I spent a large portion of today studying businesses that collapsed due to high, fixed costs. I studied why General Motors failed. I looked into the failures at Border’s and Barnes & Noble. The more I try to figure this whole investment thing out in the broader context of life and business, the more I realize: cash flow is the lifeblood of success.
It sounds extreme, but it’s the conclusion I’m coming towards: don’t have $200 in monthly cash flow to cover your food costs? Yeah, that’s going to make you miserable, although perhaps leaner. Don’t have $1,300 coming in to cover your rent/mortgage? See how much you like those “it’s the experiences and people that matter, not money” inspirational quotes that show up on Twitter. Don’t have $150 to cover the electric/water utility bill? See how many of those people and experiences you have when you haven’t bathed since the 27th.
In the cases of General Motors and the book stores, you had a situation like this (numbers made up for illustrative purposes): those businesses needed $700 million to keep operating each quarter—regardless of how many customers they had or items got sold, that cost was required. If you make $400 million over that quarter, you lose. If you make $600 million, you lose. If you make $699 million, you lose. You have to access the debt markets or create new shares to continue with the status quo.
Now, when things are going well, the business looks much more interesting—those $700 million quarterly costs didn’t rise that much as sales increased. If you brought in $1 billion, cool—you have a $300 million profit. Now, if things went really well and you brought in $2 billion, that $700 million fixed cost may have only gone up to $800 million. So you’d get $1.2 billion in profit.
In other words, although the costs would go up a bit with high sales, the general principle that emerged was this: You have a fixed amount of requirements, and until you reach that point, all business is terrible. But if you can get the tide to turn, then almost of those increases in sales can go straight to the bottom-line as profit.
A household budget operates in a similar way—you might tally up all of your expenses and realize you spend $5,000 per month while you earn $6,000 every month. While that spending/income differential remains your status quo, how you allocate that $1,000 difference is going to amount to being the lifeblood that seriously change your life.
Imagine if that was your family’s financial situation in 1998, and you took that $12,000 spread between what you earn and what you spend and you chose to buy a block of Conoco stock. With reinvested dividends, you would be sitting on 820 shares of Conoco today, with 410 shares of Phillips 66 as well. Conoco pays out a $0.73 quarterly dividend, so you would be collecting $2,394 each year form that. In the case of Phillips 66, the payout is much lower because the company is only paying out a third of profits to shareholders as a dividend, so you would only be collecting $820 each year from that decision, although I would expect that would grow more lucrative with the passage of time.
Decisions like these transform household budgets—that single decision to buy Conoco now results in $3,214 in annual income, giving you $267 per month. At its heart, that’s what income investing is all about. If you are making $6,000 per month and spending $5,000 per month, that one Conoco decision helped the spread become $6,267 in monthly income, increasing your difference to $1,267 each month. And, of course, Conoco and Phillips 66 aren’t done raising their dividends yet, so this effect becomes more pronounced with time.
Why doesn’t everyone do this? Because it requires you to do three things right: (1) you have to choose a cash-generating asset that will continue to throw off cash for a long time; (2) you have to wait several years for the dividend increases to mix with the dividends that actually get reinvested, for the full effects of the income growth to occur; (3) and you have to avoid the temptation to increase spending as soon as more income comes your way. Those are the challenges that stand in the way of pulling something like this off.
Still, imagine what can happen if you hold that $1,000 difference steady, while you slowly build a collection of Conoco, GlaxoSmithKline, Royal Dutch Shell, BP, AT&T, and Philip Morris International to add to your dividend portfolio. You do that for a couple years, and it takes on a life of its own. Just by carefully choosing six cash-generating companies to split those $1,000 monthly contributions towards will easily result in $2,000 dividends from each within ten to fifteen years. You could easily have a situation where six years of saving $1,000 per month could be sending you more monthly cash in aggregate than you’d get from Social Security checks. Even if you spent the dividends along the way, the nature of compounding starts to go haywire after the fifteen year mark so you’d end up getting substantially richer during your retirement years. Do the math yourself, and look what happens to compounding figures during years twenty through thirty.
Originally posted 2014-09-17 08:00:04.
Your example is a good way to illustrate why many capital intensive industries are also generally cyclical.
About brick-and-mortar stores, a commonly overlooked issue with their finances are how their “fixed cost” work. Many brick-and-mortar stores can appear in better shape than they really are due to how leases are reported (the so-called capital vs operating lease where leverage can be hidden by the way leases are signed). When you start adding cyclical cycles and technological shocks to these retailers… it gets rather “interesting”.