I’ve been studying McDonald’s this morning and checking out how the terms are different for the folks that buy shares of the stock compared to the early 2000s when the starting dividend yield was under 1% (of course, McDonald’s was an awesome investment for everyone who bought the stock in 2001, as it has returned 12% annually since then, turning $10,000 into $45,398).

But when you invested back then, you needed the substantial growth to happen—you weren’t going to rely on the dividend yielding less than 1% to be a substantial part of your returns.

Here in 2014, McDonald’s investors are working from a higher base, such that even if you only get moderate growth from the dividend, you’re still getting significant downside protection.

All an illustration: Right now, McDonald’s is sending out $0.81 to owners every three months for every share they get attached to their name. At an annual rate of $3.24, McDonald’s is returning 55-60% of its yearly profits to owners in the form of a cash dividend.

What if that dividend only grows at 6.5% annually, in line with pessimistic projections about the company and with the assumption that sales don’t grow because the customers that were alienated by $1.29 cheeseburgers instead of $1 cheeseburgers don’t eventually say, “ahh, screw it” and come back?

You would have a situation like this:

McDonald’s pays dividends at a rate of $3.24 in 2014.

McDonald’s pays dividends at a rate of $3.45 in 2015.

A $3.67 rate in 2016.

A $3.91 rate in 2017.

A $4.16 rate in 2018.

A $4.43 rate in 2019.

A $4.72 rate in 2020.

Really, we’re interested in the 2015-2020 pull because most of 2014 has already happened and McDonald’s has made four payments of $0.81 in a row (after this September 16^th payout), meaning that in late September that should be an announcement of a dividend raise that would take place in time for the December payment.

For someone that’s been sitting on the stock throughout 2014, there is a good chance that he or she is going to collect at least $27.58 in total dividend income between now and 2020. At a price of $93 per share, that’s a huge facilitator—you stand a reasonable probably of collecting 25-30% of your initial investment back over the next six years from dividends alone, using estimates that are on the conservative side of realistic. You get a 10% or 12% bump early on in the cycle, and the numbers will be much better because the base rate going forward would be higher.

I suspect that, five or so years from now, people will look back upon McDonald’s yielding 3.5% the same way that they look back on Johnson & Johnson yielding over 4% a few years ago, IBM yielding over 2.5% not that long ago, or BP yielding over 5.5% a year or two ago.

Imagine if those $27.58 in dividends got reinvested at an average price of $125 per share between now and 2020. You would have a situation where someone owning 500 shares bought at $94 each would be adding 110 shares to his overall count. It’s not just the $4.72 you’d be collecting in 2020; with reinvested dividends, you’d have an extra 110 shares that got automatically created collecting $4.72. In that case, you’d be collecting $2,880 each year, for a 6.12% yield-on-cost at the end of the six-year mark. And if things work out better than expected (e.g. the recent slow sales growth is temporary and people are just applying recency bias to their future calculations), then this is one of those situations where you’ll be collecting at least $0.10 in annual dividend income a decade from now if you automatically reinvest each dividend payment along the way, leveraging those forty opportunities to increase your share count.

Hi Tim. I’ve been reading your site for the past six months… [a few paragraphs I removed]… I’m just starting out, and I gotta say, receiving my first $100 dividend check completely changed everything for me! I’d rather make $100 for owning a stock than make $200 in a day from my job I know im odd. Thank you so much for your site, and keep up the writing! I check for updates every day! Signed, Graydon.

There. Right there. Graydon, you get it. The understanding of almost every individual in this country is that, in order to generate money, you have to give up your time and do something. If you don’t show up to work on Monday, Tuesday, and Wednesday, you’ll be lucky to still have a job, and you almost certainly won’t be receiving any cash for those three days missed. Even if you own a small business, the conditioning remains: you have to go out there and do something yourself in order to receive money.

The only sustainable, long-term solution to getting regular cash infusions (outside of pensions, bonds, certain real estate, annuities, etc.) is to become a part owner of a publicly traded company in which you outsource the management to somebody else.

Nowhere in the e-mail did you mention which company sent the money your way, but I am going to assume that you are sitting on 455 shares of General Electric so we can work our way through a story. While Jeff Immelt and the rest of the management team at GE are coming up with new ways to sell wind turbines, jets, gas and electric pipeline infrastructure, light bulbs, microwaves, fridges, and water irrigation, and Lord knows what else, you will receive the benefit of their work product as long as you keep those 455 shares to your name. All you have to do is stay out of jail, not get divorced, not lose a lawsuit, and not become delinquent on your taxes to remain a sweet beneficiary of whatever those 455 shares produce over the rest of your life. You are in the driver’s seat; those shares are your until the day you die unless you choose to do otherwise—you’ve got the hammer.

You can watch Judge Judy all day, you can try a different flavor of Baskin Robbins ice cream every day of the month, or you could test whether it is truly possible to sleep a full 24 hours in a day. There is no connection between your labor and the cash generated by General Electric once you get your hands on those shares of stock in the brokerage account.

What I like though is this: you are also in a position where your money starts to make money in spite of itself. You know those stories about Michael Jordan that emerged in the 1990s about how he would go out for dinner and spend thousands of dollars at a restaurant, and then come out richer by the end of the dinner because of the dividends, rents, and interest generated from his wealth during the two hours he was eating?

Yeah, you’re not there yet, but you are at the point where you can spend the money for the rest of your life, and start to enter that sweet spot territory where you can reap the benefits of what you created and grow richer at the same time. As best I can tell, General Electric’s dividend should double within the next seven years (as the core business is growing nicely at a 8% clip, and there’s still a bit of room to boost the payout ratio as the dividend growth rate hasn’t quite finished recovering from the financial crisis).

What is the implication of that? Even if you choose to spend your dividends every ninety days for the next seven years, you could still be reaching a point by 2021 or so where those checks automatically become $1,000 each year just from the growth of the dividend alone. That singular decision to get 455 shares would have been benefitting you from the growing dividends you received from 2014 through 2021, and then they would cross the hallowed $1,000 per year threshold somewhere around there. It’s great to see people delay gratification, act intelligently, and then use the proceeds to make their life easier.

I have no idea what stock sent you the $100 dividend check. It could have been BP. It could have been Chevron. It could have been Clorox. It could have been Emerson Electric. I don’t know. But I do this: you’ve just reached the “seeing is believing” territory of income investing. When you’re just starting out, all of this stuff is theoretical. You have to use your imagination a little bit. You have to channel that Benjamin Franklin work ethic to get the gears grinding forward into motion so you can see the results of your hard work.

Long story short, congratulations! The first $100 dividend check is like needing to lose 45 pounds, going to the gym for a month, and then seeing that you’re 10 pounds down. You still got a ways to go, but you’re starting to see that it is working. You’re seeing the connection between delaying gratification and then receiving the rewards by pursuing business ownership. I’m excited for you. Plant another dozen or two seeds like that, and you’d be only be a few years away from having complete control over your time. Best of luck.

If you look for wisdom from people who are dedicated to long-term investing—creating the kind of financial investment situations where you make decisions in 1990 that are still affecting you in 2014, you will often hear them talk about not selling overvalued stocks.

There are a lot of reasons why this is the case—when you sell something outside of a charity, retirement account, or certain trusts, you have to pay taxes so the amount of money that you have available to make a new investment might put you in a worse spot than had you never sold the stock.

Other times, the cost of dealing with the overvaluation doesn’t merit selling—after all, would you really want to let go of Colgate-Palmolive, Emerson Electric, 3M, and Procter & Gamble just because the price of the stock reached a point where the future forward returns from that price point would be 9.5% instead of 10.5%? In short, the decision to hold on to an overvalued stock is this: the quality of the business, and the rewards it provides you on an ongoing basis (usually in the form of dividends) is prioritized over parsing a few dollars here and there.

(Side note: things get more complicated once excellent businesses cross the valuation threshold of 35x profits or so. Someone who bought Coca-Cola stock before the 1973 crash at 45-60x earnings would have compounded at 11.0-11.5% annually since then, turning a typical investment of $5,000 into $481,000 today. On the other hand, someone who paid that same valuation for Coca-Cola in 1998 would be compounding at 2.32% annually since then, turning $5,000 into $7,200. That’s because Coca-Cola was much bigger in 1998 and also had a lower growth rate, and it hasn’t had as much time to “grow out” of the overvaluation).

But there’s another reason why you don’t sell stocks that might be moderately overvalued, and why you don’t short stocks either—an event might happen that causes a significant yet permanent change in price, and it’s something that should always be there at the back of your mind.

Many of you saw the news today that Kinder Morgan, which has traded under four different forms that all contained different assets and incentive structures (Kinder Morgan, Kinder Morgan Partners, Kinder Morgan Management, and El Paso Partners), announced that it will combine into one form that will just be “Kinder Morgan” and cover 80,000+ miles of pipelines and some oil reserves.

It’s announcements like these that should remind you why you don’t short stocks, and why don’t sell something that appears slightly overvalued: El Paso Partners increased over 30% today, Kinder Morgan Management increased over 34%, Kinder Morgan Partners increased over 27%, and Kinder Morgan increased over 20%. Anytime over the next five, ten, fifteen, twenty years when we talk about the historical performance of this midstream pipeline company, a random day in August 2014 will play a key role in the discussions of its historical returns.

You hear investor axioms like “time in the market is more important than timing the market” and it sounds like a throwaway line that may not actually change your life. And then you look at the data, and you see things like this, courtesy of Dow Theory:

From 1990 to 2005 a $10,000 investment would have grown to $51,354 had you just sat tight from beginning to end. However, if you had missed the best 10 days in that 15-year period, your returns would have dwindled to $31,994; if you had missed the best 30 days, you’d be looking at a mere $15,730…

If an investor missed just 40 of the biggest up days in the market over the last 20 years (1987-2007), their return would have totaled 3.98% versus remaining fully invested and achieving an average annualized return of 11.82%.

Kinder Morgan is a company-specific illustration of this principle: Missing the date of a key event can dramatically affect your total returns. Imagine missing out Abbott Labs when it spun off Abbvie. Imagine missing out on Kraft when it spun off Mondelez. Heck, imagine missing out on the old Philip Morris before it spun off Philip Morris International, Kraft (and plus Mondelez), as well as Altria. Imagine missing out on Conoco when it spun off Phillips 66. Imagine selling any type of Kinder-Morgan affiliated investment prior to today’s announcement.

My thesis isn’t that you should hold because random stuff might happen that will make you later regret it, but rather, that the companies I frequently talk about here contain pieces that aren’t fully realized when they are a part of a conglomerate-type of structure.

Take something like Pepsi, an excellent blue-chip holding that has compounded at 12.96% annually if you had overpaid for the stock and bought it right before the crash of 1973.

Someone could reasonably look at the $91 price tag today and say, “This company looks 5-10% overvalued.” Most likely you would revise that conclusion if the Pepsi Board announced tomorrow that Pepsi was smashing itself into dozens of discrete businesses, spinning off Tostitos, 7-Up, Tropicana, Quaker Oats, Lay’s, Ruffles, Aquafina, Mountain Dew, Gatorade, Fritos, Cheetos, Doritos, and so on, all into their own publicly traded companies. The stock would shoot up to $150 or something like that, and someone who owned a thousand or two shares would feel that sensation of winning a lottery, suddenly having an entirely new blue-chip portfolio showing up out of thin air to pay dividends on their own.

When the brands are combined under one corporate umbrella, they don’t get appreciated as much, and this discounting can cause regret if you sell shares under a belief that the stock is expensive but an event that unlocks value (I don’t like that worn-out phrase, but it’s appropriate here) occurs while you were taking a breather from a stock that you already appreciate and have owned in the past but sold for a reason you’ve come to regret.

This Kinder Morgan news give us two other reminders as well: Shorting a stock is dumb because someone could always overpay to take the company private. Even if Kinder Morgan is only worth a third of its buyout price (I don’t believe this but I’m posing that hypothetical), it doesn’t matter: You’ve permanently lost if you’ve shorted the stock and the buyout goes through. Someone irrationally gobbling up the stock makes you responsible for covering, and I would imagine this would be one of the most frustrating experiences an investor can encounter. The other lesson is this: Even if Kinder Morgan didn’t announce this buyout, things would still work out. As I mentioned with Pepsi, the company has still returned almost 13% over the past four decades even if you overpaid at the time and even though the company spent a lot more time collecting businesses than spinning them off or relying on one-time events. Great assets sitting on the balance sheet will always reward owners over time, even if it’s not in short bursts like you saw today with Kinder Morgan.

Note: I’ll try to do a more detailed write-up on the terms of the Kinder Morgan combination specifically when I get a chance, as this article was more of a broad overview on general principles applied in real-time, sticking with my recent theme of taking timeless principles and discussing their application with business events that are actually unfolding in real time. 

I’ve finally got the chance to take a look at the Kinder Morgan consolidation, and am finally getting around to that promised post on the deal. The Kinder Morgan investments have fascinated me for awhile because it’s probably the highest-quality American firm that never quite reached blue-chip status in the eyes of the casual investing public. It’s always been seen as a few notches below Exxon, Chevron, and Conoco.

If I had to guess why that perception exists, my speculation would be that people think “Kinder came from Enron. Enron bad. Used to be friends with Ken Lay. Therefore, Kinder-Morgan will eventually blow up.” Even though most people would agree that guilt by association logic is bunk, it has probably crept into the analysis of Kinder Morgan (perhaps even non-deliberately).

For those of you who haven’t followed Kinder Morgan’s growth in the past two decades, the firm is often-cited as a toll-booth company. What that jargon means is this: Kinder Morgan runs the pipelines used to transport oil and natural gas across the country (and it’s got 80,000 miles of it), and they charge a fixed fee for doing so. This doesn’t automatically make your profits higher over the long-term, but it does make your profits more consistent because you still collect your fee for shipping oil if it falls from $105 to $80 per barrel, or whatever the fluctuations ruling the business cycle may be.

I’ll use Kinder Morgan Energy as an example. From 2008 to 2009, the profits at Kinder Morgan Energy held steady throughout the financial crisis: in 2007, Kinder Morgan Energy made $1.010 billion in net profit. In 2008, $1.337 billion in net profit. In 2009, $1.302 billion in profit.  In 2010, $1.333 billion. And then 2011 was the breakout year when profits grew to $1.732 billion, which have grown every year since and are expected to approach $3 billion before the consolidation is complete.

ExxonMobil, meanwhile, saw its profits fall from $35 billion to $17 billion from 2008 to 2009. This doesn’t mean Kinder Morgan Energy is a better investment; Exxon kept buying back its stock when the price fell following the profit decline, and Exxon raised its dividend so that shareholders did just fine even as the profits experienced their greatest one-year declines of the generation.

All it means is that Kinder Morgan Energy’s business model has more consistency of profits than you’d traditionally expect from investments in the oil and natural sector gas sector. This consistency, though, partially explains why Kinder Morgan has been able to significantly increase its payouts and compound at 21% annually since 1992, turning a $15,000 investment into a little over $1,000,000 over that time frame.

What then, are the terms of the announced Kinder Morgan transaction, and what lies ahead for investors?

If you owned Kinder Morgan Management, LLC (ticker symbol KMR), then each share will become 2.4849 shares of Kinder Morgan, Inc. If you owned El Paso Pipelines Partners (ticker symbol EPB), then you will receive $4.65 in cash and .9451 shares of KMI for each EPB unit you owned.

If you owned Kinder Morgan Energy Partners (ticker symbol KMP), then you will receive 2.1931 shares of Kinder Morgan, Inc. (ticker symbol KMI) and you will also receive $10.77 in cash for every unit of Kinder Morgan Energy that you had.

This $10.77 cash payout for each share is designed to help cover the instant tax burden for those invested in Kinder Morgan Energy’s partnership units. One of the appeals of owning an energy MLP is that a substantial block of taxes are deferred—super long-term investors use these as planning tools so that they can collect MLP distributions until their death, and then their heirs and beneficiaries receive a steeped-up cost basis upon the death transfer. It lets the original investor collect lots of income during his lifetime, and then his kids or whoever can receive the units without owing a lot to the taxman.

This consolidation eliminates this possibility, and Kinder Morgan released a statement estimating that most people will owe taxes between $12.39 and $18.16 when the otherwise deferred taxes come due. The assumptions that went into this estimate are as follows: (1) passive losses haven’t already been used by the investor, and (2) KMI will trade between $36.12 and $44.44 at the moment of consolidation. So the $10.77 will cover either most or half of your tax bill, and the rest will need to come out of your pocket or through a sale of your new KMI shares to send the way of the U.S. Treasury.

If I were sitting on shares of KMI, I would continue to hold the stock indefinitely. Management has come out and said that the dividend will grow by 10% annually from 2015 to 2020, and the current dividend of $1.72 annually will be raised to $2.00 annually next year (for growth of 16%).

For long-term holders, Kinder Morgan, Inc. (KMI) seems poised to offer investors a nice starting yield with continued dividend growth going forward. Shares of Kinder Morgan are at what, $38 now? When the company pays out $2 per share next year, you’ll be collecting 5.26% on your 2014 investment. It’s a nice hybrid that, right now, combines the high yield of BP with the dividend growth rate you would expect from Chevron. With the possible exception of Philip Morris International, it’s hard for me to think of another company that offers such a high starting yield mixed with the prospect of high-single digit dividend growth over the next five to ten years.

In August 2011, I wrote my first financial piece online. Even though I’ve been at it for three years, that has not been enough time to cover a full business cycle. Really, since 2009, the stock market and the economy has been moving in the same direction: up.

That leads to all sorts of distorted impressions, complicated by the fact that the constant updates about stocks (which we can sell at a click of a button!) that make it easy for us to rent company ownership positions on a yearly, monthly, or even weekly/daily basis without actually applying anything resembling a long-term framework.

For instance, I recently wrote something about The Craft Brew Alliance, which was trading at $11.06 last week when I wrote an article about it on Seeking Alpha. I pointed out some things I liked about the company: it was charging high premiums for its craft beer that was actually selling well to beer-drinkers, and it had special arrangements with Anheuser-Busch’s independent distributors that allowed it to have years of growth in the 15-20% range and carried an unusually small debt load because of this arrangement (which facilitates growth because you’re not earmarking money for interest payments and also makes the company an attractive takeover candidate for a larger brewer).

Anyway, shortly thereafter, Craft Brew reported unusually strong earnings and the price has spiked from $11.06 to $12.53 in the week since I wrote about it, for a 13.29% gain. Some readers wrote to say that they bought the stock because I wrote an article about it, and they wanted to thank me for it.

That. Shit. Terrifies. Me.

When I write an article about any company, the endgame is not for you to necessarily buy that stock. I write for information gathering purposes, in a “hey, have you looked at this? Are you seeing what I’m seeing?” sort of way. I do not possess, nor will I ever possess, any kind of mystical power where I can predict short-term earnings results or price predictions for a particular stock. All I can do is pick up general investing principles from people like Warren Buffett, Donald Yacktman, Benjamin Graham, John Neff, John Bogle, Charlie Munger, and Seth Klarman, and then look at numbers and make common-sense inferences when it seems that those principles are applicable to specific companies at specific prices in real-time.

I had no idea that Craft Brew would report a good quarter, and someone who bought for the short-term based on that article I wrote is setting himself up to get hurt. Why? Because it was complete, random luck. It’s an advancing economy; posting good earnings figures is sort of what companies do at this point in the business cycle. There was no skill on my part being applied, and the positive results were the result of luck, not skill.

Sure, there are companies where price appreciation seems warranted—if things are fairly valued ten years from now, BP, McDonald’s, IBM, and Bank of America should all be trading higher due to growth and a higher premium that investors are willing to pay for the stock, but whether the bulk of that happens in 2015, 2015, 2016, or 2017 is something that will be the result of luck and not have anything to do with skill on my part.

When someone says they read something I wrote about Johnson & Johnson when it was trading at $65 per share and are now happy to see it trading at $100 per share, it somewhat misses the point. Yeah, it’s nice to pick up on the fact that high-quality companies don’t drop dead in good times and generally post their highest rates of earnings growth and dividend growth in relatively prospering economies, but the appeal of Johnson & Johnson is that there are dozens of billion-dollar brands pumping out regular cash profits in the highest-quality way and have been raising the cash payout for over five decades.

You don’t own Johnson & Johnson because it might go from $100 to $100. You own it because economies don’t go up year after year, and it’s nice to figure out a plan for what to do in the bad years if you don’t have a crystal ball that magically sells stocks before market declines. The best thing I’ve found is excellent companies that keep profits relatively stable in bad times, and have a managed payout ratio so you actually get sent more cash in years like 2009 so that you’re not freaking out seeing your net worth fall from $400,000 to $275,000 because your monthly cash flow is increasing from $1,167 to $1,248.

And considering that investing is often a dual activity when you’ve got to have two partners working towards the same goal (even if one of the spouses is much more interested in the process), it’s a lot easier to explain dividend growth investing than other strategies when you’re talking to someone who is only casually interested in investing. You point out: “Coca-Cola pays $1.22 this year for every share we can get in our name. That amount has increased for over fifty straight years. When the price comes down a bit, look what happens: those dividend checks keep coming.”

Dividends reinforce the point that you’re the part owner of an actual business, and when you make that fundamental connection, you’ll be able to keep your head screwed on straight when ISIS (or whatever the international ne’er-do-well element happens to be) causes some tragic mischief that instantly sends your net worth down 10% or 20%, as has historically been known to happen.

The kind of investing strategies that I write about aren’t meant to give you smooth 10% increases in net worth and earnings growth every single year. The business cycle doesn’t work that way, and the prices that people pay for stocks certainly don’t work that way. I’m not trying to answer the question, “How can I invest in a way that nothing will ever go wrong?” Instead, I’m trying to answer the question, “If a whole lot of things did go wrong, what would still be standing? Where do the profits come from during the darkest days America may know during my lifetime?”

That inquiry leads me to weird places—water utilities like York Water which managed to mail out dividend checks during the Civil War so that even when Robert E. Lee and his band of Rebels cruised through your backyard, you could still walk to your mailbox and collect twenty dividend checks in total throughout 1861, 1862, 1863, 1864, and 1865.

The reason why I point out the wisdom of stuffing your portfolio with the likes of Coca-Cola, Johnson & Johnson, Procter & Gamble, Nestle, ExxonMobil, Chevron, PepsiCo, and Kraft isn’t necessarily for the experience you get in 2014. You attach yourself to those positions for life because they will be giving you cash and still reporting profits when the next recession arrives within the next few years, and that allows you to actually increase your purchasing power while most Americans are wondering whether they can keep the lights on and the mortgage paid.

I don’t write these articles with the purpose of showing you how to turbo-charge wealth in the good times, but rather, to alleviate the stress associated with the bad times. The fact that high-quality dividend stocks have made you a lot of money in the past few years is by no means a repudiation of a dividend growth strategy, but the days of the strategy’s true vindication are yet to come.

From Alice Schroeder’s biography “Snowball” about Warren Buffett:

By the age of twelve, Warren had saved $120. In the spring of 1942, he enlisted his sister Doris as a partner and purchased three shares of Cities Service Preferred. The stock plunged from $38.25 to $27. When the stock recovered to $40, Warren sold, netting a $5 profit for the two siblings. He was, however, shocked to see the stock then continue to rise until it hit $202 per share a short period of time later. Warren realized that if he had held off selling a little bit longer, he and his sister would have netted a profit of almost $500.

Alice Schroeder’s note: Warren learned three lessons and would call this episode one of the most important of his life. One lesson was not to overly fixate on what he had paid for a stock. The second was not to rush unthinkingly to grab a small profit. He learned those two lessons by brooding over the $492 he would have made had he been more patient. It had taken five years of work, since he was six years old, to save the $120 to buy this stock. Based on how much he currently made from selling golfballs or peddling popcorn and peanuts at the ballpark, he realized that it could take years to earn back the profit that he had ‘lost.’ He would never, never, never forget this mistake. And there was a third lesson, which was about investing other people’s money. If he made a mistake, it might get somebody upset at him. So he didn’t want to have responsibility for anybody else’s money unless he was sure that he could succeed.

In the field of high-quality blue chip investing, here’s what I think happens a lot: Most people are much more affected by making investment acts of commission rather than omission. They see Visa’s stock price go from $80 to $100 in a short period of time (or they see American Express’s stock price go from $30 to $50 quickly, there’s a lot of examples that you could use) and they internally say, “I want to capture this moment and etch it into stone as a success. If I sell a stock that appreciated $20, I can add that notch under my belt. It’s permanent.” The fear, of course, is the stock could collapse, fall 50%, the business deteriorates, and you’re left with the feeling of seeing what could have been a cemented success become a permanent failure. Obviously, that’s the outcome that is trying to be avoided when people talk about wanting to “lock in” gains.

But it is a narrow analysis because it ignores errors of omission—what if you had maintained your ownership and let the position ride? To use my favorite example, Visa would have crossed the $200 mark while still growing profits at 13% annually in a high quality, easy to understand kind of way.

For this article, I wanted to find out what would have happened if Buffett had continued to hold onto his Cities Service Preferred offering which eventually got folded into Occidental Petroleum in 1982. I had trouble calculating the figure because it turns out record books for Cities Service during WWII weren’t kept with facilitating article writing for bloggers seven decades later in mind, and coming up with the right figure is something I might be able to do if I were a finance professor at a university with a couple research assistants on hand, so all I could come up with this: based on price change alone, Buffett’s $250 investment in Cities Service would have, at a minimum, been worth $683,000. A $250 investment in 1942, by the way, was the equivalent of investing $3,500 today. So we are talking a 190x purchasing power increase during the seven decades that the investment would have been allowed to compound, and in truth, it would have been much, much higher once you factor in the income generated over seven decades, which I did not have the resources to factor in at all.

But I don’t need precision to learn a lesson. Think about how many times along the way it would have been tempting to engage in one of those Wall Street clichés like “take some off the table” or “lock in your gains” or “you can’t go broke taking a profit.” Think about how many people would have done just that with their $250 investment. Would you have sold at $500? $1,000? $10,000? $100,000? $500,000? It’s a shame that there is a behavioral quirk that makes people want to sell something that keeps on growing in order to lock in a gain, because the monster wealth occurs when you own something that is super high quality, and then after the twenty-year mark of compounding, the results start to go haywire to the point where you are making money faster than you can spend it.

I get a kick out of knowing that Buffett could have been a billionaire if he retired in the 1960s, and just held onto the Cities Service, Disney, American Express, and GEICO stock that he had accumulated (at one point in his life, Buffett had half his net worth in GEICO stock, a little known fact that will eventually get its own post on the site). The reason I get a kick out of it is because all of the energy was expended up front, and from then on, all he had to do was collect the dividends and he could have lived the entirety of his life doing whatever he wanted without any financial considerations affecting his ability to live life how he wanted.

If you own a great business, you need to get used to an increasing stock price and accept it. That sounds humorous in a “you will eat this cake and ice cream and you better love it!” kind of way, but it is a real obstacle that creates a trigger finger for long-term investors. If you picked a company that regularly grows profits, then the valuation of those profits will capitalize upon themselves as the profits grow, and that you create fertile soil for regret by selling too early. Incidentally, that’s partially why I focus on the income side of investing so much; if you are trying to build a high-quality source of income, you can avoid a lot of these temptations from the beginning because you’re focused on the highest quality of checks that get regularly sent to your account, rather than spending your life staring at changes in ticker symbol values on a screen.

Today’s a sad day as I’ve been coming to grips with the fact that I have chosen the wrong topic for my site. I should’ve killed this whole passive income thing and gone into women’s lifestyle blogging.

Are any of you aware of the perks in that field?

Larissa Faw of Forbes Online wrote a piece about what I’m missing out on:

In fact, brand executives and women bloggers say the going rate for a $300 kitchen product is 500 monthly views; an all-expense trip to Hawaii requires at least 20,000 monthly views.

Because I was lucky to have some Seeking Alpha readers follow me over when I launched my site, I could have spent the last year building up a tricked-out kitchen and studying for exams on a Hawaiian beach on the dime of corporate advertisers. Why am I writing about Bed, Bath & Beyond’s stock buyback program when I should be telling you which of their pillows I think look best in the master bedroom.

Oh well, I made my bed (ahem), and I’ll continue to lay in it:

Let’s talk Abbott Laboratories. For much of the second half of the 20^th century, it was considered the blue-chip equivalent to Johnson & Johnson in the healthcare industry, except it lacked a consumer products division that would sell things like Johnson’s Baby Lotion, Band-Aids, and Tylenol that made Johnson & Johnson accessible to the average investor in a way that Abbott Labs was not.

Shareholders of Abbott Labs, however, have been reaping 14.79% annual returns since 1983, being one of those magic stocks that turned a $20,000 investment into a $1,475,000 fortune. The company grew at a 12.5% rate over that period.

In other words, someone who bought the stock for $47 in 2003 (the highest price Abbott saw that year) would have been intelligently applying the same principles of conservative dividend investing that lead people to companies like Nestle, Colgate-Palmolive, and Johnson & Johnson.

The earnings growth was there. The dividend record was there. The diversified stream of healthcare products was there. Yet, an interesting thing happened during the 2000s: the price change in Abbott Labs severely lagged the business performance of the company.

A quick overview to describe what I mean: In 2003, Abbott Labs traded at a high of $47.20 per share. In 2011, before announcing the Abbvie stock spinoff, Abbott Labs traded at $47.20 per share. The business performance, however, was much better: the company grew its profits from $2.21 per share to $4.66 per share, and the dividend grew from $0.98 per share to $1.88 per share. Put simply, you had profits doubling and dividends doubling, but the stock price remaining stagnant.

It’s something you need to prepare for, because almost every company I have ever studied has experienced a decade like this—Coca Cola from 1998 onward, Exxon during a good chunk of the 1980s, Johnson & Johnson during the 2000s, and so on.

But this is why I like dividend investing: even during that 2003 through 2011 period when Abbott Labs did nothing in terms of price change, you collected $12.28 in dividends. If gold starts a decade at $1,200 per ounce and finishes the decade at $1,200 per ounce, truly nothing happened; you have made $0 over that time frame. With a productive, profitable business that sends cash your way on an ongoing basis, you have this situation where even though Abbott Labs is trading at $47.20 in 2011, it as is if the price is really $59.48 when you tally up the total benefit generated by you from the investment. The dividend is why investors received 26% total returns over 2003-2011 rather than 0%, judging by the stock price.

Someone who bought Abbott Labs and just collected dividends would have received returns of 2.93% annually. Basically, you got your dividend, and that was it, since the price didn’t change. If, however, you had reinvested your Abbott Labs dividends into more shares of Abbott Labs during that 2003-2011 timeframe (taking advantage of the fact that the business was growing faster than the stock’s price change), you achieved 5.4% annual returns (and then things greatly improved in 2012 during the Abbvie spinoff in which you found yourself owning two separate businesses that rapidly increased in price during the 2012-2014 interim).

No, I’m not arguing that people salivate over 5.4% annual returns at the time they make an investment. Instead, I’m showing the mitigation effects that occur even when things don’t work out as planned. When you bought Abbott Labs in 2003, you probably didn’t think the stock would be trading at the same price years later in 2011. That’s a realistic bad case scenario that came to fruition. Yet, the business performed fine: you got to collect about 3% in annual dividends that you could have spent, and if you allowed your money to quietly reinvest, you got returns slightly better than 5%. It’s in the nature of a cash-generating business; you take your dividend, and automatically purchase a greater stake in the company. Not only do you have new shares, but the dividend goes up the next year as well. This kind of downside protection—the ability to somehow get 5% returns over a nine-year period even the price goes nowhere—is what makes long-term investing so enjoyable.

If you get the company right, everything else eventually takes care of itself, even when an increasing stock price isn’t the reason for the wealth-building (although, in a way it is, because the sustained low price of Abbott Labs let you buy more shares and receive higher subsequent income when you chose to reinvest).

Have any of you been checking out the price action in Noodles & Company since it posted its quarterly earnings figure a few days ago?

After reporting that each share of the stock earned $0.12 in the second quarter of 2014, and posted revenue figures of $99 million. Sales fell 0.6%, and the general operating margin came in at 20.4%. All in all, the business is growing at somewhere between 11% and 12%, which is a perfectly nice rate of growth for a company worth somewhere between $750 million and $1 billion.

Why, then, did the price of the stock fall so significantly? The most recent after-hours trade for the stock came in at exactly $21.00, below the $25.58 figure the stock was trading at before the earnings announcement (for a current 17.9% decline since the earnings announcement).

The company earned $0.24 per share last year. Analysts are expecting Noodles to earn somewhere around $0.40 per share this year. Pretend for a moment that this is the last trading day of 2014, and Noodles made $0.40 per share and traded at $21 on the dot. That works out to a valuation of 52.5x profits.

This is the frustrating part of unadulterated growth investing: even if you are right about the company, and you see it grow by a significant amount, the investment may still not work out as well as you’d like because you have to figure the shifting change in valuation into your calculation as well.

As Noodles & Company transition towards becoming a mid-cap company, its “permanent” valuation will eventually drift somewhere down to 30x profits. It’s very rare that you see a mature company in the food service industry do better than that—at the very least, it’s rare enough that you wouldn’t want to project a valuation higher than that when you perform your personal calculations.

In other words, as I study Noodles & Company, I think of the investment like this: Since it doesn’t pay a dividend presently, and likely won’t in the medium-term because it is using its cash profits to grow operations and open new stores (as you can see by the company’s recent sixteen-store expansion), you would need the stock to go from $21 to $42 to double your money.

If Noodles & Company traded at 30x profits at the time that happened, it would need to post profits of $1.40 per share. So if you wanted Noodles & Company to double your money by 2020, the earnings would likely need to increase almost quadruple from its current expected base of $0.40 by year-end. That very well could happen—I just don’t know—but the key takeaway to understand is that this isn’t necessarily going to be a situation where doubling profits at the business leads to a stock price doubling; the valuation shift from 50x earnings to 30x earnings means that some of the business’s growth is given away for free without you benefitting from it in any way.

Either way, the shares offer a much better deal today than they did last year. In 2013, shares hit a high of $51.97 while earning $0.24 for the year. That 216x earnings valuation explains why the business is still on pace to grow profits by 75% compared to last year, yet the price has fallen from $51 to $21 despite the growth in the business.

The problem, though, with buying companies that trade at over 50x current profits is that you need something like 15% or better growth each and every year for a solid six or seven years in a row for the investment to work out in your favor from a fundamental standpoint. When you have these inevitable “breathers” in performance, you create these situations where the stock price falls 15-20% even while the business is growing at 10-12%. The expectations baked into the stock price become so high that even moderately successful profit results end up leading to sharp, justifiable declines in the price of the stock.

With growth stock investing, you’re often investing with a negative margin of safety. When you buy stocks cheap, you tend to benefit from earnings growth plus changes in valuation as a stock transitions from trading at 15x profits to 20x profits while it is simultaneously growing. When you pay a fair price for a company, your total returns over time will mirror the growth of the company itself. With Noodles & Company, you know going in that your returns will lag the growth rate of the business because that comes with the territory of paying over 50x earnings for a stock. Even after the recent fall, you still would need Noodles & Company to grow at a 15% or so annual rate from now until 2020 to equal the performance you would get from just buying a plain old S&P 500 Index Fund. I’m not saying that will or will not happen, but it’s something that needs to figure into your calculations when you make these types of investments.

 “Hello Mr. McAleenan….[few paragraphs redacted]…I can’t help but feel that most of your advice is not going to be applicable to a majority of Americans. Getting a large estate is nice if you’re in the 1%, but what’s a realistic plan for the rest of us schlubs?… –Derek”

Hey Derek. When dealing with the emotional and seemingly impossible side of compounding/building wealth, I remind myself that it all comes down to three things: the amount of time that you have to invest, the amount that you invest, and the rate of return that you are able to return on what you invest. Those are the three numbers that you must manipulate in order to get what you want from an investment portfolio.

If you find yourself in a situation where the variable “amount of money” is going to be relatively scarce, then you have to rely on the other two variables to get to where you want to be. As far as returns you can get with common stocks, the general rule would be this: someone who buys and holds index funds for super long periods of time tend to get around 10%. Someone who owns a balanced fund, like you see with the Vanguard Wellington, tend to get around 8% or so. And it usually takes considerable skill to get anything over 12% annually for long periods of time.

Here is how I would work through a plan, starting from scratch, and with the understanding that the variable “amount of money” to invest will be limited to 11% of income. If I belonged to a household generating $50,000 per year in pre-tax income, my definition of a reasonable savings goal would be this: save $5,500 per year (why’d I choose 11% instead of the round number 10%? Because $5,500 is what you can put into a Roth IRA each year, and that figure would double to $11,000 if you combine both spouses).

Now, you can already feel it—we’re getting somewhere before we even started as we are about to combine the Holy Trinity of wealth creation that is (1) fresh contributions into (2) stocks that pay growing dividends which (3) get reinvested.

Look at the kind of results that are possible if you spend twenty years building a financial house in $5,500 annual brick increments.

Year 1. You buy $5,500 worth of Johnson & Johnson. That turns into $82,000 in 2034, if the past twenty years are any guide.

Year 2. You buy $5,500 worth of Procter & Gamble. That turns into $37,000 in 2034, if its past twenty years are any guide.

Year 3. You buy $5,500 worth of General Mills. That turns into $35,000, if its past 18 years are useful in predicting its future.

Year 4. You buy $5,500 worth of Exxon. That turns into $26,000, using the past seventeen years as a reference.

Year 5. The next year, you continue your oil kick, and add some Conoco. How does that work out? Really well if you include the Phillips 66 spinoff, as you’d be sitting on $42,000 between your shares of Conoco and Phillips 66.

Year 6. You pick up some Pepsi shares, which adds $19,000 to the value of your account.

Year 7. While you’re hanging out in the food sector, you add some General Mills to round out that segment of your portfolio, which sends another $20,900 your way.

Year 8. You decide to begin bank investing because a financial crisis is almost a decade away (oh no!) and so you add some Wells Fargo to your holdings. That, believe it or not, turns into $20,000 during the 12-13 years it gets to compound.

Year 9. You pick up some 3M, deciding to add an industrial component to your portfolio. This puts $17,000 in your portfolio.

Years 10 and 11. Deciding to round out the industrial components of your portfolio, you pick up General Electric and Emerson Electric. The Emerson shares grow to $19,000, and the General Electric shares grow to $6,900 hardly compounding at all due to an incipient financial crisis.

Years 12, 13, 14, and 15. You decide to spend these years picking up the missing gems that had not yet made it into your portfolio, adding Colgate-Palmolive, Coca-Cola, Clorox, and Chevron. The Colgate shares would grow to $18,000 (because that toothpaste giant is an absolute beast when it comes to creating wealth), the Coca-Cola shares would grow to $13,900, the Clorox shares would grow to $9,800 because we’re now on the eve of crisis, and the Chevron shares would grow to $8,800.

Years 16, 17, 18, 19, and 20. Now, for the finishing touches. We’re talking Disney, Brown Forman, Wal-Mart, Hershey, and IBM. The Disney shares would grow to $20,000 because they were bought during a time of crisis, the Brown Forman shares would grow to a ridiculous $18,000 in such a short period of time because it is the best company most people have never heard of, quickly building absurd amounts of wealth over the past few decades. The Wal-Mart shares would have grown to $8,800, the Hershey shares would have grown to $7,900, and the IBM shares would have grown to (or shrank to) $5,000 because its relatively fresh investment and stock market volatility is currently determining the stock price more than long-term profit growth given the infancy of the investment.

That’s what life can look like when you break it into discrete elements of $5,500 dedicated to a particular stock each year. Note, too, that usually the stock selections you make earliest in your life can make or break you, so you be sure that you choose your cash generator companions for life carefully. What would these twenty years of $5,500 investments for a total of $110,000 set aside be equal to? A portfolio equal to a little over $428,000 (note, as well, that some of those investments only had a year, two, or three to compound—this is the nature of dollar cost averaging—whereas a lump sum investment of $110,000 that compounded at 10% for twenty years would become $806,000).

In short, it is doable within the American capital markets to put together something approaching a half-million portfolio under an investment strategy that called for setting aside $5,500 annually for twenty years. More interestingly, you’d have Colgate, Disney, Hershey, and Brown Forman on your balance sheet, which should work out very, very well for you over long periods of time given their ability to earn high internal rates of return on their capital. In other words, those $8 sodas at Disney theme parks, those $5.00 bags of candy that cost $0.50 to manufacture, those $5 drinks at the bar that cost $0.30 to produce, and those mouthwashes selling for $6 that cost $0.40 are why those shareholders get extraordinarily reach over the long haul.

If you don’t have a lot to invest, then most likely, time is the element that you must rely on to do the heavy lifting. From there, it’s important to get the companies right. Take the time to study companies that are very good at producing high internal returns on capital. My person research leads me towards Visa, Mastercard, Coca-Cola, Colgate-Palmolive, Hershey, and Brown-Forman, and to a lesser extent, Johnson & Johnson and Nestle. Your studies might lead you to entirely different companies. That’s not a big deal, there are so many different strategies that can enable you to make it in America. But when the funds you are working with are a few hundred per month, the key to getting somewhere significant is to make sure you choose the companies correctly and give them the time that is necessary to grow. Those are the two ingredients that ensure progress. $5,500 x 20 into conservative dividend stocks = $428k.

One of the truly lucrative opportunities—and you only have to get it right once or twice to permanently change your life—that faced investors in the past five years was the opportunity to buy the incredibly stellar cash-generating asset The Altria Group, Inc. for fire sale prices.

A lot of things came together to put Altria on sale in 2009. Obviously, that was the year of the deepest panic selling from the financial crisis, giving you a chance to do well if you bought any company that has survived over these past five years. But you also had the fact that Altria had recently spun-off Philip Morris International and Kraft (which had also split into what is now Kraft and Mondelez), and a lot of investors didn’t know what would be left standing when it was just a domestic cigarette manufacturer (after losing its most lucrative, fast-growth asset in Philip Morris International and also parting with its most stable asset in Kraft, the uncertainty was justified).

There was a political angle was well—a lot of people thought the newly elected Obama administration was going to pass regulations aimed at delivering death blows to tobacco, rather than the bruises and gut punches that had been typical of previous administrations (of course, taxes from tobacco sources are an important part of every state’s budget, and if the vice were to ever disappear, states already struggling to make ends meet would find themselves would face the prospect of higher taxes and/or cut services).

Those factors came together to create a twice in a generation opportunity: Altria was trading at between $14 and $20 per share (the other time Altria got this cheap, as an FYI, came in 1999 when the intensity of tobacco legislation led many to wonder whether bankruptcy was in the cards).

Picking a middle point in 2009 of $17 per share—I wanted to investigate what would happen if someone had chosen to make a hefty commitment to Altria stock at that point in time.

Here’s what would have happened to a 1,000 share ($17,000 total investment). Most people that just look at stock charts will notice the increase to $42 per share and think that investors did quite all-right for themselves, turning $17,000 into $42,000 in a five-year timespan. But you’re much smarter than that.

You know that, to many people, Altria is simply the dividend stock because it is just about the only company in the world that consistently offers a high starting yield and a high dividend growth rate.

Even as a standalone company without the growth of Philip Morris International to propel it forward, Altria delivered the goods: investors collected $1.32 for each share they owned in 2009, $1.46 for each share they owned in 2010, $1.58 for each share in 2011, $1.70 in 2012, $1.84 in 2013, and at least $1.92 in 2014.

That’s huge.

Each share, without assuming any kind of reinvestment, has produced $9.82 in total dividend income per share. That’s nice if you are concerned about the long-term effects of taxes and regulations reaching a point where they inflict mortal wounds on the business model. Just by collecting cash—you’re only out 43% of your initial investment if the company disappeared tomorrow. Ten years of dividends dutifully collected and deployed elsewhere is a cash-back guarantee that lets you play both sides of the fence.

And, if you chose to stick it out and reinvest, the results are staggering. Each dividend would have gotten reinvested at an average price of $28.76. In a 1,000 share investment, the back-of-the-envelope figure looks like this: $9,820 in total dividend income that automatically created 341 additional shares of Altria.

The 1,000 shares generating $1,320 in 2009 dividend income would find themselves with 1,341 shares producing $2,574 each year (not to mention the fact that those 341 shares would currently be capitalized currently at around $42 for $14,322 in value if you needed to sell. In other words, the shares created by the dividend income alone are almost worth the entirety of your initial investment just five years later).

The other appeal of owning Altria in particular is that it has a 27.0% stake in SABMiller, sitting their quietly, pumping out its own significant dividends to Altria. I wonder what will become of it: Will it get spun off? Will SABMiller actually merge with Anheuser-Busch someday, giving Altria a huge cash infusion that would get paid out in the form of a special dividend? My guess is that the SABMiller stake is a huge source of hidden value that will create some significant wealth for shareholders somewhere down the line.

I think the most intelligent approach to Altria is something like this: you establish a base position, you reinvest for a couple years to accelerate your income growth due to growing and reinvested dividends, and then start collecting the dividends at some point to make new investments as a risk hedge against political regulations that are worse than anticipated.

I’m not entirely sure that a retirement wants to escalate their commitment to the tobacco industry, given the uncertainty of political regulations, as they near retirement by continuing to reinvest or add new shares. But I do think Altria is a nice cash cow, that if it becomes 3-6% of your overall wealth, can regular give you cash to do other things. In a mildly optimistic scenario, you could spend decades cashing dividend checks from Altria that are used to grow positions in Coca-Cola, Colgate-Palmolive, Nestle, Exxon, Pepsi, Johnson & Johnson, and Procter & Gamble. If given enough time, Altria could almost create a little blue-chip portfolio all of its own for you just from the dividends alone.

If you’ve read the headlines about Procter & Gamble’s plans for its future lately, you have probably encountered headlines like “Procter & Gamble Set To Shed 100+ Brands” or other similar expressions aimed at noting a shake-up at P&G. At first glance, it sounds like a lot—Procter & Gamble has 170-180 brands, and plans to get rid of about 100 of them, conjuring up the image that it’s shedding half its portfolio or something that sounds similarly drastic.

The thing to keep in mind is this: the brands being sold only amount to $8 billion in sales per year. As a point of reference, Procter & Gamble sells $88 billion worth of household cleaning merchandise per year. We are talking somewhere between 9% and 10% of the company being sold off here, not enough to really change the quality of the company or expectations for future growth.

I think the frustration at Procter & Gamble headquarters largely stems from the fact that the past two decades could be summed up like this: we cut costs, we increased productivity, we bought back some stock, we grew sales 2-3%, oh, and we bought Gillette sometime in the past decade. Since 2004, P&G has delivered 6-7% annual returns, so while the results might be lower than what you’d anticipate upon buying the stock, it hasn’t been the end of the world, either.

I don’t really have much of an opinion on these minor divestments—P&G is largely driven by Gillette, Olay, Tide, Crest, and Pampers, and from the investor perspective, I’d be more concerned about the growth plans for those plans rather than company modifications around the peripheries. Without any big acquisitions or changes in the status quo, P&G could march along with 7% annual earnings per share growth if the management of the company were left to the wild without any deliberate changes in strategy.

To get back to a situation where you’re seeing 10% annual earnings per share growth, you’d need another Gillette-level acquisition. That’s just life when you’re a $222 billion company.

The other thing is: You don’t necessarily need high sales growth to make something a satisfactory long-term investment. For instance, sales have only grown at 3% or so over the past decade, but total returns have been in the 6-7% range over that time frame, depending on your purchase point. Why is that? Because the company has bought back some stock, cut some costs, and focused on premium-brands with higher profit margins so that across the company, it is now earning 14% profits on each item sold instead of 12%, which is a nice side benefit that hasn’t gotten much attention.

For me, the bottom-line is this: The shedding of 10% of the company’s portfolio is a non-event; you won’t hear people talking about this years later like you did with the Gillette acquisition. If the status quo remains in place, you’re looking to collect a 3% dividend and achieve 6-7% growth in the dividend thereafter. Plus, you have a 25-30% chance P&G pulls off something big in the next couple of years to tilt the earnings growth in the direction of 10% annually. The appeal of P&G isn’t necessarily going to be growth that outpaces the S&P 500 like you’d see with Visa, but rather, that you own a company of such high caliber that you can feel confident reinvesting the dividends each and every quarter without it someday disappearing in Wachovia fashion. It’s a place to inventory wealth, rather than rapidly build wealth.

Possibly the most underrated tool in portfolio risk management is this: Take the dividends that you are receiving from a cash cow, high income-generating asset, and then redeploy those dividends into something that is either of a higher quality or promises more future growth.

I’ll give an example of how this might work out. Let’s say you greatly enjoy receiving present income, and always want to take actions that have a high probability of increasing your net worth. How would you resolve that conundrum?

For this example, I’ll use something like Linn Energy as an example of our income investments. For most of 2014, Linn Energy was paying out a dividend slightly higher than $0.24 each month. The company owns some very high-quality energy assets, however: (1) the company carries a very high amount of debt, and (2) energy assets are especially known for fluctuating. In other words, Linn Energy is not the kind of company you’d say, “Sure, I can own this for thirty years, and then pass it on to my kids, and grandkids.” Even if that ends up being the case, it would be disingenuous to pretend the asset is ideal for decades worth of estate planning.

Let’s say you are also aware that small-cap American index funds tend to deliver 12% annually (compared to the 10% annual figure with large-cap stocks, although the superior large businesses we discuss here tend to have long-term returns around the 12% mark as well), and you decide you want something like the Vanguard Small-Cap Index fund (which you can read about here) in your portfolio as well. Since its inception in 1960, the Vanguard fund has returned just shy of 11% annually.

How could you make this work? You could establish an initial investment in Linn Energy, and then tap into the power of automation to self-fund Vanguard Small Cap Index Fund indefinitely.

Let’s say you own 1,000 shares of Linn Energy. Each month, you would be collecting a little over $240. You could have those $240 checks automatically go into a Vanguard Small-Cap Index Fund, gradually building your position over time (note: If you were actually to do this through Vanguard itself, you’d need a $3,000 minimum investment, and from there, you must purchase increments of at least $100. Other brokerage houses and small-cap indexes have lower initial amounts, particularly Charles Schwab).

That would be an intelligent way to behave because you would be “de-risking” from Linn Energy with each monthly dividend collected, thus hedging yourself against the possibility of a sustained 2009 type of period in which commodity prices fall and credit markets freeze. You’d be investing $2,880 each year (or higher if Linn increases its payout) into the Vanguard Small-Cap Index Fund, allowing you to tap into broad small-cap diversification and the high long-term returns of 10-12% if the 20^th century in the United States is a useful guide.

It’s not that hard to imagine a situation in which a $30,000 investment in Linn Energy in 2014 could turn into not only those 1,000 shares of Linn Energy in 2024, but an entire new $30,000 position that got self-created by the Vanguard Small-Cap Index investments as well. Broadly speaking, you can do a lot to maximize growth or add more stable assets if you methodically deploy the dividends generated by your high-yielders. Obviously, it doesn’t have to be Linn Energy for an index fund. You could take AT&T dividends and buy Disney. You could take Royal Dutch Shell dividends and buy an international index fund. It’s just something to think about how you can use the money generated by your cash cow holdings to put together a more stable or higher growth profile collection of assets for your family over time, all without having to sell anything or sell your time for labor.

In 2009, the S&P 500 went up. In 2010, the S&P 500 went up. In 2011, the S&P 500 went up. In 2012, the S&P 500 went up. In 2013, the S&P 500 went up. So far in 2014, the S&P 500 has gone up. I have no idea what will happen the rest of this year, next year, or the year after that, other than to say this: It would be highly unusual for this string of consecutive up years to continue, and the consequence is this: A bunch of bull market years in a row can make it easy for some trash and junk—truly low-quality holdings—to work their way into your portfolio.

With the stock market up around 30% in 2013, and gains continuing into 2014, it can be easy for something to work its way into your portfolio that you would never want to own if something that comes within hailing distance of a Great Depression scenario were to show up again. A lot of times, people have the tendency to be reactive and see certain stocks fall 30%, 40%, 50%, or more before they realize, “What the heck was I doing with Pandora and Barnes & Noble in my portfolio anyway?” That’s probably something you would have wanted to discard ahead of time, before the losses arrived.

That’s my point of this post: Is there anything you own right now that would make you cringe if 2008 and 2009 happened all over again? If the answer is “yes”, and you’re otherwise diversified, and could deal with playing the probabilities of something that terrible happening again, then okay—keep doing what you’re doing.

On the other hand, if there is important money that you’re relying on—of the “I need dividend income from this stock for the next 20+ years otherwise my standard of living will be impacted” variety, then it could be worth stopping to take a moment to see if you own stocks that can meet that objective.

Now is the safest time to do so—if some low-quality companies found their way into your portfolio, you can get rid of them now before absorbing your losses and realizing what low-quality means at the worst possible time. It’s a way to correct an error before having to pay the consequences (the only downside would be if we are in the middle of a very extended upward trajectory, of the 1982-2000 type, in which case you would be missing outsized gains).

Buying Coca-Cola at $40, Procter & Gamble at $80, Wal-Mart at $75, IBM at $185, BP at $50, Visa at $215, or Exxon at $95 would put you in the position of doing very well over the coming ten to fifteen years, as you would likely experience total returns that mirror the growth rate of those companies (in the case of Visa, the P/E might come down a bit, but there’s a very strong argument to make that the continued 15% growth of the firm would more than offset some P/E compression). Those are high-quality companies you could buy today where you’d do all right.

My favorite question to ask to pre-emptively determine whether you could handle a stock market crash is this: Would you add, or at least hold, this company upon learning of a 50% drop in price? If the answer is no, there could be something lacking concerning your understanding of the business.

When I pose that question to myself, the companies I would be most likely to purchase upon learning of a 50% drop, based upon my understanding of the business and my confidence in their ability to ride out a very long economic downturn, would be: Coca-Cola, Colgate-Palmolive, Disney, Nestle, Exxon, Johnson & Johnson, and Procter & Gamble. Buy-and-hold only works if you decide before a crash that you are buying ownership stakes in companies that you would actually hold throughout a very deep recession.

The other thing that can help you keep perspective is this: Once you hold a high-quality company for a few years in a non-recession scenario, certain price protections start to get baked in. I’ll use Procter & Gamble as an example, because I’ve recently been discussing its future with you.

From 2008 through 2009, the price of Procter & Gamble fell from a high of $73.80 to a low of $54.90 during the early months of 2009. Those are the scare tactic numbers you hear that often get repeated from someone trying to illustrate the maximum moment of paper wealth to its immediate decline.

But imagine if you had owned Procter & Gamble for a few years before the recession—say, you bought the stock at the most expensive point in 2005, at $59.70 per share. From that moment in 2005 until early in 2009 before P&G made its first payment that year, you would have collected $4.88. So, for holding P&G three years through the worst financial crisis of the generation, and having bought the stock at the worst possible time in 2005, you saw your $59.70 investment turn into $54.90+$4.88=$59.78. Counting dividends, buying P&G stock at any time in 2005 would have put you in positive territory (barely) at even the lowest price point of the 2009 recession.

Now is the safest time to reflect upon your holdings and make sure that everything in your portfolio is there deliberately, as the consequences of shedding an inferior holding are relatively minimal right now, from an opportunity cost perspective. The whole point of buy-and-hold investing is making sure that you buy things that, given your goals, time horizon, and comfort zone, you will actually hold throughout the low points of the market cycle. You don’t want to be like everyone else that waits until Fall 2008 or Early Winter 2009 to perform quality checks on your portfolio; the wise thing is to make sure you are satisfied with the quality of your holdings during times like these when the other stock market participants are willing to pay a good price for your junk.

In the past month or so, I’ve become very curious about trying to figure out what Anheuser-Busch’s dividend future might look like. At first, my curiosity was tied to the fact that I’m from St. Louis, and the brewery had been the trademark business of economic pride.

You know how people have a tendency to own companies located geographically near them, especially before the 2000s liberated stock data and dividend histories for investors to broaden their scope? Well, if someone in St. Louis had ever bought the local company, on the basis that they could actually see the factories and see people consuming the wide array of alcoholic products every Friday and Saturday night, they would have built significant wealth.

The specific numbers on Anheuser-Busch’s history are starting to fade as the result of the Inbev merger so I might need to print out hard copies to save for my records, but the history is impressive. If you bought $4,500 worth of the stock in 1975, you would have received a cash payout of $432,000 during the 2008-2009 buyout, assuming optimal tax strategy. Had you made that $4,500 investment in 1985 instead, your payout would have been $112,000. And if you got in starting in 1995, your $4,500 investment would have had you walking away with $29,400. From a growth perspective, it was sort of a ‘70s, ‘80s, and ‘90s, as shareholders would pick up 13% dividend increases here and 18% dividend increases there along the way, and share price appreciation that wasn’t all that far behind.

Things started slowing down in the 2000s, and that is partially why Inbev was able to convince the existing shareholders that a takeover was appropriate—sure, the $70 per share buyout offer didn’t hurt, but long-term investors that remembered the glory days of high dividend growth and a stock price doubling every five or six years were ready for a shakeup after a stagnating stock price and meager 4% and 5% dividend growth characterized the 2000s.

But that stuff is neither here nor there.

What is really on my mind is how much differently I see the future of this company’s dividend compared to what I’m seeing from the analyst estimates. Normally, when I study a company, the range of my future projections fall within one to three percentage points of what other analysts are seeing, but Anheuser-Busch is shaping up to be a notable exception.

Optimistic analysts are predicting 10-12% future dividend growth for the brewer, and the more moderate ones have figures somewhere around 9%.

When I look at the company’s balance sheet, here is what I see: (1) A company carrying $49.1 billion in debt as the lingering effects of its merger activity. (2) A company with pension assets of $6.4 billion and pension obligations of $9.1 billion, although a lot of this disparity has to deal with the effects of low interest rates so that a return to normal interest rates will help bridge these pension shortfalls you are seeing. (3) A company that increased its dividend far faster than profits by 2013.

I’ll explain #3 better. In 2012, Anheuser-Busch made $4.45 in profit, and paid out a $1.56 dividend. In other words, 35% of the company’s profits went towards the dividend. In 2013, the dividend went all the way up to $3.03, but profits only grew to $4.81. In other words, the dividend quickly came to account for 63% of the company’s overall profits.

It generates $43 billion in annual revenue, so organic growth is hard absent acquisitions—heck, Anheuser-Busch is having to fight off the emergence of the faddish local brewery markets just to hold its turf. The executive team is talking about growing into China, Latin America, and South America, but when you’re already pulling in $43 billion, you’d have to add $4.3 billion in revenues in the first year alone if you wanted to achieve 10% top-line growth. When you’re big and have lots of debt and other obligations, you can’t expect to be Brown-Forman anymore and give out 10% annual dividend increases to shareholders every year like it’s Halloween candy.

By the way, just because I anticipate slow to moderate growth with something, you shouldn’t interpret that as me saying you should sell your Anheuser-Busch Inbev ADRs if you have any. The brands are excellent, reaching that Coca-Cola level where people will actually spend $80 for a collared shirt that carries an A-B logo.

People will be drinking Budweiser, Bud Light, Stella Artois, and most of the other 200 brands in 2024, 2034, and 2044. It really is on that short list of international stocks along with Royal Dutch Shell and Nestle that you can hold for years and years, dutifully reinvesting your dividends, without ever having to worry about it disappearing a la Wachovia. Periods of slow growth come with the territory of long-term investing. Even in the mid 1980s, Exxon Mobil had a six-year period of 3-5% growth, and still managed to deliver 12.5% returns from 1980 to 2013, so these things do work themselves out (my guess? Either Anheuser-Busch will pull out some unexpected acquisitions that quickly increase earnings per share, or the debt will decline and AB will have more money to spend on future growth than servicing past obligations).

But I’m not sure why a dividend investor would buy Anheuser-Busch Inbev today, at these prices. It is trading at 23x profits, easily the loftiest valuation it has experienced since the 2009 AB merger with Inbev (briefly in 2010, the company traded at 21x profits). Trust me, you will see a day when it trades 17x profits again. Heck, it happened in four of the past six years. And plus, the Belgians charge a separate 25% dividend tax, which can be reduced to 15% with the proper tax filing paperwork (if you own Anheuser-Busch Inbev in an IRA, you won’t be able to recapture this amount). And that is in addition to the separate US taxation of the dividend.

I’d very surprised if you saw Anheuser-Busch grow their dividend by the 9-12% amount that you are seeing from the brewery sector analysts, absent an acquisition or the management team continuing to increase the payout ratio. If I’m wrong, though, and the dividend doubles to $6 per share or something like that in 2020, then I’m going to have to step back and figure out where in my thought process I went wrong. At a minimum, it would mean I can’t figure out dividend projections for large brewers, and at worst, it would mean my entire process of studying dividend projections could be wrong. We shall see.

I was reading a forum post at Money Crashers where Hank Coleman wrote an article four years ago concerning the effectiveness of one-time dividends, with Microsoft’s $32 billion special dividend in 2004 being the most famous example in the past generation.

Hank said:

The problem with Microsoft is that it is a cash cow like Frontier, but Microsoft cannot come up with much else to do with their free cash flow. They could be expanding, buying companies, coming up with new product lines, etc. But, no…they are just handing their profits back to their stock holders, and I think that is why stock holders have seen the company’s share price go nowhere for years now. In fact, shares of Microsoft are the same price and even a dollar less now than when it began issuing dividends in 2004.

The entire post seemed reasonable until the conclusion “and I think that is why stockholders have seen the company’s share price go nowhere for years now.” It’s the perfect of someone using correct data points and then drawing a conclusion that sounds reasonable to the ear, but is ultimately incorrect. It’s one of the most unrecognized lessons in investing, even though a lot of investors do recognize it at a superficial level: a company’s business can grow at a healthy clip for an extended period of time but actually make a bad investment because the company simultaneously shifts from being pricey to being fairly valued.

With tech companies approaching maturity, there is this tendency for companies like Apple and IBM to have a wide range of 10-15x earnings that constitutes fair value. The reason this is cheaper than the 20x earnings indicator of fair value that you’d see from the likes of Kraft, General Mills, and PepsiCo is that cereal and snack profits are much easier to forecast five and ten years from now, and this increased certainty leads to a higher price that investors are willing to pay for each dollar of current profits.

Back in the early 2000s, Microsoft had not yet participated in this shift—its valuation smacked of the old days when growth assumptions of over 20% annually guided investor sentiment. In 1998 and 1999, Microsoft traded at 50x earnings. From 2000 through 2004, it typically traded between 25x and 35x profits. The reason why Microsoft was such a disappointing investment during the 2000s was because the valuation shifted from 50x earnings, to 35x earnings, to 25x earnings, and eventually settling in around 15x earnings.

Microsoft has increased its profits 2.5x times in the past decade (from $1.04 in 2004 to $2.63 in 2014). And the dividend has become a substantial part of its story. It’s an important thing to understand—the reason Microsoft may have disappointed investor expectations during the 2000s has nothing to do with vague notions of lacking new ideas or handing cash back to stockholders, but rather, the price of the stock at the start of the decade was way above the fair value levels for tech companies worth $200-$400 billion that project to grow at 8-12% annually for the long haul.

This insight plays an important role in many of the articles I write here and share with you—the only company that I’ve ever written about on this site that could be fairly classified as a growth stock is Visa. That’s because the valuation isn’t outrageous (it’s in the 25x earnings ballpark) and the high probability of future growth in the 15% range seems very plausible considering Visa is replicating its U.S. strategy across the globe and seems to have many years of growth in the 10-15% range ahead. I can find other companies out there with Visa’s growth rate; the problem is, they often trade at 50x, 100x, or even 150x profits, so that getting the company’s growth story right doesn’t lead to successful investing because you get whacked by the transition to 15-20x profits or whatever the matured valuation happens to be.

Life is a lot simpler when you spend your time loading up on Exxon month after month, year after year. The valuation wiggles between 7x and 10x profits throughout most years, the profits march upwards due to 5% natural growth plus a 4-5% buyback, mixed in with a 2-3% dividend depending on your starting point, and seems to be an automatic way to (1) tap into an annually growing dividend that (2) grows 8-12% in most years without (3) worrying that you’re overpaying. The simplicity of that, plus the small dividend checks in the beginning, probably have a deterrent effect, but once an Exxon shareholder has been at it for ten years or so, the regrets about loading up on the oil giant tend to dissipate. Why do you think that is?

Peter Lynch once remarked that casual investors know just enough to be dangerous when they start combining two principles—the belief that having heard of a company that’s been around for a while is proof that it is of blue-chip quality with the belief that a low price-to-earnings ratio is proof that a stock is cheap.

By way of example, Lynch pointed to Ford Motor Stock (F) at the high point of a business cycle right before the economy turns for the worse because: (1) stock prices tend to be high when the economy is doing well, making investors feel more comfortable about making new stock investments despite all the historical studies pointing out that this is a bad impulse, (2) Ford “feels like a blue-chip” because investors have heard of it, and (3) the low P/E ratio lures people in, who are unaware that automotive profits fall 50-75% as the economy moves from the top of the expansion to the bottom contraction part of the business cycle.

I had this Lynch example on my mind as I recently compared two companies that sound very blue-chippy—Campbell Soup and The Walt Disney Company—but offer very different prospects for long-term investors.

At first glance, Campbell Soup sounds like an equal, almost superior investment, to Walt Disney. You could have the abstract notion that when times get super tough, soup would be more indispensable than entertainment luxuries, and plus, you could see Campbell Soup’s dividend yield in the 3% range and compare it favorably to Disney’s dividend in the 1% range.

The catch? Disney is much more diversified than you might think—they own what you watch on television (Disney, ABC, ESPN, etc.), they own what you watch at the movies (the list of movies dating back to Mary Poppins is too long to specifically mention), and then the remaining third of the business is the cruiseliners and theme parks that are most readily identifiable with the Disney brand.

And the growth rate differential between the two is enormous: Over the past ten years, Campbell Soup has grown at 5% per year, growing the dividend at the same rate as profits. For Disney, the results are much better. Earnings have grown by 15% over the past ten years, and the dividend has grown by 11% annually.

That leads to significantly different results over time:

In 2003, you could bought both Campbell Soup and Disney for $20 each.

If you bought 500 shares of Campbell Soup for $20, your starting dividend income would have been $0.63 per share, or $315 annually. Now, those $20 shares are worth $44 each, and your annual income would have become $624, or roughly double your starting place in 2003 if you did not reinvest the dividends.

In the case of Disney, that $20 share would have grown to $90 per share, and your starting income of $105 in 2003 would have grown to $430 today. It’s still a few years off from catching Campbell Soup, but the capital gain differential is enormous—Campbell Soup’s price more than doubled, whereas Disney’s stock price is crossing over from quadrupling to quintupling over the same time frame.

If someone already owns Campbell Soup, I get why they would keep it in the portfolio—it hums along, giving you reliable annual that makes it a nice part of a diversified portfolio. But when you are at the beginning construction stage, you are trying to balance two interests: quality plus earnings growth. Campbell Soup passes the test on the quality front, but lacks on the growth front.

If someone needs a yield around 3%, I don’t understand what kind of thought process would lead someone to prefer Campbell Soup or Exxon Mobil or Chevron. In the case of the oil giants, you’d be at roughly the same starting point you’d get with Campbell Soup, but your earnings growth rate and dividend growth rate would be much higher (in the 8-12% long-term range, compared to the 5% range you’d get with Campbell Soup).

Meanwhile, I can completely understand why someone would like Disney—it’s one of the few established blue-chips that realistically has a chance of growing at a rate over 10% for the upcoming ten years, and this creates the potential for significant capital gains that you won’t get with Campbell Soup. A common admonishment from financial professionals is that you should avoid yield-chasing—which is something that can occur when you accept much lower growth rates in the pursuit of a higher starting yield. When you compare companies like Campbell Soup and Disney side by side, sure, you get a higher starting yield from Campbell Soup, but Disney’s growth rate and potential for significant pops in share price is so substantial that it would be a bad tradeoff to pursue Campbell Soup’s higher immediate dividend income.

Lately, I’ve been coming around to the notion that buying Berkshire Hathaway is on the short list of “very intelligent” moves you can make today if your time horizon is 15+ years out and you are looking for something that will eventually pay dividends, but are investing in a taxable account and don’t mind seeing a pile of money quietly build up as Buffett does his thing.

There’s a couple things that brought me to this point: Upon reflection on Buffett’s letter to shareholders that came out in the spring, we have a very rough gauge of what Buffett considers to be the fair value of Berkshire Hathaway stock (you should note that Buffett doesn’t spoon-feed information to his audience, so he makes you do just a little bit of independent thinking before you reach the conclusion that he desires).

In that letter, Buffett indicated that Berkshire would be repurchasing its own stock if it traded at 1.2x book value. Given that Berkshire’s book value is around $92 per share, that means there is a floor of $110 per share for the stock (if the price goes below that, Buffett would start gobbling up the shares so it would take 2008-2009 steep, general market decline to send prices below that mark to offset Buffett’s repurchase of his own stock on the company’s behalf).

So we know that Buffett considers $110 a cheap enough price that comes with a margin of safety to buy back the stock, but what’s the point at which Berkshire hits its fair value estimate? Well, Buffett’s mentor, Benjamin Graham, said that stock repurchases carry a margin of safety when they trade at a 1/3 discount to intrinsic value. Let’s assume that Buffett modifies that to reflect the superior quality of Berkshire’s operational companies and public stock portfolio investments (if this were the old textile mill days of the ‘60s, when the earnings quality at Berkshire was quite poor, it would make sense to insist on Graham’s 1/3 discount rule).

My guess is that Buffett repurchases the stock when it trades at 80% of intrinsic value (which is 1.2x book value in Berkshire’s case) so that a fair price to pay for Berkshire Hathaway stock is somewhere around 1.5x book value. Applying that to the current case, you are getting a fair deal anytime you can buy Berkshire stock below $138, such as we are able to do today.

Why, then, is Berkshire trading at a fair price when everything else around else seems to be expensive—not terribly so, let’s call it a “soft overvaluation” that characterizes the S&P 500 today?

First, Berkshire doesn’t pay a dividend. If you could go out and buy 7% yielding treasuries or 9% yielding corporate bonds (of companies that aren’t on the verge of bankruptcy), it would be no big deal. But when banks make you jump through hoops to check off a bunch of different monthly requirements so that you can get 0.75% from a high-yield, high net worth checking account, not a whole lot of people are going to be oriented towards saying, “Gee, let me put my money into a $200 billion conglomerate run by a 80+ year-old that offers a dividend yield of 0%.”

Therein lies the opportunity. If you buy Berkshire Hathaway and have a fifteen to twenty year orientation, you will likely see one of two things happen:

Berkshire will pay a dividend. This could be one of those situations where someone holding Berkshire in a taxable account will sit by and see their wealth quietly compound without having to pay anything to the tax man, and as they approach a point at which dividend income could prove useful, they may start getting just in time before or during the early years of retirement. It could be one of those situations where those buying today could have 10% yield-on-costs at the time Berkshire actually gets around to initiating a dividend payout.

Or you could have a lucrative breakup situation. Companies that are a disparate collection of operating businesses rarely remain intact after the brilliant founder is gone (Henry Singleton of Teledyne fame being the highest profile example). Sitting on a lucrative asset before a spinoff can be a life-changing experience as long-term shareholders of Abbot Labs (now Abbott Labs + Abbvie) andConoco Phillips (now Conoco Phillips + Phillips 66) can tell you. The most lucrative example in that regard came in 2008 when Altria decided to become Altria, Philip Morris International, and what is now Kraft and Mondelez.

Someone who made a $25,000 investment in Altria from over ten years ago has won at life. The collection of dividends and individual companies received has shown what happens when you buy a high-quality company that just happens to be that magical stock.

Berkshire Hathaway has the potential for spinoffs unlike any other company in the country, save for Procter & Gamble, Pepsi, Johnson & Johnson, and General Electric. What if new Berkshire management decided to spinoff GEICO? Applied Underwriters? Dairy Queen? Fruit Of The Loom? Benjamin Moore Paints? Lubrizol Chemical? Nebraska Furniture Mart? The Buffalo News? See’s Candies? Business Wire? The Burlington Northern Santa Fe Railroad? Netjets? Helzberg Diamonds? Borsheim’s Jewelry? Johns Manville? Clayton Homes? The Omaha Herald? The Pampered Chef? Wesco Financial? General Re? Heinz Ketchup?

The opportunities for significant spinoff wealth are overwhelming.

And imagine if the stock portfolio were partially dismantled through spinoffs? Imagine collecting outright ownership stakes in Coca-Cola, Wells Fargo, IBM, Procter & Gamble, American Express, or ExxonMobil because the new management team wanted to part with it but didn’t want to sell it outright in the conventional sense?

If you hold Berkshire Hathaway long enough, you’ll see a dividend. You’ll see something get spun off. That’s the nature of what happens to unrelated businesses that are held together by a cult-of-personality force with a 30% ownership stake in the whole thing. The model is so decentralized, that Buffett has been gradually removing himself from being necessary to Berkshire’s sustained success. He’s become old man river, where has different managers running each operational company with minimal oversight from him (Buffett has long said the only active decision he makes is setting the price of See’s chocolates for the upcoming year on the day after Christmas). He just collects the cash checks he receives from the management teams whose annual bonuses are tied to the amount of cash profits they are able to send Buffett. At some point, people who buy Berkshire today and hold for a long time will experience some kind of trigger event, be it a dividend or a spinoff, that will make them smile.

Most of the time, when we discuss stocks that have been irreparably harmed, we are talking about companies that have gone bankrupt, or have seen prices deteriorate so much that investors will never again so the “good old days” (usually this is the result of some kind of technological shift or high fixed costs that can’t realistically be lowered).

Today, I want to talk about a third kind of harm: share dilution.

Citigroup is one of the best companies that comes to mind I can use to illustrate the principle.

Even though no one gets made mocked by the financial media quite like Citigroup (although it does trade positions frequently with Bank of America) in this regard, the truth remains that Citigroup is an immensely profitable banking enterprise. It’s so unpopular and it is involved in so many legal settlements that it is easy to miss if you don’t check out the company’s financial forms and dig through the information yourself, but Citigroup is actually making $14 billion per year in profits. It’s one of the four dozen most profitable enterprises in the world, although you wouldn’t be aware of that fact if you followed the headlines and never got around to studying the company’s actual fundamentals.

Within two years, Citigroup will be as profitable as it was in the years leading up to the financial crisis. So everything is going to work out for long-term shareholders, right?

Citigroup lost $32 billion in 2008. To stay alive, the company had to create equity, and create equity fast. That means creating shares at a time when the stock price had fallen by over 80%, so that the existing shareholders would have to share the wealth with new partners that were entering at once in a lifetime prices, diluting the existing owners substantially.

By the time the financial crisis was over and the final results tallied, almost six new shares got created for every share that had previously been in existence. A share count that had hovered around 500 million grew to 2.8 billion. Things got so bad that Citigroup had to do a 10-for-1 reverse stock split to superficially paper over their own folly; without taking into account dividends, Citigroup’s stock price will have to increase to $500 per share for the old investors to breakeven.

Profits will have to increase ten-fold for Citigroup shareholers to get back to where they were in 2007—in other words, you’re looking at a situation where investors will have to wait until 2037 to get back to where they were in 2007. That’s failure. Sure, it’s better than owning Wachovia, but monstrous one-time share dilution is a crippling event that will most assuredly trash an investment for the rest of your life.

How do you avoid companies that engage in catastrophic share dilution? Although companies can get somewhat creative with how they fail, share dilution usually has three warning signs you can look out for: high debt and/or low capital (this is usually exhibited by banks that have forgotten crisis memories and are lowering their Tier 1 Capital ratios and liquid reserves to try and bump profits to meet some quarterly estimate figure), high-fixed costs (think the old General Motors and retail outlets like Border’s and Barnes & Noble), or debt that proves high in hindsight (this is common in the oil and gas industry, where debt loads that appear manageable to an analyst studying the company suddenly becomes crippling if commodity prices dip for an extended period of time, and the company has to issue shares to stay alive).

Now, if you are particularly shrewd, you can come pick up the pieces after the company falls apart—Citigroup is worth at least $67 based on its total book value, and it is making $5 per share in profit. At some point, $2.50 of that will be distributed in dividends (it might take five years or so for the payout ratio to get there), and it could be even higher assuming Citigroup’s total profits are higher in 2019 than 2014.

As it stands, Citigroup is a perfectly healthy bank with a double-digit Tier 1 Capital Ratio making almost $15 billion in net profits. This is a small solace if you owned the company before 2007, because you paid the equivalent of $500 per share and now have to split the profits with six new people. But it is that foul aftertaste that can partially explain why Citigroup is so cheap today, and once it starts raising its dividend in a way that reflects the actual profits it is generating, the investors that buy the stock today are going to see some rapid price increases in short order. The enterprising investor has to be unemotional about the past, and that’s the hard part.

When someone considers buying a stock, there are two types of thoughts that could enter his mind: market decisions and investment decisions. A market decision is what you’d expect; someone buys a stock and expects the price to go up, usually within a few months, or a year or two maximum.

An investment decision is much more binding in a self-imposed way—you are saying, “I really like the business economics here, and I believe this company is going to be generating much higher profits five, ten, even fifteen to twenty years from now. Getting past the obvious niceties that nothing is ever certain, you reach the conclusion that a company worthy of such an investment has a high probability of achieving the returns you predict.

One of the companies that is difficult for me to study is Altria, the historic tobaccomaker that went by the name Philip Morris until it changed its name to the bland “Altria” about a decade or so ago for public relations reasons, err, to reflect “its comprehensive business” at the time.

If you’ve been reading the site for a while, the story of the old Philip Morris is old hat to you: from 1926 to 2003, the old Philip Morris was the absolute best stock you could have purchased and held at that time period, giving you 17% annual returns even though the core business only grew at 11% over that time frame. That humongous six percent spread is the product of Altria’s perpetual undervaluation that allows investors to reinvest and then receive higher income going forward than they otherwise would have a right to receive.

Part of me wonders how much worse the taxation and regulation facing tobacco can get from here: Entirely bland packaging? Only smoking in homes? Doubled taxation rates from here? I’m not sure there’s a lot left to wring out of the industry, and I wonder whether politicians will ever truly deliver a death blow to the business because the Big Three tobacco companies contribute heavily to the funding of state budgets, particularly education.

I’m thinking out loud here, but I wonder whether Altria and Reynolds American will be able to reinvent themselves in a Wells Fargo manner, using smokeless tobacco, e-cigarettes, wine and beer to carry themselves through the coming decades.

What particularly catches my attention about Altria is this: the company owns 27.0% of SABMiller, the legendary brewer. For someone who owns a share of Altria now and intends to hold for the long term, I wonder what is going to happen to that SABMiller stake over the long term. Will something like Anheuser-Busch eventually succeed in buying it out, thus giving Altria tens of billions of dollars in cash to either acquire new businesses or give shareholders a massive, one-time dividend?

Will it get spun off like Philip Morris International and Kraft, giving Altria shareholders an ownership stake in both tobacco and beer separately? It doesn’t get a whole lot of attention now because it quietly adds a couple hundred million dollars to Altria’s balance sheet each year in the form of SABMiller dividend payments, and the fact that it has a total valuation fluctuating between $20 and $30 billion makes it a colossal stake that doesn’t get fairly taken into consideration when Altria is contemplated as a potential investment.

When used as a modest part of estate planning, Altria could serve a useful purpose. Imagine owning 1,000 shares of Altria that constitutes a 3-6% of one’s portfolio. You’d get $1,920 in annual dividends (based on the typical 2014 rate of $0.48 per share) that you could mix with fresh cash from elsewhere to make brand new investments as part of a perpetual “de-risking” plan in the event that the political risk associated with tobacco proves worse than anticipated. Do this for a decade or so, and the growing dividends from Altria combined with the growth of your new investments would make Altria something akin to house money in that even if the company were to completely fall off the face of the earth, you’d still breakeven. It’s a great contingency plan.

More likely, Altria will continue to raise its dividends, you’d be able to make a mini blue-chip portfolio funded entirely from Altria dividends over the years, and at some point in time, that SABMiller stake will come to create significant wealth either due to a spinoff or in the form of a special dividend.

Using tobacco dividends to buy other cash-generating assets seems to be the best way to recognize Altria’s exceptional long-term returns and unique ability to offer a high current yield mixed with high current growth, while also hedging against the unique political risks in the tobacco industry. And meanwhile, that 27.0% stake in SABMiller just sits there quietly.

Before the 1920s, it was not a common experience for America’s affluent class to own any stocks at all in their portfolio, unless they had a hand in creating the company, working for it, or a close association with it (e.g. you’ve been living in St. Louis since the 1890s, and Anheuser-Busch is the largest profitable enterprise in the city, so you might own that).

In a way, corporate bonds were regarded in the same way that long-term investors think about purchasing stocks today; an act of total ownership. If you purchased a General Mills bond in 1905 that was secured by a mortgage on the flour mill, you felt pretty secure. If Americans stopped eating cereals and using flour, you’d get a big chunk of your investment back when the factory got auctioned off. Talking about a portfolio of common stocks would have made you persona non grata in affluent circles, as you would have been seen as the reckless lunatic that owned assets that were only tied to profitability and not tangible assets.

What changed in the 1920s?

There were two developments: one was intellectual, and one was cultural.

On the intellectual side, Edgar L. Smith wrote a book titled, “Common Stocks as Long-Term Investments” that pointed out two things. First of all, he noted that the returns experienced by American stockholders beat the returns of American bondholders by two to three percentage points per year. Fine, everyone knew that then.

But his greater insight had to do with safety: he pointed out that, despite the higher volatility in stock price, the thirty largest American companies offered a guarantee of sorts: over a typical investment period dating from two decades before the Civil War until 1923, you were guaranteed to break even within six years if you bought your stocks at the average price point those stocks experienced during the year. The other insight Smith noted was this: under a worst case scenario, in which you purchased each of the thirty largest American firms at the absolutely most expensive day that it was possible to do so, you broke even within 13.5 years. The typical experience, though, was that you would double your investment capital every five to six years.

That might be an influential argument in the faculty lounges of Harvard, Yale, and Princeton at the time, but it wouldn’t be enough to actually transform behavior. If you were the kind of person deliberating between corporate bonds and common stocks back in the 1920s, you are also going to be the kind of person that thinks in terms of worst case scenarios. If you’re culturally used to buying corporate bonds, knowing that stocks could take 13.5 years for you to break even isn’t exactly something that is going to cause you to have a Paul-going-to-Damascus type of conversion if all your life you had been trained that corporate bonds are equated with wealth preservation.

What really changed was this: Social proof, and the rise in common stock prices once it became clear that the United States and its economic engine were going to emerge victorious in WWI. All of a sudden, the guy at the country club was buying a bigger house, a model T Ford off the line, and this newfangled household appliance gadget called a toaster. While I think envy and jealousy is responsible for a lot of global misery because people make financial decisions aimed at impressing those that travel in their social circles (without pausing to reflect upon what it must say about the other person’s quality if they respond to you better with a $400,000 house than a $250,000 house), I don’t discount Seth Godin’s wisdom that change happens when people see something new and answer the question “Do people like me do stuff like this?” in the affirmative.

I mention all of this as a matter of perspective. A century ago, buying General Mills, Procter & Gamble, and General Electric common stock was seen as being a bold investor. Nowadays, we associate those stocks with, “Oh, that’s something Aunt Mildred is interested in.” And instead, the airwaves get populated by companies trading at 100x earnings, 75x profits, or whatever—that won’t be around 20 years from now. That’s not investing; that’s trying to buy a lottery ticket based on a narrow window in time and hope and pray the price of the stock goes up. That’s not much of a difference between that and going to a casino.

The right answer lies in the middle ground; people that would only own corporate bonds were probably too conservative in preserving wealth (although, if 7-8% cash returns from your bonds fully funds your lifestyle, why fix something that isn’t broken?), and nowadays, we ignore the perfectly good common stocks because they are too boring. Hopefully you recognize the intelligent middle ground.