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.