The other day I posted a funny little quote to Twitter, wondering what kind of reaction I’d get:
Buffett is probably the most frequently cited investor on the planet, so I thought this might make for an interesting conversation starter. What was the social media reaction?
Crickets. Only one ‘like’ from my thousand Twitter followers. I thought the reaction was very telling. The world’s greatest investor drops golden nuggets from his arse like that and hardly anybody takes notice.
(To be fair, this quote is hardly new: I pulled it from the 1995 Berkshire Hathaway annual meeting)
Perhaps it’s because this little gem of investing wisdom runs so counter to the popular investing advice that spreads on social media these days…
“Just keep investing in the stock market. The stock market always goes up.”
“Save everything you can into your 401k, invest in low cost funds. When the market rises you can retire.”
I’m not saying the popular advice is entirely wrong, but this wealth creation plan is based upon the need for continually rising stock prices. Yet here’s the world’s greatest investor telling us the nearly the exact opposite — He doesn’t need rising markets prices to build wealth. It doesn’t attract him.
Real investors might want to take a few moments to contemplate this discrepancy. Don’t worry, I’ll wait. 🙂
Wealth Building Outside Of Market Gains
If you do a quick internet search for “The world’s richest investors” you’ll probably come up with a long list of individuals that control a company. Those companies provide the truly wealthy investor with cash flow that can be continually compounded. Rain or shine. Whether the market rises or falls, the wealthy investor just keeps compounding.
Because of this, truly wealthy investors don’t feel the pressure to earn money from the markets. Truly wealthy investors have all the income they need from businesses, bonds, dividends, real estate rents and other asset income. They have no reason to sell investments during a downturn to pay the grocery bill — cash flow comes from non-market sources.
Warren Buffet is no different. Back in 1964 he bought control of failing textile manufacturer Berkshire Hathaway and with a little bit of cash flow from textiles he bought his way into better businesses like insurance. This move cemented his cash flow engine into place, and enshrined his place amongst the ultra wealthy.
Fast forward a couple decades later and Buffett was loaning out cash by the billions during the 2008 financial crisis at very high rates of return in the form of preferred stocks (yielding anywhere from 6% to 10% depending upon the terms). These loans kept companies like Bank of America, Goldman Sachs, Dow Chemical, and GE alive during the financial crisis.
When the entire stock market was tanking, he had cash to spare. This is a salient point investors should truly study.
Sometimes Buffett invests in entire businesses, and other times in individual stocks — but those investments almost always spit off tons of cash (and usually a growing stream at that) which Buffett eventually compounds.
And yes, he absolutely takes advantage of market gains when stocks swing his way. The difference is, he doesn’t need those market gains to build wealth.
If you think about it, this is almost exactly the opposite of today’s most popular investing strategy — Hold as little cash as possible while investing in broad market index funds (at current market prices). Then, wait for prices to rise.
A Cash Engine For Main Street Investors
While you and I might not be the world’s next super investor, we can still learn from the successful strategies — By building our own cash flow engine!
It won’t be easy however — For most people, your primary cash engine is going to be your job for a very long time, but there’s absolutely no reason you can’t start building a cash engine right now.
Do this by purchasing assets that produce cash flow independent of the market:
- Dividend Growth Stocks — I write about dividend growth stocks all the time because they’re one of my current favorites. Stocks might go down, but they’ll still pay growing dividends. Today it’s entirely possible to find stocks growing dividends in excess of 10% annually. At those rates, your dividends will double in 8 years.
- Bonds — It’s not always possible to get good rates of returns from bonds, but shrewd investors like Howard Marks have done extremely well investing when these debt assets are distressed.
- Preferred Shares — While Buffett often gets sweetheart preferred share deals, small investors also have the opportunity to invest in preferred shares. Just like Buffett, I was buying-up preferred shares during the financial crisis. The returns were incredible.
- Real Estate — Real estate can also be part of an incredible cash flow engine when the investment can be made at good cap rates. In some areas of the world this will not be possible.
- Businesses & Other Assets — Some businesses spit off cash, and others consume it. Maybe you own a small business that can provide cash flow independent of the market. I’ve certainly considered buying one.
Personally I’m leaning heavily into dividend growth stocks these days, but there have been times when over 50% of our portfolio was in preferred shares… because the bargains were incredible!
Meanwhile, I try to keep cash on hand and remain opportunistic. You never know which assets Mr. Market is going to have on sale tomorrow.
Why A Cash Flow Engine Works
So why does this cash flow engine strategy work so well for the superinvestors of the world?
A few reasons come to mind:
- A cash flow engine ensures continuous compounding… even when the market declines or stays flat for multiple years. This is a gigantic advantage.
- There’s no need to sell stocks to fund a comfortable lifestyle. The cash flow engine provides for all necessary living expenses.
- Excess cash flow also allows great investors to cherry pick the best assets at good prices during the height of a downturn. They can afford to buy the good assets when prices are cheap.
- Returns are inversely proportional to the price paid. Lower prices paid mean better returns. Without the pressure of finding “rising investments” investors can focus on finding better values.
I also think it’s important to frequently remind yourself exactly what the market is — a place where stocks are bought or sold, NOT something to invest in. Current prices do not always accurately reflect real asset values. Mispricings happen all the time.
For the best investors, the market is simply a tool – like a hammer or a screwdriver. They don’t need to use that hammer for everything, but instead wait to pick up that tool until using it seems most appropriate — When the best possible prices can be realized.
While most investors dream about constantly rising stock prices, I believe this to be a very wrongheaded approach to wealth building. As net buyers of stocks over our lifetimes, investors should actually desire lower prices. Returns are higher when prices go lower.
This point is lost on many investors drunk on excessive capital appreciation.
Even though the market hasn’t seen a bad year in over a decade, there absolutely will be periods when the stock market doesn’t “go up” for a time. Will you be prepared?
In my case, I think Mrs. Tako and I are ready. We have a pretty good cash flow engine. It’s taken us over a decade to build it, but that cash engine provided some pretty incredible returns during the 2008 recession — primarily because we could make significant investments when others were trying to conserve cash.
I see no reason why we can’t repeat that strategy when the next downturn happens.
[Image Credit: Flickr]