During the 1980s and 1990s resurgence of book when Barnes & Noble and Border’s would deliver record profits on behalf of shareholders, the company was successfully implementing a “high fixed cost and then everything flows to profit” business model (this is in contrast to a business model when you make roughly the same profit whether you sell 1,000 or 100,000 widgets).
This kind of business model comes with one particular risk: You must sell X number of goods to to avoid losing money. In the case of Barnes & Noble, the first $1.5 billion in 1998 went towards paying expenses–the required payments to content publishes, employees, high rents to operate the large stores, and so on. If you sell $1 billion worth of books that year, too bad–you’re going to lose $500 million. If you sell $3 billion, then great–your costs might only go up to $1.55 billion to account for the extra wages paid to employees that need to stack the unusually high book sales volume. The point is that the fixed costs can either act as a hard floor or hard ceiling, depending on what your sales figures are.
This bookstore model is analogous to how many households operate–you have a fixed number of expenses to cover housing, transportation, food, insurance, and a few miscellaneous items. If those expenses total $6,000 per month, trouble happens if you bring in less than that. If you regularly bring in $12,000 per month, then you have the option of letting that additional income trickle towards your investment accounts.
Once you take advantage of this saving and spending gap for long enough, interesting things start to happen. Almost everyone has heard the phrase, often uttered with a certain invidiousness, that “The rich get richer.” It’s not a conspiracy. It’s math. If you reach a point where income greatly exceeds your expenses, and eventually, your passive income greatly exceeds your expenses, then you will always be growing your financial assets throughout the rest of your life.
Imagine if your household spends $72,000 per year and you own 25,000 shares of Chevron. You wouldn’t actually have your entire net worth in Chevron, but I’m using it to illustrate the general principle. Every quarter, you need to come up with $18,000 to keep your household running. Chevron is going to give you $26,750. That $8,750 quarterly gap is where permanent wealth creation happens.
Why? Because you benefit from Munger’s famous lollapalooza effect. You still retain your full ownership position in Chevron, which will continue to send you quarterly dividend checks for as long as you are alive (it’s been going strong since 1882). But now, each quarter presents you with the opportunity to automatically add to that income stream.
General Electric catches your eye? Invest your surplus in GE for a year, and now you have 1,400 shares of GE stock to your name as well. When that company pays you the $0.92 annual dividend, you now have an extra $1,288 in annual dividend income to complement your payouts from Chevron.
Then, during the next year, you will benefit from three things: The growth in the dividend payout at Chevron, the growth in the dividend payout at General Electric, and then whatever you use the surplus income to purchase. That’s the secret to permanent wealth creation. It’s always been about generating more cash than you spend, and then doing something intelligent with the surplus so that the gap will be even bigger next month.
The reason why everyone doesn’t do this? Because it requires unusual, though not impossible, sacrifice during the early days. The average American household generates $53,000 per year in income. To get your hands on 25,000 shares of Chevron, you will need to save $1,800 per month for 20 years. Your initial monthly income is $4,400. Your initial savings rate would have to be 40%. That takes discipline, and a minimization of wants.
Of course, there are other ways to do the math. Hopefully, your salary would grow throughout your life. If your household was generating $90,000 per year in year 20, the required savings rate would only be 24% of each paycheck. Or, you could accelerate your savings rate over time–if you started saving $1,000 per month in year one, for a 22% savings rate, and maintained that savings percentage for twenty years, you could get there provided your annual income increases by 6% annually over that twenty-year period.
Also, if your goal was less ambitious, and you wanted to cover the annual $72,000 in expenses but not create a surplus, you would need to get your hands on the equivalent of 17,000 shares of Chevron instead of 25,000 shares. You could get there in twenty years by saving $1,250 per month, or 28% of your initial starting salary. You wouldn’t have that “General Electric” spread, but you would be powered forward by the growth of Chevron’s dividend over the long haul. If inflation runs at 3.5%, any growth in Chevron’s dividend above that amount would make you richer.
Benjamin Franklin understood this concept well, remarking in The Way To Wealth that “a young man must make what he can, and remember to keep what he holds..compounding is the stone that turns lead into gold.” It wasn’t just a pithy phrase to him–he understood how it could work in reverse and create “the tyranny of compounding.”
When France lost nearly all of its North American holdings by 1775 under the reign of Louis XV to pay off debt from the Seven Years’ War of 1756 through 1763, the monarchy realized that it would have to tax its own people to make up for the income lost from the colonial territories. France brought back the vingtieme tax, which reached everyone except the Catholic Church and certain nobles, by taxing an additional 5% of all revenues from land, property, commerce, and industry.
It produced 18 million livres, but crippled the economy because it was a tax based on revenues rather than profits, having a disastrous effect on capital intensive French businesses. Eventually, English textiles grew to eclipse the French output, and this weakening of France could have been avoided if: (1) diplomacy could have avoided The Seven Years’ War, and (2) France heeded Franklin’s recommendation to tax imports rather than putting it on the production of all French goods (taxing people doing other stuff in foreign countries is how France built its colonial empire and fortune during the middle of the second millennium.)
No one is immune from these forces. It applies to households, businesses, governments. Compounding of surpluses can be harnessed to auto-create wealth, and compounding of debts can explode into required payments that far exceed borrowing (just look at the stories arising out of the payday loan industry.) That is why it is important to sacrifice and achieve a high savings rate early in life. It is a grind with a big payoff. Munger advised living like a pauper into you hit your first $100,000 in life because then you guarantee that you’ll have money working for you. That amount gets $333 in income investing back into itself each month. It’s the first significant milestone that puts you on the path to always be growing.
Originally posted 2015-08-28 22:20:43.