Principles of Wealth: #19 of 60*

There are two ways that investments can build wealth. One is by the generation of income. The other is through appreciation – an increase in the value of the underlying asset.

Certain asset classes are inherently structured to increase value by generating income (e.g., bonds, CDs), while others increase value through appreciation (e.g., “growth stocks” and entrepreneurial businesses). But there are also many asset classes that provide both income and appreciation. The prudent wealth builder will likely have all three types of assets in his holdings, but he will favor those that provide both income and appreciation.

To the experienced investor, these facts and the principles that govern them are obvious. But they weren’t obvious to me when I began investing many years ago.

Back then, I thought of a stock as nothing more than a share of the equity in a company. Therefore, the only consideration I made when buying stock was whether I wanted to own the company. In other words, it was all about equity. I didn’t realize that some companies provide their shareholders with dividends – i.e., an annual distribution of cash, usually based on the company’s profitability that year.

I was familiar with profit distributions from my experience as a partner in private businesses. At the end of each year, my partners and I would look at the P&Ls, accounts payable and receivable, and cash balances, and then decide how much cash we could pull out of the business and put into our happy little pockets.

In doing this, I discovered that how much we distributed each year was an important decision. If we took out too much, the business would be cash poor and we might not have enough cash for needed expenses, including marketing costs, in the following year.

Taking out very little, although it seemed like a smart and safe idea at the time, turned out to be a problem of a different kind. Having “excess” cash in our accounts made it tempting for us to take more risks than prudent and/or spend money on things that didn’t add to the company’s long-term health and/or profitability.

This holds true for public companies. Distributions are generally a good thing for investors so long as they don’t put the company’s future cash needs in jeopardy.

Because I have for most of my career received more income than I can spend, I don’t look to stock dividends as a way to pay my bills. Nevertheless, I prefer owning companies that have a steady history of sharing profits with stockholders. Not only because that is generally a sign of good economic health, but also because reinvesting those dividends is the best way I know to accelerate the growth of my stock-based wealth.

I have two portfolios of stocks. Both are comprised of large, Warren Buffett type companies, most of which give dividends. Over the long stretch, these companies give me an average appreciation of about 7% or 8% and an additional return via dividends of another 2.5% to 3.5%. The combination gives me a great deal of safety with a return that is at the high end of what stocks are capable of over the long haul.

Of course, when businesses are new and have little or no profits, distributions are a non-factor. There are no profits to dole out. And that’s why small-cap and “growth stocks” rarely give dividends. These stocks compensate for their lack of distributions by offering the potential for dramatic growth.

I have enjoyed owning stock in private companies during 5- and even 10-year-long periods of 50% to 100% profitable growth. There is no faster way to see your wealth increase. But I have a rule about investing in such businesses. I don’t do it unless I understand them as an insider and have some say over how the business runs. Which means I rarely invest in them. And when I do, I consider them as speculative investments.

I take the same approach to real estate. In the past, I’ve invested in real estate for the sole purpose of seeing it appreciate and then selling it for a profit. More commonly now, I invest in rental properties (residential and commercial) that give me an income – usually 12% to 15%. Even better is when I can I buy properties that give me both income and the potential for price appreciation. This is easy to do when the real estate market is weak and I can pick up properties for less than their replacement costs. When that happens, I can go for years earning close to 25% in total. And you can make a lot of money with that level of ROI.

I even apply this approach to investing in private businesses. Although I can’t expect them all to be profitable immediately, I look for business opportunities that have a good chance of getting to cash positive within a year or 18 months. I’ve not been able to do this all that frequently. But the half-dozen or so deals I’ve done like that have given me astronomical returns of 50% to 100% over periods of several to many years.

* In this series of essays, I’ll be rethinking and expanding upon many of the observations I’ve made over the years about wealth: What it is, what it’s not, how it can be acquired, and how it is usually lost.