Almost everything I try to accomplish when it comes to portfolio construction is a combination of three ideas that I learned from Columbia professor Benjamin Graham, Berkshire Hathaway Vice Chairman Charlie Munger, and Wal-Mart founder Sam Walton.
Benjamin Graham’s theory of diversification is one of the most basic suggestions that I find compelling to follow. In fact, Graham’s arguments in favor of diversification is so common-sensical that most investors take it for granted that diversification is a given, and the only question thereafter is how to diversify. Most people have moved beyond Andrew Carnegie’s recommendation to “put all of your eggs in one basket, and watch that basket” because they want to continue to make money in the event that something bad happens. If your McDonalds holding starts to falter, you still have Exxon and Chevron pumping out oil dividends for you. If Wal-Mart starts to run into trouble, you have Coca-Cola dividends coming in still. It is a great way to arrange your life so that you can run into trouble with some stocks and still make money due to the heavy lifting performed by the other companies in your portfolio.
The second strategy concept I find highly persuasive is Charlie Munger’s recommendation that investors spend most of their time focusing on companies that consistently increase their intrinsic value. He calls this “sit on your ass” investing. All you do is accumulate capital, find an excellent business at an attractive or reasonable price, buy shares, and count the dividends as they roll in.
Nothing is guaranteed in this life, but it is highly likely that Exxon will continue paying out its dividends like it has done since 1882. General Mills, Procter & Gamble, and Colgate-Palmolive have been paying out dividends since the 1880s and 1890s. If those four companies become meaningful parts of your wealth-building story, you can know that you are buying into a business model that was able to pay dividends during WWII when the Germans and Japanese were actively trying to kill Americans and take an ax to the leading powers of Western Civilization.
The third concept I find useful is the notion of liquidity. This comes from Sam Walton who once said that you cannot go bankrupt if you do not owe anybody anything.
When I study the great businessmen of the 20th century who have failed, one of the following three elements is almost always present:
(1) Excessive risk taking
(2) A drinking problem
(3) A liquidity crisis/cash flow problem.
In the past five years, we saw an excellent, and generally conservative bank, Wachovia, collapse because it did not have liquidity. A shortage of cash at the wrong time can be a great way to bring some long-term pain into your life that may perhaps have some serious ramifications down the road.
That is why I gravitate towards stocks that pay dividends. If you buy 300 shares of Royal Dutch Shell, you will have $1,080 deposited into your banking account each year. It adds to the cash flow you have coming in from your job. I love the long-term economics of a company like Berkshire Hathaway and Google, but I couldn’t build an entire portfolio stuffed with those companies because they do not improve your liquidity. But with dividend stocks, every dollar you set aside adds $0.03-$0.04 to your annual cash flow.
A great way to be a terrible investor is to make concentrated bets in terrible companies that set you up for a liquidity crisis. The good news is that you can structure your assets in the exact opposite way to achieve a more desirable outcome for yourself. You can follow Graham’s advice and diversify across 20-50 companies so that you can handle unexpected business performance and still grow your health. You can deal with the highest quality companies so that the probability of business failure is miniscule on an individualized basis, and becomes even more remote when you view a portfolio of 30 companies with unassailable moats. And if almost all of your holdings pay out meaningful dividends, you can have money coming into your checking account all the time so that you can avoid a liquidity crisis.
Diversification. High-quality. Cash coming in. That’s it. That’s the secret. Combine those three elements, and wealth-building for the long haul is yours.
Originally posted 2013-07-21 08:05:01.