Thursday, January 8, 2015

Cash Flow Is Cash, But Better

To hold cash, or not to hold cash. That is the question.
Over the years, I’ve witnessed consternation on the part of fellow dividend growth investors either directly through emails I’ve received or via passing comments in regards to whether or not and/or how much cash should be held on the sidelines, awaiting opportunities to deploy it.
Should we hold cash? How much cash should we hold? Warren Buffett holds billions of dollars in cash at any given time, so we should probably hold cash as well, right?
I’m going to discuss this a little bit today.

Start Digging

First off, I want you to realize that if your whole goal in life is to dig a giant hole, you’d be better off constantly and consistently digging, rather than sitting around collecting shovels.
And there are parallels to those of us whose major investing goal is to build enough passive dividend income so that expenses are covered, thus freeing us from wage slavery to pursue our passions or otherwise spend our time in a way that’s most becoming to us.
What I mean by that is that every dollar not invested in cash flow-producing assets is a dollar that’s not freeing you by working for you. If working at a job you don’t particularly enjoy is a version of prison cell, then every dividend dollar that hits your account can be likened to an imaginary digger, slowly chipping away at the rock and dirt that sits between your cell and the outside world, beyond the prison walls.

I’ve Never Held Much Cash

I’m perhaps biased. I’ve been incredibly anxious to invest cash almost as soon as it has hit my hands ever since I started actively investing back in early 2010. Holding unproductive cash for any lengthy period of time just didn’t make sense to me. After all, stocks offer an average annual return of around 7% over the long haul, after factoring inflation. That’s your real return.
Cash, meanwhile, loses value. Inflation ravages cash over time – so much so that $1.00 of purchasing power in 1994 now requires $1.61 for the same purchasing power. So something that cost $1.00 20 years ago would now cost $1.61, all else being equal.
Now that’s over 20 years. Cash doesn’t lose value to inflation so quickly to where holding cash for a month or two will hurt you, right?
Well, that’s correct. But we’re not talking about holding cash for a month. If we were, you’d be regularly investing like me. We’re talking about holding a substantial portion of cash on the side for however long it takes for a notable market opportunity to present itself. Perhaps where stocks become so cheap that you can’t ignore them.
In that case, I’ve got bad news for you. The broader stock market – the S&P 500 index – has increased by 94.7% over the last five years. And they’ve almost moved in a straight line up, about as straight as stocks can go.
Maybe that means stocks have to correct from here. But maybe not. What I can tell you, though, is that someone who’s been waiting for a big stock market correction over the last five years to deploy capital has been doing a lot of waiting.
I’ve been hearing about how crazy I am to not hold a lot of cash for over two years now. I can’t tell you how many emails I’ve received or articles I’ve read over the last 24 months or so that indicated that the stock market was going to crash. The charts say so, or interest rates are going to rise, or the Fiscal Cliff is going to cause stocks to go over a cliff, or the solar eclipse is a different shade of black.
But you know what I’ve been doing over the last two years?
I’ve been busy ignoring the noise and consistently investing in high-quality stocks that pay and grow dividends. And my portfolio has grown from $81,000 to almost $178,000.
So much for cash. 

Cash Flow Is Cash, But Better

See, what I’ve realized that there is something much, much better than cash: cash flow.
Cash flow is cash, but it’s way, way better. And I’ll tell you why.
So I’ve already discussed how much my portfolio has grown, but that’s really of minor importance. What is actually quite important is the cash flow via growing dividend income that the portfolio now generates.
My portfolio of 51 dividend growth stocks is now generating almost $6,000 in annual dividend income for me.
Did you catch that?
By not holding on to cash I’ve actually built a machine that generates cash every single month, on the order of approximately $500 per month (averaged out).
So I don’t need to hold cash in order to “take advantage of the dips”. My portfolio produces the cash flow – real cash money, folks – necessary to buy stocks routinely and consistently, without the necessity to hold on to a big pile of rotting and shrinking cash. My cash pile is being replenished for me every time I spend it. I invest $500. And then a month later I have another $500. Even better, this cash flow is growing due to the power of reinvestment and regular investment of my other cash flow that comes from work on my part.
So let’s say I could give you a choice of two buckets: one that holds $6,000 in cash that once spent is gone forever, or one that magically refills itself with $6,000 every 12 months and is likely to increase that amount over and above the rate of inflation annually. Which would you choose?
What I realized early on is that, as an investment, cash by itself offers me little utility, other than to work for me. If it’s not working for me it’s not providing any value at all. And I turned that realization into an incredible work ethic for my cash, where I’m basically an intolerable boss who requires my cash to work 24 hours per day, 365 days per week. I offer no holiday pay, no sick time off, and no vacations. I’m miserable. And every single time I have a new hire, I put that new hire to work right away. What’s even better is that these workers recruit new workers for me, compounding my work force!

Compounding And Opportunity Cost

This is because cash compounds itself when it works for me. Keeping $1,000 on the side, waiting for “an opportunity” that may or may not come seems silly to me when I already have “an opportunity” right in front of me to buy 25 shares of Kinder Morgan Inc. (KMI). Those shares will likely appreciate over a long period of time, regardless of the stock market’s ups and downs in the interim, due to the high-quality, cash flow-producing assets that the underlying company owns in the energy space. Furthermore, those 25 shares pay me $44.00 per year in the form of a dividend. And I can reinvest that $44.00 back into KMI shares, buying more than one share per year, which will also pay me a dividend. So not only am I growing my cash flow via the reinvestment of that dividend income, but KMI continues to increase its dividend annually – the company is projecting 10% annual dividend growth during the 2015 – 2020 period. Thus, I’m reinvesting cash flow into an asset that just so happens to also be growing the cash flow it’s paying.
Growing cash flow by reinvestment into cash flow-producing assets as well as growth via the asset itself paying out more cash flow. It’s enough to make you question what exactly an “opportunity” really is and why you’re busy waiting around.
Holding a lot of cash on the side may seem smart due to opportunity costs. The thought is that if stocks do indeed decline by a marked amount then there’s an opportunity cost of being fully invested or close to it because you won’t have capital to strike.
However, the flip side is the opportunity cost I just laid out in front of you. I could have held $10,000 in cash over the last two or three years, after stocks started noticeably appreciating. But there is just as much of an opportunity cost there as well. And that opportunity cost is the dividend income I’m now receiving and the value of the portfolio as it stands today. The opportunity cost is in the cash flow I’m now producing which I wouldn’t have otherwise been enjoying this entire time had I kept more cash aside.
Furthermore, by investing your cash into high-quality stocks that are attractively valued on a regular and consistent basis, your cash flow via the growing dividend income these stocks pay will grow over time. Thus, your “opportunity cost” naturally reduces itself over time. When you’re producing $1,000 or $2,000 per month in dividend income you don’t really have to worry about opportunity costs anymore. And that’s because your proverbial magic bucket is refilling itself so often and so aggressively with cash flow that you never lose a chance to strike when the iron is hot.

When To Strike?

But if you are the type of person who sleeps better at night with $5,000 or $10,000 in freely available cash that can be invested at any time, then more power to you. No investment return is worth losing sleep over.
However, I do sometimes question the strategy of holding on to a lot of cash in regards to timing and deployment. I’d like to think I’m rational and intelligent, and so I can understand the value in having some cash on the side if/when calamity strikes and the market takes a serious drop. However, when exactly do you deploy cash if/when this happens? If the S&P 500 falls by 5%, do you strike then? What if it falls by another 5% the next week? Did you strike too early? Do you instead wait for a 10% drop – a full correction? What if that’s just the start of something more sinister?
The problem with holding more cash than what is set aside for regular investing, in my view, is that there is no perfect time to deploy it. And that’s because we can’t time the market. You have no idea when it’s just the right time to finally release that cash and get it out there working for you, because you don’t know what’s next. You start paying attention to the noise and think the 8% drop over the course of a week is the start of global turmoil, only to watch it bounce back shortly thereafter. Now what?
It’s like we recently witnessed just this past month. The Dow Jones Industrial Average fell by 1,000 points from October 8th to October 15th. 1,000 points. Do you let the cash go after 500 points? Or 1,000? Is the 1,000 the harbinger of better opportunities? Well, you had to act fast, because the DJIA bounced back just as fast – up by 1,000 points by October 24th.
You can’t time the market. But you know what is fairly easy to time? The Coca-Cola Company’s (KO)dividend payout schedule. With 52 consecutive years of dividend raises and quarterly dividend history dating back to 1920, I’m fairly confident that next dividend and the dividend after it are going to hit my brokerage account. And this exercise can be repeated for the other 52 companies I’m invested in.
So the market can’t be timed. But my cash flow can.

Cash Flow Your Life

Although I don’t keep a lot of capital on the side and I’m typically pretty fully invested, that doesn’t mean I can’t invest relatively aggressively in stocks when equities do indeed become cheaper. I’m not missing out on any new opportunities, even while I take advantage of the opportunity of cash flow my portfolio generates.
For instance, this past month was volatile, as I touched on above.
And what did I do?
I deployed more than $4,400 over the past month.
I was able to do that because I cash flow my life. I live below my means and create a sizable gap between my income and expenses, thus leading to a constant surplus of capital with which I can invest. And of course there’s that dividend income I touched on above. So the difference between my income and expenses has been somewhere around $2,000 lately. Add in the $500/month average dividend income and that’s $2,500. I also maintain an emergency fund of somewhere around $5,000 that I can always tap in case a real emergency actually befalls me, or in case cheap stocks start calling my name. And so I tapped into that fund a bit this past month, which means I’ll have to rebuild it slowly now that the market, and many stocks within the market, have rebounded a bit.
I get that someone who holds thousands of dollars in liquid cash on the side probably sleeps well at night and has all kinds of warm and fuzzy feelings. But don’t think that if you don’t hold a bunch of cash on the side that you can’t take advantage of volatility when it presents itself. You simply have to cash flow your life and create a regular surplus of capital so that you’re investing in the ebbs and flows of the market- dollar cost averaging your way in over a long period of time. This creates a whole new source of cash flow all by itself, thus increasing your surplus and your ability to take advantage of opportunities.
I personally invest just about every single month, and have done so for more than four years straight. And I typically invest multiple times per month, thus catching opportunities every couple of weeks or so. You just can’t be much more opportune than that, in my opinion. And you can invest just like this if you cash flow your life appropriately.

But What About Warren Buffett?

You’d be hard pressed to find a bigger fan of Warren Buffett than me. I’m currently re-reading his biography. No easy task when the book is 900 pages. Furthermore, I’m planning on visiting the Berkshire Hathaway Inc. (BRK.B) annual shareholders’ meeting in 2015 as part of my honeymoon. Yeah, I’m a fan.
And so I never fail to notice when people cite Warren Buffett on the topic of holding cash in case there’s a major stock market correction.
For instance, Buffett, via Berkshire Hathaway, currently has more than $50 billion in cash and equivalents at his disposal. He calls this kind of capital his elephant gun, and rightly so.
And there was this quote in the 2008 shareholders’ letter:
I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.
I admire that conservative nature. And I also applaud it and agree with it.
However, it’s important to note that Berkshire Hathaway is a $345 billion company. Let me repeat that. It is a $345 billion company. Buffett requires a fair measure of cash on hand due to the nature and size of the company, which includes substantial insurance operations. But I don’t run a $345 billion company. And I’m quite sure you don’t either. The comparisons to Warren Buffett and Berkshire Hathaway are therefore completely misplaced and just not applicable.
Sure, they don’t need anywhere near $50 billion to cover short-term obligations, and so some investors are speculating that he can’t find any elephants – stocks/companies aren’t cheap, so goes the thought. But I think those same investors have glossed over the fact that he’s been routinely taking down elephants over the years, even quite recently. These elephants then continue to grow his cash flow to the point where now it’s becoming difficult for him to actually spend/invest it in an appropriate way to meaningfully move Berkshire’s needle. But I don’t have that kind of needle to move. It’s quite easy to move my needle.
So take 2008, the year I cited above for that quote. Berkshire ended that year with less than $26 billion in cash. Fast forward to 2013, Berkshire spent $18 billion on two major acquisitions: NV Energy Inc. and a portion of H.J. Heinz Company. Now Berkshire has over $50 billion. Do you see how that works? He continues to take down elephants, but those elephants happen to produce prodigious cash flow, thus increasing the amount of ammo in his elephant gun for his next hunting trip. His elephant gun is actually reloading faster than he can hunt, exactly because he’s deployed capital with some regularity over the last 50 years. Buffett is cash flowing his life (and his company), though on a much larger scale than you or I can imagine.
However, while Buffett currently has a $50 billion cash pile that builds up, I also want to point out that Buffett wasn’t always so eager to hold on to cash. Buffett wasn’t always running at $345 billion company that took major acquisitions to meaningfully impact the bottom line. What about a young Warren Buffett, a Buffett that would be more aptly comparable to a situation that we might find ourselves in? Well, I don’t know if we can ever aptly compare ourselves to the greatest investor of all time, but a young Buffett is at least in the same universe.
Consider this quote, from page 283 of Buffett’s biography, “The Snowball: Warren Buffett and the Business of Life”:
In January 1966, another $6.8 million had rolled in from his partners; Buffett found himself with a $44 million partnership and too few cigar butts to light with his cash. Thus, for the first time, had had set aside some money and left it unused – an extraordinary decision. Ever since the day he left Columbia Business School, his problem had always been getting his hands on enough money to pump into a seemingly endless supply of investment ideas.
So Buffett’s problem as a young investor anxious to increase his wealth as quickly as possible was to find enough cash to invest. Buffett didn’t slow down putting capital to work until his partnerships had eclipsed $40 million. I assume you don’t have a first world problem that aggressive. I know I certainly do not. Which is why I continue to invest capital almost as fast as it hits my tiny pocket.


I recommend that unless you’re already sitting on a portfolio worth well over $100,000 that’s spitting out at least $3,500 in annual dividend income, you should continue to dollar cost average your way into the stock market month in and month out, regardless of the media noise, the predictions, or your desire to sit on cash. In fact, I would recommend continuing this strategy straight through to financial independence, but I can relax my attitude on this just a bit if you’ve already developed a cash flow bucket that refills itself with at least $300 per month with which you can dump on new opportunities. However, I personally wouldn’t feel comfortable with more than 2% of my portfolio sitting in cash for any time frame longer than a couple of months during the asset accumulation phase for the reasons I’ve laid out. That is, not until I’m very close to financial independence or already financially independent and capital preservation is even more critical.
That being said, if you are close to financial independence or already financially independent then you’re likely already cash flowing your life with passive income, and thus any cash flow surplus that represents the spread between income and expenses can be used to build a substantial enough cash cushion so that you feel completely comfortable. I’ve already discussed in the past that I would want to increase my emergency fund slowly and surely past the point of financial independence, so as to constantly increase my margin of safety due largely to the fact that unforeseen medical problems become more likely as you age.
However, if you’re a new investor with a portfolio worth $20,000 or $50,000 I truly believe you shouldn’t even be considering the idea of sitting on cash. You need to get those dollars digging for you as soon as possible. This isn’t the time to collect shovels. This is the time to be actively digging your way out to freedom. You may be thinking that there’s an opportunity cost in investing your capital relatively quickly, but your true opportunity cost is in not already having a significant source of recurring cash flow with which you can regularly tap to increase your wealth at an even faster pace.
I find the comparisons to Buffett fun to entertain, but they’re just not really applicable to a retail investor. We don’t run $350 billion companies that require major acquisitions to move the needle. The aforementioned purchase of 40 shares of KMI would move my needle right away, which is why I deploy capital so frequently and enthusiastically. Buffett may sport an elephant gun, but I proudly shoot my BB gun with regularity. And it regularly reloads itself!
As a final note, I’m not recommending to forgo an emergency fund. That should be separate. This is specifically discussing the cash portion of your investment portfolio. Like Buffett’s desire to not rely on the kindness of strangers, I also do not want to be in a position where I’m forced to borrow money at disadvantageous rates in the case of an emergency. However, I also keep in mind that a six-figure portfolio that has been built by putting capital to work regularly, and produces a source of cash flow that could be used in an emergency is really the ultimate form of an emergency fund anyhow.
Full Disclosure: Long KMI and KO.
What do you think? Do you typically sit on a sizable portion of cash, or are you more interested in building cash flow? Is cash flow better than cash? 
Thanks for reading.

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