The Cash Flow Engine — Why Real Investors Don’t Need The Market To Build Wealth
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]
27 thoughts on “The Cash Flow Engine — Why Real Investors Don’t Need The Market To Build Wealth”
Great post, Mr. Tako! I love that you approach and share the idea of investing as a business owner who can control cash flow through different market cycles. For me, I like real estate investing for this reason. Thanks for expanding our ideas of what it means to invest in equities.
Yep, equities are just businesses and should be viewed as such!
I’ve long said the best returns are from assets nobody else pays attention to. Things like buying a local business or some obscure piece of real estate can be incredibly lucrative.
The problem? These investments aren’t passive. These days I’m trying to simplify my investments, so anything that will cause any extra work automatically gets punted. Like you, I’m focusing on the cash flow I get that’s independent of share prices. It keeps trending in the right direction, so I’m happy.
Yes, yes, yes! I try to pound the table about income investing every Friday. There are usually some great deals in discounted bonds. When the credit cycle turns, there will be tons of irresistable deals out there. I hope to get my income allocation above 60% when it happens.
great post Tako
While its great to see some price appreciation in stocks, it sucks.
I love to drip my dividends and when the stock rises i either get less drips or no drips at all.
Im one of those you mentioned who doesnt hold much cash but invests it right away. I try to buy undervalued growth dividend stocks but it would be nice to have a great cashpile as well.
Anyways, keep it up Tako!
This cash flow engine is much the concept I employ by building passive income streams via syndicated real estate deals.
It’s like mailbox money in they it is purely passive now and allows me to reinvest it to make more. And when I retire and when the market tanks I don’t have to lock in losses by selling depressed equities if I can live off the cash from these income streams. I had called it my capital snowball
Warren Buffet also said, and I quote:
“Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund”
“The 21st century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners — neither he nor his ‘helpers’ can do that — but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.”
Yes, he did say those things… but that’s not what he does. He’s very much in the public eye these days, so *of course* he’s going to give the standard “safe” advice to the masses.
Look at what he actually does though. That’s an entirely different story.
I just noticed that you have a new header on the landing page with the City skyline. Nice. From which vantage point was this shot taken?
I’m a big fan of income investing and love the growing dividend income steam.
You have created a great stream of growing dividends and this will be a torrent in another decade.
Thanks Mike. The header image changes on every page load (or it should), so I’m guessing you’re referring to the skyline photo I took of Wakayama city.
I took it at a rest stop is called “Kinokawa SA (Northbound)”. Here’s a google maps link: https://goo.gl/maps/kEn2Uw1gH8z
I always find this topic interesting. Mainly because of taxes on dividends etc eroding my income versus capital growth (with deferred taxes effectively)… and oftimes it seems that it’ll take longer to get a portfolio throwing off 4% of cashflow for FIRE versus 4% of portfolio drawdown. Think, the best is almost to ride that capital growth, job income, bonuses so you can then flip into income and secure the cash flow…
Another thing I find interesting about capital growth versus dividends is in relation to Berkshire itself, in that they don’t pay dividends, but have been a great example of capital growth and made holders very wealthy on paper. Interestingly if something “happens” like fraud at Berkshire and the share plummets to 0, investors will have received no proceeds to date and all that compounding will have been for naught. If instead they’d received a 1% dividend yield over that time they’d easily have recovered their initial investment.
Just because Berkshire doesn’t pay dividends doesn’t mean they don’t love dividend investments. They really do. Check the history/Buffett’s comments. He absolutely loves divided income.
That said, I highly doubt we’ll see a major fraud at Berkshire that could truly upset the applecart. The business isn’t really structured that way. A huge catastrophic loss at one the the insurance companies could do some major damage, but they could simply sell the stock-holdings to cover any overly huge insurance claims.
Check out how all the assets are held at Berkshire sometime. It’s interesting.
Am familiar with their love for divis.
In terms of the potential for fraud, was thinking more in line of the fact that you’ve got huge trust in that organisation, if you wanted to do something you could definitely do so – it’d be the perfect crime for the next level of management once Buffett and Munger move on. Am just aware of it, since in South Africa we had just such a crime recently. Although multiples smaller, the CEO of Steinhoff managed to make a $20bn acquisition conglomerate disappear overnight, was a big personality, very well respected, perpetuated over 20 years apparently. You could hide a lot in a big co like Berkshire of market cap $500bn.
Was just thinking that perhaps (as an outsider) don’t want to hold all my eggs in a single Berkshire basket, whereby due to receiving no dividends as a shareholder over these years I’d having nothing if it went against me. I’d rather be like Buffett and buy dividend paying companies, not only capital growth like his Berkshire shareholders.
Yeap, cash flow is king. Your cash flow engine will generate income in good and bad times. It might fluctuate a bit, but the income should still come in.
I have dividend stocks, bond, real estate, and business income. Even if some of these decreases, we should still be fine. Stock market appreciation is gravy.
Totally agree Joe. I’ll take the gravy when I can get it, but I’ll eat my steak without it too!
Warren’s quote seems to be referring to individual stocks. I don’t think it is fair to apply it to investing in the broader US stock market via index funds, which to my knowledge, Berkshire doesn’t do. Telling people not to invest in index funds because the prices have been going up for the past decade is telling them to time the market.
Maybe you should re-read the post. I said no such thing. This post simply points out the difference between the popular investing strategy of the day and what super investors like Buffett actually do. And why it works.
I never said anything close to “don’t invest in index funds”. This post is about cash flow.
Yup we get a lot of questions like ” a stock market crash is coming! What ever will you do?!”
Simple. 1) Yield Shield 2) cash cushion 3) geo-arbitrage.
We survived the 2015 oil crash in retirement with our portfolio in tact. It’s pretty sweet when you get paid those dividends and fixed income even as the market goes down. I never lost a single night of sleep. Cash flow baby!
What could you do for item 3 Geo-arb when the downturn/crash causes your currency to be the weak one?
Bob, regarding Berkshire and dividends – read Berkshire 2012 annual report p19 – p21. In short, at BRK, you decide on a percentage earnings you want as payout, and sell some shares.
Hi Mr. Tako, great post. I’ve been reading Ben Graham’s intelligent investor and recently went through a section where he wasn’t so enthused with preferred shares.
Something about not having many rights during bankruptcy and them bring able to be recalled. But you’ve done well with them and slept at night (I presume) invested in them during the GFC.
What do you tend to look at to determine preferred shares risk? Do you recall the section I read and how did you read it, does his advice still apply?
Great post! Couldn’t agree more that having a steady cash flow or passive important is more important to grow your wealth than market one off gains.
Can someone please explain this
“Returns are higher when prices go lower.”
Think about your return as a product of earnings yield and you’ll get it.
Earnings yield = E/P
Hi Mr. Tako,
Are your investments still tilted towards dividend growth stocks, even now w/ the free fall of the market? How come no bond funds, especially since Fed is the main buyer?
I’m not a huge fan of bonds with rates this low.