in Diageo or Hershey any differently than I do our letterman jacket company.
To give you an example, so far this year, across all of Aaron and my personal household accounts, at all institutions, only two sell orders have been executed, both of which were with a single custodian in a single account. Both were minor in the scheme of things. I sold off a portion of our largest aggregate holding to buy shares of another business that I believe has become more and more attractively priced in the past month, the valuation differential and diversification benefits becoming too great to ignore as I start to build this other stake. The other happened a few months ago. A couple of the calls we had written against certain blocks of the Exxon Mobil position we had picked up while everyone was decrying the death of oil were assigned to us to our displeasure. Up until almost immediately before the options were exercised, it looked like they were going to all expire worthless, which would have let me write another set of calls against them for additional income. The old Standard Oil recovered faster than I anticipated. Still, you know one of my rules: never write an option you wouldn’t be happy to have assigned. We made a nice sum of money on it, anyway, between the capital gains, dividends, and call premium so complaining about it strikes me as misguided and we still have plenty of Exxon Mobil stashed away in various places as a long-term holding.
In fact, I don’t think we’ve had any major sales activity since back in 2014 when I talked about all of us winning the evolutionary, economic, and cultural lottery. Even then, our turnover from such a redeployment decision was significantly lower than the typical mutual fund. Activity is rarely your friend as an investor.
What interests me are the underlying results from a business. Meaningful changes in the long-term DuPont variables that are driving return on equity, sales per square foot increasing or decreasing materially… those could be a source of intense discussion to the point I lose myself in conversation with someone. What does it mean for intrinsic value? Who is benefiting? What is causing it? Is it an actual shift in the business, as measured by units sold, or is it a temporary accounting quirk, as measured in some nominal fiat relative to some other nominal fiat? What does it say about society’s values or changes in cultural patterns?
In fact, I don’t even think stocks are all that special except that, historically, due to the incentives systems and laws we have in place in modern civilization, they tend to be the highest returning asset class on an aggregate basis as they unleash human productivity, harnessing self-interest in a way that has resulted in the greatest standard of living in all of history. That is the reason stocks hold my attention. One of the rules I try to teach you – a dollar is a dollar is a dollar no matter how it is generated – means that I don’t much care how those dollars come into the coffers, provided they are consistent with my moral and ethical values. I don’t want to own stocks to feel good about myself – to buy shares of some exciting or esoteric company because it says something about me. To borrow a phrase from an investor who had an enormous influence on my life growing up, I’d just as soon get a dollar from a sewage treatment plant as from a software company. It’s the dollar I care about.
This isn’t limited to stocks. It extends to asset classes. If we found ourselves in an unthinkable Through-The-Looking-Glass world where equities had long-term cyclical earnings yields of 3%, 10-year Treasury bonds were yielding 6%, and high quality commercial real estate yielded 12% non-leveraged, and it persisted for any length of time, I can say it would be highly probable, absent any unique considerations, that allocation shifts would result in most of Aaron and my productive net worth being in real estate and fixed income securities; at least going forward from new cash put to work. And, in doing so, I’d be as conservative as I am now. I wouldn’t leverage the bonds. I would have ample equity and liquidity cushions on the properties acquired. I’d look for a margin of safety either in finding properties with untapped potential rental increases or chances for improvement. It’s all the same principles; a philosophy that can help to protect you from catastrophe and give you what I believe to be the best chance of acquiring nearly all of the material desires of your heart if you start with a long enough runway and do what is necessary to feed the compounding cycle, mostly by developing a strong economic engine at the core of your empire, be it a high earning career, a single successful business, a collection of apartment buildings, a portfolio of copyrights, a valuable patent you can license, or any number of things.
What I care about, having had to achieve financial independence with Aaron on our own, is the quartet of cash flow, liquidity, profitability, and net worth. All four are necessary if you want to sleep well at night and never have to worry. To stay with the music analogy, think of yourself like the conductor of an orchestra. There are times you have to decide which section is more important and needs to be emphasized, never giving such preference to one that you ruin the performance.
- Cash Flow – This refers to the timing of incoming and outgoing funds; always making sure there is money there to pay obligations, cover expenses, fund acquisitions, or whatever else your operating needs require
- Liquidity – The pooled reserve you keep into which you can dip when cash flow is insufficient, whether it be due to seasonal fluctuations in a business or a larger one-time outlay
- Profitability – The actual surplus wealth you generate from operations
- Net Worth – The liquidation value (assets minus liabilities adjusted for any taxes that would be due when reaching for your remaining capital) of the balance sheet
The Two Sets of Questions You Need To Ask Yourself When Building a Portfolio
As that quartet pertains to publicly traded securities – building portfolios of stocks, bonds, and other assets that are bought and sold on exchanges or traded over-the-counter – there are two separate series of questions that must be asked. (There are other questions that matter, too, such as the expected timing of required cash flows for life events but that goes beyond the current discussion.)
The first deals with selecting the individual components that make up your productive wealth.
- Where are the cash flows originating? How is the cash being generated?
- How much am I paying for each dollar of cash flow, adjusted for time, taxes, and inflation?
- On what terms, and under what conditions, am I buying the cash flow?
- What funding source am I using to pay for the cash flows? How stable is it?
The next deals with the portfolio construction, or how those individual components relate to each other.
- How are the component weightings determined?
- What is the net exposure from correlated risk, both in terms of the underlying cash flows of the components and the market risk of the holding itself (e.g., if a significant percentage of the stocks in an equity portfolio are held by non-stable owners who engage in high turnover or have funding sources that can be quickly redeemed, you can get a lot more volatility than would otherwise be justified. It can be intelligent for a person to hold a certain core set of assets that serve as a central pillar meant to mitigate these environments.)
Both are important. They are different but interconnected disciplines, each of which require mastery if you want to enjoy a long and productive relationship with your wealth; to have your money earning more money for you so you know the peace that comes from the certainty that no matter what life throws at you or your family, it’d be very, very difficult to lose your standard of living and freedom to do whatever you want with your time.
Everything else – talk of individual stocks, mutual funds, index funds, real estate, private businesses, intellectual property – it’s all a distraction to those questions. They are the means to an end, the end being cash flow, liquidity, profitability, and net worth. Those questions, in a fair society with intelligently regulated free markets, are what determine your outcome.
Stop Trying to Pick Stocks and Start Focusing on Businesses
This is the reason I talk about not understanding stock pickers. Stop trying to figure out what will be up or down next year. Instead, cast your gaze out to the future and figure out what collection of assets gives you the highest probability of satisfactory or more-than-satisfactory “look-through” cash flow, liquidity, profitability, and net worth. There are times I think of myself like a farmer planting economic trees. I know about what I expect in those time frames and what needs to happen to make sure things are moving along nicely. Rarely, if a mistake has been made, a tree has to be cut from the forest or orchard. Even more rarely, a tree may be destroyed for one reason or another. It shouldn’t matter to you if you’ve organized your financial affairs wisely.
Reader Comments (24)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
Todd
June 5, 2016
Joshua , If I understand you right you talk about how a person should not borrow money to buy stock. But you do borrow money to buy a business or rental property. If some one was to tell you that they borrowed money to buy stock how would you feel. Case in point with home equity loans at less that 3% could you see where it would be ok to take out a home equity loan to buy dividend stocks like say KO, PEP, JNJ, MO, XOM ecxt. which all pay over 3% dividends. With a diversified portfolio the dividends would pay the interest and then some over time since they would be raising them. When some one buy a new car or truck and borrow 20,000 dollars most people not all don't think about it but if one was to say I borrowed 20,000 dollars to buy good dividend company's they would say your crazy.
Adam J. Mead
June 6, 2016
Replying to Todd
"If you're smart you don't need leverage, and if you're dumb you shouldn't be using it." That's a Warren Buffett quote that you should keep front of mind when you drift toward thinking you've found free money via leveraging your dwelling to buy financial assets. Another: "Don't risk what you have and need for what you don't have and don't need."
The issue is there are many risks you are implicitly taking, even if you don't state them or see them explicitly. The companies you are buying - which are, granted, fairly stable - contain leverage themselves. Both on an operating leverage basis and a financial basis. The best way to picture this is a see-saw (stay with me). You have on the ground level the business - it fluctuates with the vicissitudes of business, though not so much as other businesses, but it does fluctuate. This is the operating leverage. Now picture on top of one leg of the see-saw another see-saw. This is the financial leverage in the business. This is the debt that was borrowed to fund operations and, quite simply, allow the business to own more assets than its equity alone would allow. Now again, picture a third see-saw on top of the second. That's your home equity loan. When you put leverage on top of leverage on top of leverage, a small swing might not be noticeable. But what happens when all start shifting at the same time? In short, something you probably want to avoid.
My own personal philosophy is that you should borrow if you absolutely NEED to, in order to buy a vehicle, or home. You should not be borrowing $20k to buy a car. You should be buying a 15 year old beater and saving the difference to buy a better car later, with cash. The problem is people get into these cycles and don't see what's actually occurring. A car is an expense, you should be paying for it as you go such that when it's worn out, you just go out and buy another one. But people can't stand to see cash on their balance sheets. A quick and easy method is to save 10 cents per mile as a sort of capital reserve against your car. If your car has 100,000 miles on it, you should have $10,000 in the bank as a reserve for purchasing your next car. Basically you're "paying for" your depreciation. While not "correct" in terms of pure finance theory, it's the only method I'm comfortable with. It let's me sleep at night.
Much longer than I originally anticipated so I'll end here. Just enjoy the process and the proceeds with come in due course.
Todd
June 6, 2016
Replying to Adam J. Mead
If you think Warren Buffett doesn't use leverage your fooling your self. Just look at the balance sheet. There very few companys that don't use leverage and if you run your investments like a business then having leverage is not a sin. It is a tool if used wright. I know people who use cover calls which I think is market timing ,like worse then leverage because you could be forced to sell your stock. I'm not talking about margin debt I am talking about long term borrowing where you are not forced to sell. Remember money against the house not the stocks if you lose your job you can sell stock or use dividend's income to make house payments. I know people will say don't borrow money against your house to invest that is just wrong. Run the numbers over a 20,30 year period mortgage loan at say at 3% take that money but in SP 500 index fund 30 say 8.5% return. what would you have 231,165 dollars total value. Your total loan cost would be 30,355. And if you are smart you would put it in roth IRA at 5,000 a year for 4 years and pay no tax on it and draw 4% at the end of 30 years giving you 9,246 tax free dollars a year in income or leave alone for the next 20 years and give it to your kids and have $1,181,726. That is at a 8.5% return which is below SP 500 historical average. I know you should not leave money to your kids but just think how would you feel if dad or grandpa left you money how would that improve your life or the people around you or give it all to your favorite charity. The world will not come to a end regardless who is president, human behavior is always fix whats wrong and move forward.
Adam J. Mead
June 7, 2016
Replying to Todd
Berkshire has enormous leverage in float, which I'm guessing you do not possess. Another form of risk-free leverage is deferred taxes which Joshua has gone into detail about in the past.
I've "looked at the balance sheet" of Berkshire. There is leverage in the Rail / Utilities segment, but that is not guaranteed by Berkshire. Nor is it excessive even by traditional standards, and those are utilities. BNSF's fixed charge coverage ratio in 2015 was 6.80x. I calculate the utility's coverage at about 6.71x. Does that strike you as overly leveraged? Additionally that is at the company level, not the investor level.
The Manufacturing, Service and Retailing Operations have a combined $6.9 billion in NP + Term Debt & Other, against $57 billion in equity. That's a debt to equity ratio of 12%. The division nearly has enough CASH to pay off it's debt.
The Finance and Financial Products segment primarily consists of Clayton's mortgage portfolio, which is financed with debt as a bank would be. If you go by the consolidated balance sheet, the F&FP division has tangible assets of $37.6 billion to tangible equity of $20.4 billion. That's an tangible assets / tangible equity ratio of 1.84x.
You are talking about financing equity with debt, not assets with debt. There is a key distinction. I am not comfortable with it. You might be. But please watch out that you are not just "pounding it into your own head", looking for confirmation from this or any other board.
dave (nestle)
June 7, 2016
Replying to Adam J. Mead
Good thoughts!
So, I met with a VERY wealthy business man just a few days ago to present an idea to him. This guy is probably one of the richest individuals I ever came face to face with. (as an aside, wealth was only one noticeable trait about him) Anyway, towards the end of the meeting we were just talking a bit personally, so I asked him how does he figure he came to acquire so much money/success/etc. He said "When I started(young and leveraged), I was just too stupid to know that failure was a big possibility.
Todd
June 7, 2016
Replying to dave (nestle)
Dave , Adam my ignorance is my advantage. 🙂
dave (nestle)
June 7, 2016
Replying to Todd
Hey Todd!
Listen, my comment was in no way calling you, of all people, out. Just a recent interesting thought that I shared mostly for entertainment value. Interesting to me because here were two guys talking about their younger days, one who risked it all and lost everything(me) and the other who made zillions. Sitting back now this guy realized just how risky his startup days were.Would either of us do things over differently if we could? But I guess thats why if it was easy everyone would be rich. Also I am myself not ashamed to admit that I am always looking for unconventional ways to make a buck. So just keep trying to learn as much as you can cause its all compounding 🙂
Todd
June 7, 2016
Replying to dave (nestle)
Dave, I don't take any thing personal on this blog I love to see different views. I'm sure I am entertaining to most people. I know Joshua would not agree with this but we both think alike at the core. Long term investors the Ronald Read kind of guys. My Aunt is still holding stocks that my Uncle bought that date back to the early 1960's. Some day maybe a bunch of use from this blog could all get together in person kind of little Omaha gathering of couse with Joshua.
Alfonso Pajares
June 6, 2016
Replying to Todd
The main issue with your thought process is you're expecting the dividends as a given. In a bear market or something like the financial crisis that dividend stream may be shut off for the better of the company. That leverage (Borrowed money) now cannot get paid unless you sell shares or find another way to pay for it. If you need to sell shares you are selling at the worst possible time. The logic in going against that is why even bring in the risk, no matter how small, if you don't have to.
Todd
June 6, 2016
Replying to Alfonso Pajares
So lets say you wanted to buy a company would you not to have to borrow money to buy it and take it's earning to pay back the loan. So it's earnings are like dividend's which are not a given. It is all about risk , look at Buffett did he not borrow 3 Billion dollars even though he is sitting on 60 billions dollars. There has been very few times in history where you can buy dividend paying stocks that yield higher than cost of money. I should explain myself a little more, a person should only do this if they have the cash flow to pay the payment and not use or count on the dividend to help pay for the loan. I am just stating that dividends on good company's are yielding more that loan cost which you can lock in for 10,20,30 years That is crazy , we will look back on these times as a missed opportunity for the long term investor. Yes it is risky buying stock on borrowed money so is buying your house if you lose your job you will be in the same boat except with the stock the dividends can buy you time and you can sell a little at a time. You can't sell a room at a time on your house. Now let say your borrow 20,000 on your house to buy dividend stocks the stocks are clear but your house is not. I have experience this in my life I am taking a far greater risk by working for my company. In 2008 my wage was frozen then in 2013 they cut my wage by 20% but guess what my dividend stocks did yes most of them raised there dividends as they also cut workers and lowered wages, they did this to protect the share holder AKA me. My stocks got me through and getting me through the rough time. Yes I have borrowed money against my house that I bought stock with which are now giving me cash flow. That said my debt to equity is 20% my equity is the stocks which is clear and free. I believe in the equity markets and will be fully invested my hole life I started investing in May 31,1988 100 share of Walgreens and 100 Shares of Coca Cola where my first stocks.
Alfonso Pajares
June 7, 2016
Replying to Todd
Notice what you stated in your statement though. Buffet borrowed $3B while having $60B readily available. He isn't risking much because he can pay off that debt at any time. He is essentially shorting. I'm not saying your idea isn't feasible but you have to understand that you are adding risk is all. As you stated in another comment debt is a tool like any other. It's simply an addicting tool to most people since they stretch for that last bit of yield.
Eric Vaughn
June 8, 2016
Replying to Todd
If you're going to take all the equity out of the home anyway, why not just rent so you can invest the entire difference? I think the answer is in the tremendous non-financial benefits.
Todd
June 8, 2016
Replying to Eric Vaughn
Eric, I bought my first house for 12,000 in 1990 ( yes it is not a miss print ) I sold it in 1999 for 59,000 When I bought my second house for 20,000 ( still not a miss print ) Put 65,000 in remolding it. I got some of the money to remolding from my stock I sold in Enron at 65 dollars a share, I did not get the 85 dollar a share. I first bought Enron in the early 1990's. When I tell people that I made money on Enron they tell no you didn't. I did sell my last 100 share for 1.85 a share. Back to my story so I have put in my house 20,000 + 65,000 = 85,000 it appraised for 148,500. If I rented I would not have any equity to pull out to invest.
K.
June 6, 2016
Love the tree planting analogy. Recently realized that I was getting too caught up with collecting pretty companies and not thinking enough about returns, or, I mean, cash generation. 🙂 It's nice to like the companies in the port, but more important that the investments are working! (I remember a post about your bookshelf of items representing your core holdings with things like toy trains, etc.) I only invest in stocks and mutual funds right now because they are the easiest for us to work with.
Question: what do you mean when you say this: 3. On what terms, and under what conditions, am I buying the cash flow?
I am learning to use covered calls. Recently decided to cover a portion of our DIS shares for practice. Sorry you were called on your oil stock. No time to roll?
I recently sold a shipping company that we had a small investment in and perhaps it was a mistake. But, I had a few problems with it. First, the business had a lot of debt, and second they were using some of the debt to pay their dividend. Perhaps that was OK to sell after all.
I keep an "Earnings Yield Per Share" column in my portfolio spreadsheet, inspired by one of your articles. Thank you for the ongoing lessons.
Mr.owenr
June 6, 2016
The job is the economic engine? I thought the eventual profits being paid out as dividends was the central economic engine that people build. (Dem stocks b dat njin, you dig?). (Held in taxable accounts so you can use that money).
Anyways this article was very helpful so thank you.
Ang
June 7, 2016
Replying to Mr.owenr
You have to have an economic engine to fund your investments. You will never get the profits or dividends without the initial cash flow. Joshua's economic engine happened to be the businesses that he built. For a majority of Americans, it will be their income from a W-2 job, since a majority do not build up their own businesses. See the red ring problem: https://www.joshuakennon.com/the-red-ring-problem-getting-rich-too-late-in-life/ with emphasis on: "For highly skilled workers, such as a heart surgeon in a reasonably sized city, the economic engine is the price that he can charge for a unit of time"
Mr.owenr
June 8, 2016
Replying to Ang
So if I understand correctly, an economic engine is essentially the active actions you take to get cash, be it working a W-2 job or writing a book. These are the steps to baking a pie (which you can't do, never forget that). But it is only an 'economic engine' if it generates the median income of an american. The investments however are not an economic engine because the investments generate cash passively.
Ang
June 8, 2016
Replying to Mr.owenr
I think the criteria can also include the "control" component. If you are buying stocks on the open market, unless it's a tiny micro cap, you likely will not buy a controlling stake. In that case, it's not an economic engine because you don't get to choose capital/cash flow allocation strategy. If you buy a controlling stake in a business, or buy controlling ownership in real estate, in my view those ARE economic engines, since they spit off cash that you can then choose to do whatever you want with
Mr.owenr
June 14, 2016
Replying to Ang
What questions should I be asking in order to get an economic engine?
Don Hilario
June 7, 2016
read this 3x already, just for the pleasure of it. great post (as always) Josh!
Gilvus
June 11, 2016
I like to explain investing with a similar analogy, in that each dollar you have is like a seed in your hand. You have three choices:
- You can eat the seed to nourish yourself. In real life, you can be frugal but you'll still have baseline expenditures (taxes, rent, utilities).
- You can save the seed, and watch it grow stale. In real life, assuming a normal (non-deflationary) economic environment, every dollar you save will lose real purchasing value year by year, even as its nominal value (the outward appearance of the seed) remains the same.
- You can plant the seed, thereby putting it to work and producing more seeds for you in the future. In real life, this is any form of investing that produces a return above inflation.
I like this analogy because it also illustrates the concept of opportunity cost; it demonstrates that when you do one thing to your seed-dollars, you can't do the other two.
"On what terms, and under what conditions, am I buying the cash flow" refers to the fine print that comes with an investment that could severely change the nature of the investment. For example:
- You purchase equity in a company at what seems to be a very attractive dividend yield. Later, the company issues a huge batch of new shares as part of a Secondary Public Offering. This dilutes your ownership in the company, and hurts your returns.
- You purchase a bond at a very attractive coupon rate, but it's a callable bond. Soon after, when interest rates drop, the bond issuer calls back the bond, pays you the principal, and re-issues the bond with a lower coupon.
- You discover rich veins of gold hidden in the remote mountains of a far-off country, and you buy the land and mineral rights before anyone learns of your discovery. The government of this country is cash-strapped from poor management and corruption and decides to nationalize your gold mine without compensation.
- You purchase securities in a country with a ridiculously high withholding rate. The cash flow looks very strong, but first the foreign country imposes their high withholding tax. Then, you convert their currency back to your native currency at an unfavorable exchange rates. Finally, your native country takes its cut (income tax)...so at the end of the day, your cash flow has been reduced to a shadow of its original amount.
In each of these cases, you invested in what seemed to be a good cash flow, but you purchased that cash flow on terms and conditions that greatly diminish the amount of money that you actually get to spend, save, or reinvest. At the end of the day, the most important thing is not how much money you earn, but how much money you keep. That's what Joshua means by "on what terms, and what conditions?" It's the second half of the Mungerism "on what price, and what terms?"
Derek
June 12, 2016
Replying to Gilvus
Great explanation and examples of the question "on what terms, and what conditions?"
Johnny
June 17, 2016
If I may answer:
On what terms, means how much he is willing to pay for cashflow. A good company can be a bad investment if you pay too much.
Millionaire Confidential
June 30, 2016
As a self made Ultra High Networth individual >25M+,
aversion to debt has mean very little liquidity. the minute there is extra cash, boom invested in another deal be it business or real estate. with multiple cash flows and no debt, I've gotten away with having very little liquidity. Would you do anything different?