A brilliant 94 y.o. investor?

Edward Zajac is an amazing man: at 94 he is still alive, sprightly (or so it would appear from his photo), and actively investing his own $2.5 million share portfolio …

… and, is still sharp enough to describe himself as an opportunist.

Wealthy Matters shares Ed’s financial success with his readers (you should read the whole article to learn more about Ed’s ‘EZ’ investing system):

Stick with stocks, says investor Edward Zajac. He should know. The 94-year-old has been trading for 72 years and said he’s made about $2.5 million.

So, should we all aspire – strictly from an investing standpoint (after all, who doesn’t want live to 94 and still be so ‘with it’) – to be like Ed?

Absolutely!

According to my calculations, Ed (assuming he started on or around the average salary for college educated technicians “installing computer systems” of $1,900 in 1939) would had to save 50% of his salary until he retired young (at the age of 51) and receive Warren Buffett level stock investing returns (21% compounded) for the entire period!

What I can’t model, because the numbers simply fall short, is how Ed managed to draw enough salary to “travel the US in a recreational vehicle with his wife” after he retired in 1968, yet still manage to double his portfolio again in the 42 years since he retired.

Good on you, Ed, we have a lot to learn from you

Dividends: real cashflow or fake cashflow?

If you’ve noticed, I made a couple of adjustments to this blog:

The first is that I have reduced my posting schedule to (generally) twice a week; I’m trying for a Mon./Thur. posting schedule, but – if you enjoy reading this blog (near-future multi-millionaires need only apply!) – your best bet is to sign up for the RSS/e-mail feed on my home page because I’m fickle … if I get the urge, I’ll post daily, or simply shift days to suit my increasingly challenged schedule

The second is that I’m posting more business-related posts (e.g. my Anatomy Of A Startup occasional series) … I am funding a series of startups with the ultimate aim of a Y-Combinator style of early stage entrepreneurship mentoring / funding program and what I am sharing in this series is real ‘special sauce’ stuff … like everything that I do, it’s usually simple but works!

Back to the first change: if I write less frequently, I’m hoping to challenge myself and my readers even more. To whit, my last post (inspired by Canadian Couch Potato’s brilliant post on the same subject) inspired a one week long comment-debate … one of the best that I have seen on this blog.

The main thrust was the debate around income v capital growth.

Jeff stated the ‘for’ argument best when he said:

The reasons why people desire rental income from real estate are the same reasons why people desire dividends from stocks…you get a cash flow without having to sell the asset at an inopportune time.

But, there’s a key difference between so-called ‘Income Real-Estate’ and its stock market equivalent – Dividend Stocks: Income RE produces REAL cashflow, Dividend Stocks produce FAKE cashflow!

To illustrate, let’s take a look, first, at income-producing real-estate:

Tenants pay rent; you pay costs; what’s left (if any) is real, spendable, excess income/cashflow that generally increases with inflation. Bad RE doesn’t produce an income. Period.

Now, let’s take a look at so-called Dividend Stocks (i.e. Company stocks that you buy specifically because they produce a nice, steady dividend stream):

Dividend-paying company sells stuff; they pay their suppliers and other costs; Good company produces profits / Bad company produces losses.

In either case, the Board meets and says “we gotta pay some dividends”.

The CFO says “But, we got bills to pay!”; CTO says “I got R&D to do!”; COO says “I got warehouses to build!”; CEO just wants to keep his job (he is hired/fired by the Board, remember) and says nothing …

The Board says: “Too bad. If we don’t look after our shareholders they’ll crucify us … even worse, they’ll vote us off our nice cushy board positions and we’ll even have to buy our own lunches!”

“Let the CEO deal with poor cashflow and working capital, insufficient warehouses space, outmoded products and technology, lack of marketing, and so on … heck, we’ll even borrow money from our provisioning funds or the open market, if we have to. No matter what, those Dividends must be paid … after all, we are a Dividend Stock!”

So, they say “no” to the CFO, COO, CTO, CMO … and, every other shmo’

Do you want your board fussing over distributing cash that it may or may not be able to spare? Or, would you rather that your Board focussed on building a GREAT company, with GREAT long-term growth and profitability prospects?

In order to answer that question, there’s one more feature of dividend stocks that we still need to examine; Kevin @ Invest It Wisely says:

The pro-dividend guys do have a compelling case that dividends grow more smoothly than the ups/downs of the markets.

To which I say, “so what?”

As we have already seen, the apparent  ’smoothness’ of the dividend stream can be illusory.

And, what are you going to do with any dividends that you have received pre-retirement?

I presume that you are going to reinvest them so that you, too, can get to $7 Million in 7 Years (or, at least to your own relatively large Number by your own relatively soon Date).

In other words, you’ll just take that relatively nice, smooth dividend stream and throw it right back into the choppy market [AJC: Next, you'll be telling me that you're Dollar Cost Averaging ... somebody, grab me a Tylenol, please!].

If you’re going to be fully invested in the stock market, for a number of years, then why don’t you at least buy some stocks in great companies that are going to grow, grow, grow … profits?!

If they happen to pay dividends, well great [AJC: you're going to give it straight back to them, anyway, aren't you?], and if they don’t, well who cares?

I mean, would you rather own “this dividend stock [that] has delivered an annualized total return of 3.10% to its loyal shareholders”? Or, would you rather own this never-ever-paid-a-dividend stock that has delivered an annualized total return of 20+% to its loyal shareholders for over 40 years?!

However, there is one special case (i.e what if you are already retired?) that I want to examine next time …

Another case AGAINST dividends …

The graph shows the promise of dividend-investing, but Canadian Couch Potato states the reality – the case AGAINST dividends – far more eloquently than me:

Why do shareholders believe so strongly that a $1 dividend is preferable to a $1 capital gain? Meir Statman looked at this question in a 1984 article called “Explaining Investor Preference for Cash Dividends,” coauthored by Hersh Sheffrin. He also reviews the idea in his new book, What Investors Really Want, pointing out that receiving $1,000 in dividends is no different from selling $1,000 worth of stock to create a “homemade dividend.”

Even when this idea is explained to people, most refuse to accept it. Statman suggests that it comes down to a cognitive bias called mental accounting. Investors categorize $1,000 in dividends as income that they will happily spend, but the idea of selling $1,000 worth of stock is “dipping into capital,” which causes them great anxiety. This idea is deeply ingrained in many investors, but it is an illusion, because a company that pays a dividend to shareholders is depleting its own capital.

If you want to understand the arguments – both for and against – investing in so-called ‘dividend stocks’ for the sake of the dividends, you would do well to read Canadian Couch Potato’s whole blog post AND the comments … all for/against arguments are well thought out.

Here is my argument against dividends in a nutshell:

Since you can create a dividend stream yourself (“ignoring taxes and transactions costs, a stock that pays no dividend but increases in price by 6% provides precisely the same return as one whose share price rises 4% and pays a 2% dividend”), it boils down to what could the company do v what can you do with the ‘spare cash’ that the company plans to issue (or not issue) as a dividend:

1. If the company keeps the dividend:

- They could buy more inventory: if their business is a volume business, more inventory = more profits. Consumer products companies such as Kraft and Unilever are great examples.

- They could do more R&D: investing in R&D is necessary gambling on the future; often it will be money wasted (in which case it’s better off in your pocket as a dividend), but sometimes it will provide a huge payback, such as when a pharmaceutical company develops a breakthrough medication, or a venture capital firm finds the next FaceBook.

- They could invest in marketing: more marketing = more sales; pretty simply, huh? Consumer products and technology companies are classic examples; the more often they put their products in front of the consumer, the more sales they seem to get.

- They could invest in more infrastructure: more factories, more locations = more revenue and more profits. Manufacturing companies, high tech businesses, and retailers are all tied to physical infrastructure.

- They could invest the cash – Many companies (think Microsoft, Apple, the tobacco companies, and the brewers) are sitting on a ton of cash. Heck, Berkshire Hathaway is sitting on so much of it, even Warren toys from time to time with giving it back to the shareholders (i.e. by issuing a dividend); after all, if they can only get 3% while it’s sitting in the bank and you can get …? Inevitably, though, they use this cash to make a spectacular purchase that transforms the company: think Google’s $6.5 billion offer for Groupon, or Berkshire Hathaway’s $44 billion purchase of BNSF Railway.

2. If you take the dividend:

- You could buy more stock in the same company: this is the basis of the automatic ’dividend reinvestment policy’ that most companies now offer. So, let me see … you invest in company ABC because it issues a dividend, and you use it to, what? Oh, buy more stock in company ABC?!

- You could buy more stock in another company: why invest in another company? Oh, because it provides a better return. So, why not pull ALL of your money from the worse-performing dividend paying stock, and put it all in this company?

- You could buy more stock in a bunch of companies: diversification is often seen as a good thing [AJC: by many reading "how I became rich" blogs; rarely by those writing them]. The more you diversify, the more you tend towards average market returns. Why would you want to take your cash out of a company that produces spectacular returns [AJC: that's why you invested in the 'dividend stock' in the first place, isn't it?!] in order to put your money into something that produces average returns?

- You could keep your cash in the bank: strangely enough, this one makes sense; if the company can’t do anything better with their ‘spare cash’ than give it to you, wouldn’t you rather have it sitting in your bank account rather than theirs, so that you can at least have the flexibility to make the decision what to do next, eg leave it in the bank, buy some index funds, pay down debt, or even buy back into the company stock when they get out of the ‘sit on a ton of cash with no vision for the future’ doldrums.

… but, if any of these things are better than leaving the money in the company, wouldn’t you be better off taking all of your money out of the company all in one go (i.e. sell the stock) rather than in dribs and drabs (i.e. taking small dividends)?

Let me finish off with a story:

Warren Buffett got started by purchasing a textile company and immediately canceling it’s dividends!

Why?

So that he would have more money to invest in growing the company.

Potential investors who wanted dividends invested elsewhere … those who didn’t invested in Berkshire Hathaway and became multi-millionaires!

Berkshire Hathaway still operates on the same principle: why pull money out of BH when Warren can grow your money faster?!

Beat 80% of professional fund managers!

I’m disappointed! I thought that 7million7years.com and it’s membership-site ‘cousin’ 7m7y.com were important enough to be hacked … but, they weren’t

Turns out that MANY GoDaddy-hosted WordPress sites have been similarly ‘hacked’ – with users seeing a [false] SECURITY WARNING ALERT!!! message. GoDaddy appears to be working on have fixed the issue, in the meantime, please read on for today’s un-hacked post ….

_________________________________

Shawn at Watson Inc. outlines a sensible ‘system’ – one that I have spoken about before – that beats “80%-90%” of professional fund managers [my highlights]:

Some may ask what I mean by systematic investing. Peter Lynch (Fidelity), Warren Buffett (Berkshire), and even Dave Ramsey recommend a conservative and simple approach for the typical investor: rather than trying to outsmart the markets, use benchmarks to track the markets instead. For example, the Vanguard Index 500 fund has outperformed two-thirds of all mutual funds on a rather consistent basis (Cash Flow Quadrant, 1999). Usually over 10 years, these types of index funds yield a return exceeding 80-90% of returns of the “professional” mutual fund money managers (Motley Fool, 2007). Interestingly, the average millionaire is this type of investor (The Millionaire Next Door, 1996). Although there is no 100% guarantee, this method does dramatically decrease the risk over time and provides respectable returns. Provided that one starts early enough (i.e. before mid-forties), consistent investing over time can be the key to achieving a great deal of wealth.

Now, who wouldn’t kill for a system like that?

Well, me for one … and, I’m guessing, most of you!

You see, we (7m7y readers) have a very special filter that QUALIFIES us; it’s the title of this blog: “How to make $7 million in 7 years”.

Now, there’s no reason why you CAN’T read this blog if your target is, say, $1 million in 20 years … I can’t physically stop you … but, it’s ill-advised, because most of what I say would just be ‘noise’ to you …

… just confusing ‘chatter’ that sometimes runs totally counter to what you read elsewhere.

What I say here is ‘noise’ if you really do have very modest financial goals, or no real financial goals beyond saving and trying to become debt free.

So, in my “$7 million 7 year” context, I say “so what if I can beat 80%-90% of fund managers?” because the amount that I can make simply won’t be enough to help me reach my Number … certainly not if it’s one of my main financial strategies.

Instead of worrying about the pro’s and how the vast majority are simply butchering the mutual funds that they are supposed to be wisely managing, realize that investing in the ‘market’ (e.g. by investing in a low-cost index fund as sensibly suggested by Shawn) actually LIMITS your returns to that achieved by the market: 8% over 30 years in any market, 12% in ‘average’ times, and 0% (or worse) in recent times.

Try this:

a) Plug your starting Investment Net Worth (i.e. what you could scrape together to invest) into a compound growth rate calculator

b) Also, plug in how much you think you will be able to add each year

c) Include the number of investing years that you would like to have before you finally ‘stop work’ to live off the fruits of your investments

d) Plug in any number from 1% to 12% that YOU think an Index Fund will reasonably return over the number of years that you allowed, above

e) Halve the answer that the calculator gives you to (very roughly) allow for 4% inflation, for every 20 years (or prorate, if less than 20) that you chose, above.

f) Divide your final answer by 20: on a VERY GOOD DAY, that’s roughly (in today’s dollars) what you will have to live off, each year.

If that’s good enough for you, congratulations on two counts:

1. Thanks to Shawn, you’ve just found your Ideal Investment Strategy … and, it’s easy / low risk, to boot! And,

2. You’ve also saved 2 minutes a day, because this blog – for you – is just noise …. [crackle ... and, out!]

But (!), if the answer is NOT good enough for you [AJC: it sure wasn't good enough for me! But, it just might be good enough for you - be TOTALLY honest, this could be the financial 'tipping point' for you] … commiserations: your life just became a whole lot harder!

If so, keep reading … I’ll do what I can to soften the blow

From Warren to Phil to Me to You …

Phil’s a great speaker and this is a great story; it tells you where Rule # 1 comes from.

BTW: if you’ve read / got / intend to buy the book, this spreadsheet will help you apply the ‘rules’:

Rule 1 Investing – Worksheets – 90518

The Zero Dollar Emergency Fund!

Last week I asked How many months do you have in your emergency fund?

Earlier, my blogging friend JD Roth at get Rich Slowly (GRS) asked the same question of his readers, and this is what he found:

This shows that more 7m7y readers have 3+ months living expenses in their ‘emergency funds’ than GRS readers, which means …

… I’ve done a terrible job

On the other hand, if you answered “what’s an emergency fund?” good for you, you’re already a step ahead of the pack … you see, not everybody – including me – thinks that you need to have an emergency fund at all!

[AJC: At least not until after you reach Your Number]

For instance, Liz Pulliam Weston writes at MSN Money that you should have a $0 emergency fund, replacing it with a concept that she calls ‘financial flexibility’:

The whole idea that everyone needs a big pile of cash, and needs it right now, should be rethought. In reality, the failure to have a fat emergency fund isn’t inevitably a crisis. At the same time, those who feel safe because they have three or even six months’ expenses saved up might be kidding themselves.

Let’s say your take-home pay is about $4,000 a month. Although you have been spending every dime, you make a concerted effort to trim your expenses by 10%. This not only frees up money for your emergency savings but lowers the total amount you need to save from $12,000 to $10,800.

Still, it will take you 27 months — more than two years — to scrape together your emergency fund. And that assumes nothing comes up that forces you to raid your cache.

Let’s explore this a litter further: JD Roth has $10,000 in his emergency fund, but that doesn’t just represent $10,000 today …

…. it represents the future value of $10,000:

Let’s say that you intend to retire in 20 years, if you earn 9% on your money (say, invested in Index Funds) then you are giving up, say, 2% bank interest (by having your emergency fund sit in an ordinary savings account for quick ‘emergency’ access) to earn 9% – or, a net of 7%.

That extra 7% earned represents about $8k in extra interest/profit that you are giving up for the benefit of ‘peace of mind’ in an emergency. But, we aren’t investing our money in Index Funds, because we are on a mission: we want to reach $7 Million in just 7 Years!

To us – that is, those of us on a steep financial trajectory - this $10k pile of cash represents seed capital for your new business venture or next real-estate acquisition [AJC: and, don't tell me that an extra $10k wouldn't be a big help for either of these endeavors] …

… now, $10k ‘invested’ at:

• 15% (stocks) grows to $35,000 after just 10 years
• 30% (real-estate) grows to $106,000 after just 10 years
• 50% (business) grows to $384,000 after just 10 years

… a slightly larger price to pay for peace of mind

The Instant IPO

Recently, I pointed all of the difficulties of the Entrepreneur’s Holy Grail – the IPO [cue angels] …

… for all these reasons – and more – I didn’t IPO my businesses … but, I found something almost as good:

7million7years Patented Instant IPO

It works like this:

Step 1

Make sure that your company is profitable and has a reasonable track record of growing profits. This should value your company at 3 to 5 times earnings (i.e. annual net profit after tax)

Step 2

Find a Public Company in a related industry that is trading at least 12+ times its earnings after tax – the more the better, for you!

Step 3

Sell your company to that company and negotiate a mutually agreeable split of the difference between your ‘private value’ and their ‘public value’!

Basically, what you are doing is using the public company’s stock to “IPO” your own company:

You see, when you are on the outside, your company is worth only 3 to 5 times its profit to a buyer, but as soon as the other company buys you and ‘absorbs’ your profit into their profit stream, that profit is suddenly (well, after a relatively short ‘disruption’ period where the market has to get used to the sudden change in profitability of the public company) ‘worth’ 12+ times itself.

[Hint: The smaller you are relative to the size of the acquiring company the smaller the disruption ... on the other hand, the smaller you are, the less attractive your cashflow may be to them, so it helps if you also have some 'secret sauce' - i.e. Intellectual Property - to make you look that much more attractive to the 'big end of town']

The company that has acquired you has just made a huge windfall by using the difference between how private companies are valued and how they – the public company – are valued to their advantage … in fact, there are plenty of public companies that do this as a matter of course. Sometimes, it even need only be only an ideal coincidence that your company actually adds any other business synergy to theirs!

But, when you sell to them, you will find – if you are a smart negotiator – that they have gone to all the expense and trouble of the IPO process for you

Let’s look at an example: say that your company produces $1,000,000 net profit each year, and you have found a likely candidate public company. You have evaluated the market and believe that your business would sell for $4 million in the private sale market.

But, you realize that your widgets complement those of Acme Widgets Inc. very nicely. Acme’s stock is currently trading at a P/E of 12.

You approach the CEO of Acme Widgets Inc. [AJC: actually, if you're VERY smart, you'll engineer it so that he approaches YOU ], but play reasonably ‘hard to get’.

The CEO realizes that:

a) Your widgets do indeed fill a hole in his product range that will cost his capital (and, short term profits) to fill in house, and

b) Your $1 mill. profit adds $12 Mill. to his company’s value (i.e. his stock price will eventually go up by about $12 mill. when the value of all the stock out there is totaled), and

c) He happens to hold a nice bundle of stock and options set to vest in 18 months or so.

So, what is worth $4 million to you, is worth $12 million to him … how much would you sell for?

Don’t be high …

Don’t be high when you are buying or selling stocks

… you can take that advice to the bank!

New Rule # 1 Group on Share Your Number

The KC-inspired discussion on Rule # 1 Investing (thanks, KC!) has prompted me to create a new group on Share Your Number, the home of people who want to help others (and themselves) to reach their Number ,,, and, now also the only web-Community [webmunity?] partially devoted to all-things-Phil-Town – well, at least to his book: Rule # 1 Investing.

To kick things off, I am sharing some resources (including my very own Rule # 1 spreadsheet!) … so, why don’t you join today?!

Join here:

http://shareyournumber.ning.com/group/rule1investing

Fundamentals Will Out!

[pro-player width='530' height='253' type='video']http://www.youtube.com/watch?v=HiW2-hygtzU[/pro-player]

I’m not being rude when I say this guy is one-eyed about stock … apparently, his Canadian ‘friends’ call him “The Pirate”

He gives a nice explanation that stocks follow interest rates, more so than the general economy (as measured by GDP growth) … but, in his next video he gives 5 rules, the only one of which really makes practical sense to me: FWO

Fundamentals Will Out

This means, that no matter what crazy gyrations the market may undertake in the short-term, over the long-term the fundamentals will ultimately decide which way stock prices go: buy on value!