Charlie Munger: The First $100,000 Is A B*tch

A Sunday mailbag from reader Ben:

Hello Tim,

My name is Ben and i have read most of your articles on seeking alpha. I like your idea of establishing the net worth of $100k and investing them in dividend stocks for reliable income. I am 33 years old and i am not sure if i took too long to come up with my first $100k. ( I have kept another $100k in a separate account for my first house down payment and i dont want to invest that money in stocks )

My question is ” Is this the right time to invest in Dividend paying stocks based on their valuations ? Are there any stocks that are reasonably priced worth our consideration ? ”

I am asking this question because i am a firm believer of the famous sentence ” Price is What you pay and Value is what you get ”

Your response is much appreciated.

Thanks,

Ben

Hey Ben! I appreciate the question.

For those of you who are newer readers, the “First $100,000” was a concept from Charlie Munger. At an old Berkshire Hathaway shareholder meeting (back from the 1990s I think), a young guy asked Munger for the most intelligent financial advice he could give him. This was towards the end of the era when Buffett and Munger would say very specific things at the Berkshire meetings (as opposed to the “I don’t know you and your circumstances, and can’t tell you how to live your life so just try to learn what you can and get a little bit smarter each day” that has become the default response to such questions in recent years).

For a while, Munger would give the explicit advice: “The first $100,000 is a b*tch, but you gotta do it.” And then he would go on to say (my paraphrase from memory):  “I don’t care what you have to do—if it means walking everywhere and not eating anything that wasn’t purchased with a coupon, find a way to get your hands on $100,000. After that, you can ease off the gas a little bit.”

The logic was that $100,000 is the mark at which your money at which your money really starts working for you (to fast forward Munger’s advice two decades, it might be more appropriate to use $150,000 as the figure). Either way, you can see how you’re latching yourself onto a rocketship once you hit the six figures. A $125,000 portfolio yielding 3.3% is making $343 per month which you get just for staying alive another 30 days. If the dividends grow by 7% across the portfolio, and you are reinvesting the dividends, those $343 monthly checks will be turning into $378 checks this time next year without you adding anything. Then, they’ll turn into $416 two years from now. Three years from now, they will turn into $458 monthly checks. It’s a self-propelling thing.

If that had been your story over the past three years, you would have gone from generating 7.91% of the average American household’s monthly income in dividends alone to 10.57% of the average American household’s monthly income. That’s not even including any additional contributions to the snowball, and the strides taken by the dividends themselves get bigger and bigger each year. Things are a lot easier if you have something automatically growing for you each month, and a base of reinvestable capital is a great item to mark off your checklist of things to tackle early in life.

As for valuation, it depends on what you’re trying to do, although a good rule of thumb is this: If you look around you and can’t figure out what to do, dollar-cost average into ExxonMobil stock.

The Exxon Computershare option lets you buy Exxon stock each month for no charge.

It’s one of the few “when in doubt” options that exists in the market place. Why? Because the company has earnings power of $35 billion in annual profits across 40 countries. They generate so much free cash flow from their operations that they retire 4-5% of the outstanding common stock each year. The dividend goes up annually, which is rare in the commodities sector because the business model isn’t really built for that kind of linear smoothness (but Exxon’s operations are so diversified and its dividend payout ratio so low that it can afford to massage its dividend growth). If you had $10,000 and a buy order for Exxon Mobil in 1975, you could be chilling in a $2 million house that you bought in cash right now. More recently, every $10,000 invested into Exxon in 1995 would be worth $85,000 today.

The additional beauty is that the company almost never gets overvalued. The only time it would have not worked out for you (yet) is you went all in on Exxon stock in 2007 right before the financial crisis when the price of oil was breaking new highs, and my guess is that even purchases at that point will deliver satisfactory results when we stretch out the passage of time another ten years. Large oil companies very rarely get overvalued because their profits are cyclical and no one gets called a genius for stating the obvious that Exxon is a good company, but it’s a great all-weather option for someone who wants to increase their purchasing power by six or seven percentage points above the inflation rate over the long term.

As for other dividend stocks, it depends: What are you after?

If you want to look for rapid future dividend growth, as well as a stock set to increase in price, you’d want to look at something like Citigroup. That’s true value investing. The book value of the stock is $65 per share and its stock price is $45 per share. That’s the kind of discrepancy that makes the value investing team at Tweedy, Browne salivate. Once Citigroup receives clearance to raise its dividend in the next year or two, my guess is that you’ll start to see rapid price appreciation over where we’re at now (but who knows?).

The catch? In the short term (next 1-3 years), it’s entirely possible that the stock price could be quite volatile. Also, it’s the type of company that would eventually demand an exit strategy. You might be fine holding it for five, ten, even fifteen years. But it’s not at all the kind of stock made out of Johnson & Johnson or Nestle timber where it would be a useful tool for creating intergenerational wealth. No one says, “I want Citigroup stock to be part of my estate twenty-five years from now.” But as a value stock with a nicely growing dividend over the next five years, it could be worth a look.

If you want something rapidly growing, you might take a look at Visa. Its valuation is admittedly lofty, but the company has no lost, low capital requirements, and grows super fast.

People fret about its valuation being in the 25-30x earnings range, and that’s an understandable concern. But when Visa went public again in 2008, it was trading at 40x profits. And you know what Visa did? It grew profits per share from $2.25 per share to $7.59 in 2013. That’s why the IPO investors who paid 40x profits have achieved 23.68% annual returns since then, turning every $10,000 invested into over $36,000 already.

Analysts are estimating that Visa will be making $15.00 per share in 2019. What do you think it will be valued at then? 20x profits? 25x profits? That gives you a share price of $300 to $375 five years from now, plus any dividends you receive. Paying Visa’s current valuation would only make sense if you are very, very confident that its earnings growth projections will pan out. Otherwise, don’t do it, as the stock price offers no current margin of safety.

I’m also coming around to the notion that Colgate-Palmolive is a great deal, even though it always seems perennially overvalued based on any traditional valuation metric. That conclusion is partially based on historical analysis (I noticed that people who paid around 30x profits for Colgate-Palmolive in 1999 have achieved 9.8% annual returns since then). It’s almost based on a qualitative look at their business. Soap, toothbrushes, and toothpaste cost very little to manufacture on a wide scale, but the company can sell them for 10x or more what it costs to make. The earnings figures have been constrained by currency devaluations (particularly Venezuela), and the company is not nearly as developed in its international growth story as Coca-Cola. I’m becoming more and more open to the idea that Colgate-Palmolive in 2014 is similar to Coca-Cola in 1988. It doesn’t look cheap at first glance, but when you look at where future profits are headed, and then adjust for the super high quality of those profits, you might see what I mean.

Getting the business right is more important than getting the valuation right. The main hurdle is to make sure that you’re compounding and reinvesting with the right businesses. I’m sure there were plenty of times in the 1980s, 1990s, and 2000s when Wachovia looked much cheaper than Nestle. Yet, the Nestle investor that started buying stock in 1996 would have turned every $1,000 invested into the grocery food giant into $6,000 today, while the Wachovia investor would have gotten completely wiped out. The same exact delayed gratification behavior, and yet one person increased his wealth 6x and the other person effectively took his money and torched it.

You can be different than everyone else though, Ben. Reverse engineer the process. Don’t make a list of companies that look cheap and then choose the highest quality company from the list. Instead, make a list of the companies that you believe are the highest quality, and from there, choose one that looks fair to you. Once that constitutes 80-90% of your portfolio, maybe then you can find room for a Citigroup or two. But, for the most part, the harm of overpaying 15% for Johnson & Johnson will be minimal compared to misjudging the long-term earnings power of a company that superficially appears to be cheap in the here and now.

With Easter coming up, I’ll end with a biblical metaphor. You know how David hooked up with Bathsheba and that seemed to be a pretty big deal, with adultery going against the 10 Commandments and all? Well, years and years later, the consequences of that decision turned out to be quite nice, as that was the bloodline that ended up producing Jesus Christ.

Well, if value investors have a list of “10 Commandments”, the ultimate sin would be overpaying for a stock. But if that stock turns out to be a wonderful business, years and years later, the consequences of that decision will turn out to be quite nice. Even someone who paid over 30x profits for Hershey in the late 1990s would be getting 11% annual returns averaged out to this day.