Why Do We Invest? What Makes Us “Wealthy?”

Throughout history, investments have been described in terms of the “income” they produce. It is an investment’s income generating capacity that drives both its economic value and, ultimately, its market price, not the other way around. But a huge, competitive money management industry requires simple yardsticks for firms to use in showcasing and comparing their investment performance. Thus, market price appreciation and “growth” have become paramount, even though they are less important to individual investors for whom the size of their income stream is more meaningful than whatever price “Mr. Market” assigns to the source of that income. Fortunately, retail investors do not have to fall for the drumbeat message from the financial media and professional investment community that market price appreciation is the quintessential goal. We developed the Income Factory as an alternative that allows investors to focus on building and capturing the economic value of their portfolios, irrespective of whatever price Mr. Market chooses to assign to them from one day to the next. __________________________________________________

During most of our working lives, we focus on our income. How much money does a job pay us, or if we are considering a move, how much money will the new job pay us? It seems pretty straightforward.

It was certainly straightforward back in 18th and 19th century England, if you read the literature of the day. Life was brutal and not having the resources to survive was a constant theme from Charles Dickens to Jane Austen. The average person, as Bob Cratchit and his family knew so well, was just one pink slip away from the poorhouse. Even upper-class families of the sort Jane Austen described in novels like Pride and Prejudice and Sense and Sensibility were consumed with apprehension about their sons’ and daughters’ marriage prospects, driven by concerns about the income or lack thereof of their children and their children’s prospective partners or suitors.

One thing I always found interesting in so many of these classic novels was how the wealth of various characters was usually defined in terms of their annual income. Mr. Darcy, for example, of Pride and Prejudice, is described as having “an income of £10,000 a year.” The financial position of most characters, whether they have a lot of money or a little, is depicted in terms of the income their assets or estates produce, not by what those assets would reputedly be worth in market value terms. If Jane Austen’s world had an annual Forbes Magazine’s list of the world’s richest people, it would have ranked them by their yearly incomes, not by the market value of their assets.

That makes total sense and certainly reflects how we think about ourselves and our own financial prospects. “How well we’re doing” or how well our sons, daughters, relatives and friends are navigating financially through life is almost invariably expressed in terms of our personal income. How much money are we or they making?

If we turn our attention to retirement planning, again the time-honored way to think about it has been in terms of income. Back in the day when companies provided traditional pensions because they expected their employees to work for them for most or all of their careers, “defined benefit” pensions promised employees a specific income stream. You worked so many years at an average salary of X and you were then guaranteed a pension of a fixed amount when you hit a certain age. It was expressed as an annual income for a reason, since that was what employees could relate to and were used to thinking about in evaluating their own financial requirements. They could compare the anticipated pension payment directly with their current on-the-job salary and know how close their post-retirement income would come to replacing their pre-retirement income.

That’s why so many of the personal financial products developed over the years have been of the “annuity” variety, where some financial firm would promise, for a fee (often an exorbitant one, although not always disclosed too clearly to the buyer), to pay clients a fixed amount of income for the rest of their lives. The financial firms developing and selling these products recognized that most consumers just wanted a predictable stream of income, and did not want to concern themselves with having to calculate the size of an investment portfolio capable of generating that income stream, or having to assemble or manage the portfolio on an ongoing basis.

Income, Wealth and Market Value

In the Donald Duck comic books I read as a kid, Donald had a rich uncle named Scrooge McDuck with a swimming pool literally filled with gold coins, who would regularly go swimming in his pool of money. While wallowing in one’s wealth, whether a pool of gold coins or a sizable portfolio at one’s brokerage firm, is satisfying for some, for most of us the ultimate purpose of our wealth, especially our investments, is to generate an income stream that allows us to pay our bills and meet our other financial contingencies without worry or anxiety. In other words, it is the financial security and flexibility the income provides to us, not the market value, per se, of the invested assets, that makes us feel financially secure, or even wealthy.

The rise of 401K plans, individual retirement accounts (IRAs) and other “defined contribution” retirement plans has dramatically changed the role of millions of investors, whether retired or planning to be at some point, as well as the way in which we all think about our invested assets. Previously we had professional investment firms responsible for managing the assets in our corporate pension plans, making sure they grew at a pace that would support the pension payments retiring employees had been promised.

Under defined contribution plans, the individual owners of the IRAs and 401Ks have become their own pension plan managers, with no money management firms doing it for them as previously. Now the pension plan beneficiaries themselves (i.e. all of us) are responsible for making sure our own IRAs and 401Ks are up to the task of providing us with the pension payments we will need in retirement. To paraphrase Walt Kelly’s classic comic strip character Pogo, “We have met our pension plan and it is us.”[1]

Having no big institutional third party promising – come hell or high water – that they will pay us retirement income of X dollars per month for the rest of our lives has profoundly changed the investment game for millions of people. One immediate result has been an explosion in retail investors’ interest in the “how to” of money management. And where have retail investors turned in order to learn how to invest their money more professionally? To the institutional investment professionals and a business and financial media schooled in traditional investment management dogma, all of them eager to share it with a vast new retail audience.

The biggest lesson retail investors are taught right away is that market value is the most important measurement of investment performance. Obviously, the media and market gurus pay enormous attention to it, and expect their viewers to do so as well. Prices of various indices (Dow Jones Industrials, S&P 500, NASDAQ, Russell 2000, etc.) are displayed prominently and continually on every business news channel, and the latest price changes are reported as news updates throughout the day. With all this attention, it is no wonder individual investors have come to believe that market price is the main thing they should be focused on in managing their own investments.

Clearly the professional and institutional investment industry lives and dies by market value, with “performance” measured largely by how much the market prices of one’s portfolio assets increase during a particular time period (monthly, quarterly, annually, etc.). “Total return,” the most common performance measurement used, is the sum of market appreciation (or depreciation) and cash dividends received. But for most professionally-managed stock portfolios (not our Income Factory), dividends are a relatively minor portion of the overall total return, with market appreciation (or depreciation) the major component.

Why does the investment community use market price appreciation as its primary performance measurement? The short answer is: What choice do they have? The investment management industry needs a common, easily understood benchmark. Market appreciation is simple, straight-forward, easily calculated and readily available.

Investment management is a highly competitive industry, and professional money managers constantly have to prove themselves and justify their value to clients, their investment committees, their boards of directors, or to whomever it is that makes decisions about how to compensate them or whether to continue with them or change to a new manager. In a similar way, mutual funds and other public investment vehicles have to compete constantly with other funds, asset classes and investment products for the retail investor’s business. So “total return” – which for most funds and firms is largely market appreciation – has become the standard industry-wide performance benchmark.

Just because market price performance is the simplest, most readily calculated and easily understood answer to the performance question, that doesn’t mean it is the correct or most relevant answer. The increase in value, reflecting the latest market price movements for the past week, month or quarter, may reflect nothing whatsoever about the underlying value of the companies whose stock is held, or their earnings or dividend paying capacity. It may be merely “paper profit” that reflects random market sentiment influenced by political events, cyclical or seasonal factors, the weather, or other issues having little or no impact on the economic value of the holdings.

As retail investors managing our own money for our own purpose – to create and grow a cash income stream over a long-term horizon – we don’t have to accept market appreciation and paper profit growth as the primary yardstick for judging our own performance, just because the financial industry as a whole has chosen to do so for its own competitive purposes. In fact, the dirty little secret many professional investors would prefer us to ignore is this: market appreciation is not the most important factor in the growth of someone’s personal portfolio.

To understand why not, we have to step back and review what it is that gives an investment – a stock, a bond or whatever – its value. Where does value come from?

About 80 years ago an economist named John Burr Williams wrote a book called The Theory of Investment Value in which he articulated the idea that the “intrinsic value” of a security was the discounted present value of all the future cash flows that it would generate; primarily cash dividends and any residual value to be collected by selling the stock or winding up the business. Although less well known than Benjamin Graham and David Dodd, who had published their groundbreaking work (Security Analysis, 1934) on fundamental value investing a few years earlier, Williams’s work complements theirs. Graham and Dodd emphasize using fundamental analytical methods to determine what a company’s earnings and cashflows are likely to be, while Williams shows how – in theory – a rational market would value those earnings and cashflows. Together, their work explains and underpins the whole idea that stock markets are not casinos, as they were largely viewed in the 1920s, but are vehicles – albeit imperfect ones – for pricing and trading investments that have rational, determinable economic value.

The lesson for us in all this is that, ideally, the income should come first and then the market valuation will follow. In other words, the ability to generate an income stream is what drives the economic value of most assets (stocks, bonds, real estate, etc.), not the other way around. Once you know (or at least can make a good estimate about) the cash dividends that a security is likely to pay going forward, then you can calculate its theoretical intrinsic value (based on a number of factors, like how risky the security is, how fast its dividends are likely to grow, how high or low a discount rate should be applied to the future cash flows, etc.). But the point is, the income – both current and future – is the main thing that drives the security’s value.

If I were a portfolio manager in a perfect world, and could choose the yardstick I would like to be evaluated on, I would choose to be judged on how rapidly and consistently I grew my portfolio’s income stream, and not on how much its market value grew. If I consistently grew the income stream, then the value of the portfolio would be growing from an economic perspective (i.e. its usefulness to its owner, in the form of producing an income, would obviously be increasing), even if “the market” failed to recognize it and assign a higher price to it in the current quarter or reporting period. Using such a yardstick would better allow me to demonstrate my “income building” skills as a portfolio manager, since analyzing and selecting securities for their income generating capacity is something far more under my personal control than divining how much my securities are likely to go up or down in market price, which can happen for a myriad of reasons, few of them under my control or capable of being accurately forecast.

Of course, it would be very difficult to judge professional money managers across many different industries (pensions, endowments, mutual funds, hedge funds, etc.) on this sort of yardstick, even if the data could be collected and analyzed. So, in an imperfect world that needs to find a common benchmark to judge professional money managers across the board, they have no choice but to chase the market appreciation target set by the industry in which they compete.

However, as personal investors, we only have one client we have to satisfy: ourselves. So we don’t have to chase benchmarks that are not relevant to our long-term goals. If our long-term goal is to maximize the cash-flow that our portfolio produces, and to grow that river of cash as rapidly as possible from one year to the next, then we should formally set that as our specific objective, and not be goaded into pursuing a market appreciation strategy just because the larger investment world is hooked on it.

Does this mean our portfolio will never grow in value because we will be putting all our efforts into maximizing its cash income and not be focused on its current market price? No, but it means we will not regard every market movement – up or down – as somehow related to our securities’ cash generating abilities, or deserving of some sort of action or reaction on our part. Instead, we will recognize that the great majority of market changes – whether of the market as a whole or just the ups and downs of our specific holdings – are caused by random factors that have nothing whatsoever to do with our own securities’ ability to continue making dividend or distribution payments. On big market movement days, when our friends and colleagues call us and say “Hey, do you see what the market’s doing? What are you going to do?” our response will probably be along the lines that we will continue to collect our dividends and look for opportunities to re-invest them at what are now bargain prices.

As we re-invest dividends to create ever-increasing income, the economic value of the investment portfolio generating those dividends will grow as well, whether or not its market price immediately reflects that. If the market is rational, then our portfolio’s market value should eventually rise to reflect its ever increasing economic value. Whether it actually does or not is less important to us, however, since it is the income the portfolio generates that really matters, not how much the market values the portfolio generating it. In short, we don’t have to worry about market prices but can put our efforts into re-investing, compounding and growing our income stream (and thus our economic value), while letting Benjamin Graham’s “Mr. Market” catch up to us over the long run. Markets are not necessarily rational or predictable in the short term, but over the long term it is reasonable to expect that if our portfolio (our Income Factory) increases its economic value by continually producing more income for us, eventually its market value should reflect that as well. Which it should do if John Burr Williams, basic economic principles, and eighty years of history can be relied upon.

The Income Factory, both the theory and practice of which I describe in detail in other articles here on Seeking Alpha, is the name I have given to the strategy of focusing on growing a portfolio’s income stream and not worrying too much about how Mr. Market values the portfolio generating that income stream. In formulating this approach I have drawn on several investment strategies institutional investors have used for decades, especially in the credit, high yield and alternative investment arenas, where they discovered long ago that achieving “equity returns” doesn’t always require taking “equity risks.”

Besides borrowing from the credit, high yield and alternative investing universes, our Income Factory strategy also builds on fundamental equity strategies that investors, both retail and institutional, have traditionally used to grow their incomes and/or portfolios over time. These strategies – often labeled “value” or “dividend growth” or “total return” investing – typically depend on current dividend income for a portion of the total investment return, but expect most of that return to come from future growth of both the dividend itself and the stock price. I started out with a classic approach along these lines, and found it to be successful over a period of years in doing what it was supposed to do: grow my investment portfolio at an equity return (in my case over 10% on average for quite a number of years). But I did not enjoy the periodic “white knuckles” roller coaster ride aspects of it, when the market was down, my portfolio was in neutral, reverse or occasionally “free fall” mode, and I was gritting my teeth trying to decide whether to hold tight or take some sort of action.

That’s when I began to migrate to what ultimately became The Income Factory strategy, writing about it as it evolved while also trying to “perfect” it. In many ways it remains a work in progress, although having thousands of readers on the Seeking Alpha investment site who have read my articles and embraced Income Factory principles in their own investment strategies suggests to me that we are on the right track.

I would like to thank my numerous readers and followers for their support over the years as The Income Factory has migrated from a “heretical idea” to a now broadly supported strategy, with numerous Seeking Alpha Marketplace services available to readers wishing to utilize various applications of it.


[1] Cultural historians and others may appreciate that cartoonist Walt Kelly created the phrase “we have met the enemy and he is us” and used variations of it in his Pogo comic strip from the 1950s through the 1970s. The phrase itself is a pun based on Commodore Oliver Peary’s report to General (later President) William Henry Harrison of his victory over the British in 1813 in the Battle of Lake Erie that he had “met the enemy and they are ours.”

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source link

2020-02-25