BUFFETTS BOOKS ACADEMY: INTERMEDIATE COURSE
LESSON 25: WHAT IS INCOME INVESTING
LESSON OBJECTIVES
- Learn what income investing is.
- Learn how you can employ income investing techniques.
LESSON SUMMARY
In this lesson we learn about the fundamental principles of income investing. Often people become unpleasantly surprised when they find out how much money is required to live comfortable after retirement. Therefore income investing is a neat concept to be familiar with when planning your retirement.
Income investing is the concept of purchasing bonds and stocks that will provide income for the owner in retirement through stable coupon and dividends. The amount should be so high that when you are living the life style you want to, your portfolio would remain the same or even increase.
A practical example can be used to explain this concept. Imagine that you have $1,000,000 in retirement and you are able to make a stable 5% return. In that case you would receive $50,000 each year in proceeds from your investment. That means that if you expenses are equal or below this amount you can maintain the lifestyle for the rest of your life.
Which approach should you take if you are near retirement age and you want to invest in companies that benefit you right now and well into your retirement? The answer is quite simple: “Invest in stable companies that pay dividends”.
To illustrate this, it is shown is this lesson how high debt companies through the recent financial crisis dramatically cut their dividend payments. This is surely not a situation you want to be exposed to if you are supposed to pay your bills with your dividend payments. Companies that have a much lower debt on the other hand managed to sustain or even increased their dividend.
One simple rule to remember when speaking about income investing: “Always purchase assets that will increase your cash flow next month”. It could be low debt stocks paying dividends, or a bond paying coupons. Income investing has a compounding effect that is hard to find elsewhere.
Typically the attractiveness of your investment opportunities constantly changes. The benefit of a continuously increase in monthly cash flow is that you can keep investing in the assets that is currently undervalued.
Finally in the lesson a conclusion is presented:
- Income investing provides a quarterly payments during retirement.
- Income investing provides a stable stream of cash that allow you to buy the currently most undervalued assets. This is especially beneficial prior to retirement.
- As a rule of thumb 1/3 of earnings as dividend and 2/3 as retained earnings is desired.
Related Article: Income Investing
NEW VOCABULARY
Income Investing
Using stable and safe dividend paying stocks and coupons from bonds as a stable income source that allows you to live your desired lifestyle in retirement. To do this you must solely buying assets that increased your monthly cash flow.
LESSON TRANSCRIPT
How do you plan to pay for your retirement? Income investing can help you.
Imagine you are 65 years old and want to retire. You have half a million savings right now. If you spend $50,000 a year of that savings and you have invested that half a million dollars at 7% a year, you’d be broke by the age of 80 assuming you don’t have retirement benefits.
If you own a house and haven’t completely paid for it yet, throw those variables in. Your half a million dollars of savings would even be depleted faster than just 15 years. This is something that you have to plan for, because if not, you will be in a situation where you don’t have enough funds and resources sooner or later.
What is income investing? It is purchasing stable stocks and bonds that pay dividends in coupons. If you own enough of these and hold them through the years, these will provide the income for you in your retirement. If your income is enough to meet your spending requirement considering the equity and Par value, this will grow as time marches on.
Here’s an imaginary character named Jack. He maxed out his IRA from age 22 to 65. If he’s consistently giving his contribution of $5,000, he has $1,000,000 in stocks and bonds at the end. Now, assume that Jack bought companies that paid 3% dividends and purchased bonds that paid decent returns of 5% or 6%. If he’d been buying these throughout the duration of his life up till the age of 65, those dividend payments wouldn’t just be 3%. They would continue to grow with the company and they might turn to 5% or 6% based off of the initial price that he purchased the stock for.
Assume that his average over that duration is 5%. If jack has a million dollars at 65 years old and he’s retiring, those stocks and bonds that he would have been purchasing through that duration would be paying him $50,000 a year just as income alone. That’s what a 5% return on dividend and coupon would bring you.
Let’s say Jack adhered to the rule that if you’re 40 years old on your birth certificate, you should have 30% invested in bonds and 70% in stocks. At 65 years old, pretend he has about 60% of his money in bonds and 40% in stocks. That 40% equates to $400,000 for his stocks. If that’s the use, those stocks will continue to grow just as long as he picked stable companies that are growing their equity and also growing their earnings. That $400,000 will continue to grow as it continues to pay him those dividend payments as well. His $50,000 totality for all these investments might turn into $55,000 to $60,000 as those dividend payments continue to increase on stocks and equities.
How can you invest in a company that provides those benefits now and into your retirement? You have to adhere to all the advice from course 2 unit 3 lessons where you have to invest in a stable company that pays dividends. Why? Because you are income investing.
Here are examples of companies paying decent dividends, but have a lot of debt and how those dividends weren’t received. Think about as if you are the owner of this at age 65. The last thing you want to do is to own a company that has a dividend that might be paying 30 cents, but then it goes into a recession and the company drops that dividend down to 10 cents. If you had a million dollars and you’re receiving that 30-cent dividend, that might equate to $30,000 whenever you add up all the shares. If the company drops its dividend, you might only receive $10,000 or $20,000, because of the market condition! You need to avoid this especially when you’re already old and retired. You need dividend payments at that time of your life.
Here are companies that dropped their dividend payments during the 2008 recession and companies that sustained their dividend payments during the recession. The companies that dropped their dividend have a lot of debt. The companies that sustained their dividend payments do not carry a lot of debt.
General Electrics dropped their dividends from .31 to .10, while JP Morgan dropped their dividends from .38 to .05. The graph in video shows just the Dow Jones and Industrial Average to just show you how the market dropped significantly in 2008 and 2009. In the middle of 2009, GE’s debt to equity is 5.0, which is extremely high. If you remember back in unit 3, we want companies with the debt to equity below .5. Having 5.0 means they have 5 dollars of debt for every 1 dollar of equity in the business. GE cut the dividend – a wise decision, indeed. They shouldn’t be putting more money in their pockets during difficult times. However, you still don’t want to be the owner of a company like GE at age 65 when you’re relying on that money as income. On the other hand, JPM actually took a steeper cut from .38 to .05 cents. They have a lower debt to equity ratio that GE.
Intel and Johnsons & Johnsons are two companies that didn’t drop their dividend payments during the 2008 recession. Johnsons & Johnsons even increased their dividend payment from .46 to.49 dividend. Their debt to equity was .28, which is below the .5 that we’re looking for in investments. If you were 65 years old and relying on that income to pay the bills and live your lifestyle, you need a company that will continue to pay you your money. Intel’s dividend actually remained exactly the same as .14 as what they were paying before and after the recession. Their debt to equity was a .03, which is pretty much non-existent. They had no debt at all! Both companies are all the result of the fact that they were in a very good conservative situation where they didn’t have a lot of debt and they were growing their equity consistently.
Always purchase assets that will increase your cash flow next month. If you stick to this, you’re going to see a compounding effect that you won’t find anywhere else.
Here are 2 examples. First, I purchased 100 shares of the Shell Oil Company. I will have $20.66 more next month than I have this month. That’s a result of those dividend payments that I’d be receiving from the company. Second, I bought $1000 par bond at a 5% coupon. I will have another $4.16 next month in order to invest.
Income investing in companies that increase cash flow has a compounding effect. Assume that I typically had $1000 to invest each month. If I chose that as the first course of action, I’ll have $1028.66 to invest next month. The following month after that, I’ll have even more, because I keep following that rule of investing in companies that continue to increase my cash flow each month.
The said approach will provide increasing liquidity every month, so you can invest in the most undervalued security. Let’s say you want to purchase stocks that don’t pay dividends. You buy only companies with an increasing market price. Now if the market then goes to a recession and you’re still holding that company, it will not provide any type of cash or liquidity for you to invest.
If you’re consistently buying companies that pay dividends, you’re receiving those payments. Plug it into whatever undervalued asset is out there, whether stocks, bonds, or preferred shares. Income investing provides liquidity to constantly be plugging that cash into the most undervalued asset.
Conclusion: income investing provides you quarterly payments or semiannual payments if you have bonds that will give you a cash flow and source of income when you retire. If you start buying them now, those payments will do nothing but increase. If you’re buying decent companies, you will have higher yield on your money when you retire. Find companies that has about 1/3 of their earnings through dividends and the other 2/3 go back to the book value of the business. You don’t have to pay taxes on that 2/3, that’s why I prefer this ratio. That 1/3 affords the opportunity and continues to improve cash flow with undervalued assets.