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The rich, rich in more ways than one, focus on assets, in particular, cash flowing assets instead of buying plasma TVs, they buy dividend paying stocks. Instead of buying sports cars they buy four-plexes first and use the income to buy the sports car. Instead of buying a large house, they invest in covered call option stocks which deliver a monthly cash flow stream and later buy the large house. They invest in their education on the various assets before purchasing. Rich folks invest for cash flow first and capital gains second. A rich investor will buy an apartment complex first because it makes cash flowing business sense. If the property appreciates in value, the appreciation is gravy.
“What about Warren Buffett?” John asked. “From what I have read, my understanding is that Warren Buffett buys good companies and invests for the long term. My understanding is that Buffett invests for capital gains.”
“That is a great question John and here is the answer. Warren Buffett buys businesses and uses those assets to grow his wealth. He treats an investment like a capital incubator. He buys good businesses at the right price with sound, internal and competitive economics working in their favor and holds onto the stock for long periods of time, sometimes never selling, generating returns of approximately 20% a year. He views a company’s retained earnings as his return on investment. He does not sell unless the underlying economics of the business change thus, he does not invite the tax man to the party allowing his investment to compound without tax consequences.
“Thus, there are similarities between a cash flow methodology and the Warren Buffett approach. We are looking for cash flowing assets that generate in excess of 20% a year whether it is cash flowing rental property, covered call options or dividend paying stocks … more on this later. Buffett leaves his money in the “compounding engine” of a business investment and does not withdraw for cash flow. He does take a paycheck from his company reportedly at $100,000 a year. Buffett avoids the tax man as much as possible by leaving the money in the engine until the end of the investment when he sells which again is sometimes never. Essentially, by identifying great businesses to invest in, Buffett builds super compounding investment engines for his capital.
“In our world, we do pay attention tax consequences. Ideally, we invest in passive assets such as rental property which can potentially be taxed at 0% indefinitely. Thus, a passive rental investment is much like a Buffett investment … taxed at zero percent until it is sold. We also invest in portfolio income investments which can be taxed at 15%, an inferior quality compared to Buffett. The main difference is that we are investing for cash flow. We want monthly payments so that we can pay all of our monthly expenses and be financially independent. Buffett has his own business and delivers himself a paycheck to cover his expenses, so technically he is financially independent although he actively manages Berkshire Hathaway. One of the key differences is that he is willing to leave more money in the investment so that it may continue to compound without inviting the tax man.
“I am not against leaving your cash flow in a compounding engine but first, I prescribe that you become financially independent through cash flow so that later, you can choose to invest how Buffett does and let your money compound in a great business investment. First, become financially independent so you have the freedom later. If you are interested in how Buffett does it, you really must study Buffettology by Mary Buffett. This book provides a detailed analysis of Buffett’s investing methodology … truly a must read.”
“That answers a lot for me,” John said. “So Buffett invests in great businesses that generate yields in excess of 20% a year through their retained earnings and he lets the investments churn, or compound so his money grows without interference from the tax man. He views his wealth as something that should grow whereas we are viewing our wealth as something that can cash flow and compound as well, but cash flow first.”
“Correct John, but also keep in mind that Buffett views businesses and their consequent retained earnings as his cash flow, he just doesn’t want it distributed to him in part because of the tax consequences but also because he figures that he has already found a great investment vehicle so where else would he allocate the money in an investment that can generate a return of 20%?
“In an analogy to an apartment complex, a rental property investor looks for, let’s say a property that delivers a 25% cash on cash return per year. Buffett on the other hand identifies a good business at the right price that can generate 25% a year. When the business has cash flow, he wants the money to stay within the company because it can continue to grow in value and generate 25% a year on the new earnings. In the apartment complex analogy, it’s similar to the ability to use the cash flow to add on to the existing apartment complex, say eight more units that will generate 25% a year on the new money. Or, again in the rental property analogy, it is the ability of the investor to take the cash flow and use it to buy a new building that will generate a 25% return or greater. The property investor has to work a little harder to reduce the tax consequences but he also has the advantage of leverage through the bank’s money and he has the option of choosing what to do with his cash flow at potential zero percent taxes. He can use the cash flow to pay for a car if he chooses … Buffett has to leave the money in the investment to avoid capital gains. This leads to ultimate wealth but it does limit your options on using the money to buy things.”
“How many toys can one person have?” John asked.
“Good point John, just keep this in mind. There are many different flavors of investing. Again, your job is to identify the right one for you.
“Let’s continue on, again, remember, the rich invest in cash flowing assets, assets that generate enough to cover expenses. Once this threshold has been reached, you are financially independent.
Again, our four stages of financial independence:
Stage 1: Monthly Passive Income = Monthly Expenses
Stage 2: Monthly Passive Income = 2X Monthly Expenses
Stage 3: Monthly Passive Income = 3.33X Monthly Expenses
Stage 4: $100,000 in Monthly Passive Income
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