I have written about BP several times before on this site, as the company is one in which the reputation of the firm has created a historic opportunity due to the lingering memory of the oil spill and the litigation that has come after.

A frequent theme, though, on this site is that you need to be empowered to find those times when the fundamentals of a company are much better than a company’s reputation, and I have cited to McDonald’s and Johnson & Johnson in the past to illustrate the concept. The best example of a stock now, here in the moment, suffering from the same phenomenon is BP.

It’s spoken about as if the company is roadkill, a shadow of its former self. The company’s reputation is a far cry away from its business strength as the company is set to make almost $15 billion this year. In net profit. It’s amazing how little that factoid comes up in discussion.

What I find most intriguing? This: Since temporarily suspending its dividend in 2010 because of the oil spill, BP has paid $1.68 in 2011 dividends, $1.98 in 2012 dividends, $2.19 in 2013 dividends, and an estimated $2.32 in 2014 dividends. In other words, each share will have collected $8.17 in total dividends since the oil spill.

Not only was BP’s dividend on the mend since the oil spill, but for people that chose to reinvest, they were able to do it an average share price of $38.15 per share due to the uncertainty created by the oil spill.

If you had 100 shares, you would have received $817 by the end of 2014, which would have gotten reinvested at an average price of $39.15, netting you a bit over 20 additional shares of stock. This is the stuff that gets skipped over when conversations about long-term dividend investing come up.

Most people, if you asked them on the street, would probably guess that BP has been a disaster investment since the oil. Unless you study this stuff, it’s not necessarily intuitive how 10,000 shares can automatically turn into 12,000 shares over the course of a couple years.

What if you owned BP before the oil spill?

From an income perspective, it looks something like this:

Before the oil spill, BP was paying out $0.84 per share in quarterly dividends for an annual rate of $3.36 in dividends. Someone who owned 1,000 shares before the spill happened would have been collecting $3,360 in annual dividend income.

From 2010 through 2014, those 1,000 shares would grown to a little over 1,200 shares due to dividend reinvestment. At the current rate of $2.32, you would be collecting $2,784 in annual income. That is because BP had to auction off about a third of its business to pay for litigation costs associated with the spill.

By the way, this is why people do blue-chip investing. If you held before the oil spill, the consequence of a worst-case scenario is that your income gets knocked down a bit, and then slowly starts to rebuild. You’re not dealing with 100% wipeout risk here. You’re collecting checks of $2,000-$2,700 for a few years instead of $3,300.

For investors that bought after the oil spill, BP is a life-changing investment if you were aggressive with the amount of stock you bought. Heck, it’s still offering investors a good deal—for most of its history, it was like Exxon in that it yielded around 2.5% to 3.5%. The cloud of uncertainty still hangs a bit, and you can get a slightly better than average deal by buying some of the stock today (which, compared to the general expensiveness in the rest of the market, isn’t so bad).

The fact that every 5 shares of BP owned since the oil spill has produced 1 new share is an important part of the wealth creation story. Let the pundits and guys on CNBC talk about how BP was trading in the $70s and $80s before the oil spill, and is still well below its previous highs. They can have that story. I’m interested in the story of dividend recovery and wealth-creation, as reinvested dividends from BP have really started to pile up since 2010, bringing burned investors closer to their previous income highs while the post-spill investors made an investment of a lifetime if they bought BP, parked it, and plan on reinvesting or spending the dividends for the next couple of decades.

When investing within the confines of a Roth IRA, there are two different strategies that an investor can pursue (or combine them both) to work around the $5,500 maximum contribution limit that are allowed to put into the account.

The first strategy involves focusing on growth that you can convert into income later—imagine if you spent a couple years putting $5,500 into something like Visa, Disney, or Becton Dickinson. They tend to grow in the 10-13% range, although neither of the three companies pay a particularly high starting dividend yield at the moment.

If you were to let those three companies do their thing for twenty years, and you had $16,500 left to compound at 12% annually, those three stocks would have a combined value of somewhere around $179,000 in the year 2034. Although Congress will likely raise the rate of annual contributions permitted to a Roth IRA over the years, we can make the back-of-the-envelope that it would take about three decades of putting the maximum allowable amount into the account each year for someone be able to get $179,000 tucked away inside a Roth IRA.

With those kinds of companies that exhibit high growth rates, you get all of that money perpetually behind the shield of the Roth, so you never have to pay any taxes on the distributions you take from the account (the catch is that it doesn’t lower your tax bill at the time you contribute, and you can’t claim any deductions on money lost within the count). That $179,000 could be put to extraordinary use twenty years from now—what if US bond rates normalize towards something approaching their historical tendency, and you are able to slowly convert that capital into something yielding 6.5%? You just created a tax-free cash flow for yourself of something resembling $11,500-$12,000 each year. That’s what optimal tax strategy in a good case scenario looks like.

For other investors, that might want to do something that involves lower growth potential, but offers much better high current yield. This process may result in less wealth, but it creates a better process from which to spend your life working. There’s a lot of companies that fit this profile—AT&T, Altria, Philip Morris International, Reynolds, Conoco, Royal Dutch Shell, GlaxoSmithKline, and BP—but I’ll use BP as an example for our purposes.

The average price of BP for the past three years has been $41.32. Let’s say you were able to set aside three years of Roth IRA contributions into BP (it may not be wise to put it all into one stock, so take this for illustrative purposes of the principle). You would have essentially acquire 400 shares of the oil giant. At the present time, you would be collecting $936 in annual income from the BP investment.

All of a sudden, that BP stock can act as a tool to amplify your future investments. Let’s say you want to buy Johnson & Johnson for your Roth IRA next year—instead of only getting to purchase the $5,500 worth of the stock that you happened to contribute, you would get to purchase $6,436 worth of Johnson & Johnson due to the pooled BP dividends that you combined with your fresh cash.

And that is only one year of BP dividends. Maybe BP will pay out $0.615 each quarter next year (up from $0.585 quarterly this year), and you’d get to combine $984 with your fresh $5,500 contribution instead of $936. Having a couple cash cows like BP in an IRA, dutifully paying out high dividends, provides you an outlet to amplify your cash contributions by making larger investments each year compared to what would otherwise be possible just from the spare cash created by your labor alone. Six or seven years from now, I could easily see BP providing $1,800 each year to add to your investment amounts, making the effects of this strategy grow more pronounced with time.

It comes down to your style: Are you the type of person who thinks, “I will completely delay gratification for decades, and don’t need any rewards on the path until that moment.” If that describes you, the first option might be better. If your thought process is more like, “Hey, I have to set aside a lot of money to make this happen, and I like receiving the little rewards along the way so I can make each year’s Roth IRA investment be higher due to the combination of cash cow dividends I am able to use”, then the second option would be preferable. Investing is a lot more fun when you deliberate and then choose a strategy that matches your personal style while knowing what creates personal satisfaction for you.

My guess is that anyone who is a lawyer, or at least familiar with the legal process enough to understand that separate, discrete elements need to be met in order to win a lawsuit, looks to a nearby wall to contemplate head-pounding upon reading most political/social/legal commentary on the BP lawsuit resulting from its 2010 oil spill.

Why do I say that?

Because almost no commentary on the BP oil spill has discussed in depth the heart of the issue that Judge Carl Barbier of the U.S. District Court in New Orleans, LA addressed yesterday:

Did BP’s operators, employees, and/or management act with negligence—or gross negligence—regarding the jolt of methane gas that exploded on the Deepwater Horizon while drilling the Macando 252 well?

The answer to that question has a significant effect on the future for BP shareholders. According to the Clean Water Act, you have to pay $1,100 per barrel of oil that you spilled negligently. However, if you spilled the oil in a grossly negligent manner, then you may have to pay a maximum of $4,300 per barrel of oil spilled.

BP says that they spilled 2.45 million barrels of oil, and the United States government says 4.2 million barrels of oil got spilled into the Gulf (Source, Ruling Against BP Could Mean $18 Billion Fines). That’s why you see newspaper headlines blasting the $18 billion figure across the top of their websites—in a worst case scenario from BP’s vantage point, they could be found (1) grossly negligent, meaning they have to pay $4,300 per barrel rather than $1,100 which would cap BP’s exposure at $4.6 billion AND (2) they would have to pay the maximum $4,300 for 4.2 million barrels of oil if the judiciary agrees with the U.S. government experts completely.

We still have a long ways to go—it would not surprise me if it took until the 2020s for this case to be fully resolved—before we know what the total cost will be for BP. Because Jude Barbier was a district court judge, BP is now filing an appeal to get Judge Barbier’s gross negligence ruling overturned.

The difference between negligence, and gross negligence, is this: For BP to be found liable for negligence, the plaintiffs only have to show that BP owed a duty of care in its maintenance and handling of the Deepwater Horizon, breached it, and it caused damages. This wouldn’t be difficult to prove—and that’s why BP set aside $3.5 billion in cash provisions on its balance sheet to go towards paying off a finding of negligence.

But gross negligence—what quadruples the cost to BP—is a much higher bar because it suggests a higher state of moral blameworthiness. For BP to be liable for gross negligence, the plaintiffs against BP would have to show two things, first that:

(1)    From the standpoint of the BP actors at the time of the accident’s occurrence, when viewed objectively, the conduct involved an extreme degree of risk, considering the probability and magnitude of the potential harm to others, AND

(2)    The actors on BP’s behalf had actual, subjective awareness of the risks involved, but nevertheless proceeded with the conscious indifference to the rights, safety, and welfare of others.

To speak candidly, I was caught off guard that Judge Barbier concluded that BP acted with gross negligence. Look at that second element that needs to be met—you have to prove conscious indifference to the rights, safety, and welfare of others in your conduct. On the Deepwater Horizon, BP had (1) their contractors wear alarms to warn against any risks, (2) installed million-dollar monitors onboard to sense surges in methane gas, and (3) the company had detailed evacuation procedures which were put in place and were followed after sensing the odor alerting them of the gas surges.

This is the specific point at which I was wrong in my analysis: I thought the district court judge would look at the million-dollar monitoring equipment, sensory bracelets, and evacuation procedures that were put in place and conclude, “This may very well be a negligent explosion, but it is not a grossly negligent explosion because million-dollar sensory equipment, high-tech bracelet alerts, and detailed evacuation procedures do not offer proof that you are ‘consciously indifferent’ to the ‘rights, safety, and welfare of others.’”

The hard part for BP came in 2010-2012 when they had to sell off a little over $40 billion in assets, and this permanently reduced BP’s earnings power by a fifth. For a mental conceptualization of what had happened, the asset sales basically turned back the clock and reduced BP’s breadth and scope back to the size it was in 2005.

Going forward, in the worst-case legal scenario in which: (1) BP loses its appeal, (2) has to pay the maximum penalty of $4,300 per barrel of oil spilled, and (3) has to pay for the full amount suggested by the U.S. government, you’d be looking at another $18 billion or so in total costs. That would mean that BP would lose another ten percentage points or so off its pre-oil spill size, giving BP about two-thirds of the earnings power that it possessed in 2010.

The mitigating factors that would suggest good news for BP would be this: (1) BP had $27.5 billion in cash and cash equivalents on hand at the end of the second quarter in 2014, (2) the appeals court may rule that BP did not act consciously indifferent to the rights, safety, and welfare of others, reducing the potential scope of BP’s penalties down to $1,100, (3) BP may continue to be held grossly negligent, but the per barrel fine may be lower than the $4,300 maximum permitted, and/or (4) the judge may rule that the amount of oil spilled fell closer to BP’s 2.5 million barrel estimate rather than the government’s 4+ million barrel estimate.

This trajectory, however, does diminish BP’s ability to significantly grow the dividend in the coming years. The solace, though, is that investors reinvesting their shares will achieve a significant snap-back effect when you spend years reinvesting $0.585 quarterly dividends that are slowly growing into shares that are trading around $44-$45, such that you may have significantly turbo-charged your acquired wealth fifteen years from now when you look back at those high dividends reinvested at low prices when the price of the stock is significantly higher. Fifteen years from now, someone who reviews their reinvested dividends during the 2010s may regard the period as foundational in building wealth.

I know this isn’t a legal blog, and posts like these are boring to a lot of people (and no one wakes up in the morning wanting to hear the opinions of a law student), so I won’t make a habit of this, but I wanted to offer something different from the commentary out there from people like State Senator Brice Wiggins who said, “I think BP should accept the ruling and settle the damages so that we can move forward on restoring the Gulf Coast. Or Cynthia Sarthou, who said, “”BP’s oil is still washing up on the beaches of the Gulf and is still impacting the Gulf’s communities and wildlife. If BP will just own up to the damage they’ve done, then we can get to the business of restoring the Gulf. They should be making it right in the Gulf, not spending millions on PR and legal fees appealing this decision.”

This commentary about BP “taking responsibility for the damages” is obnoxious because it is entirely result-oriented; people look at the damage done, and form opinions on that. But gross negligence is supposed to be much more than that because it involves a certain mindset—it’s about consciously disregarding risks while possessing a state of mind of indifference rather than merely breaching duties owed to others—and the question of how to treat an organization that spends millions in safety equipment yet encounters a disastrous result is much more nuanced than the commentary currently prevalent on most mainstream publications would suggest (with the Financial Times being a notable exception).

No ones like to talk about Total SA, the French oil giant that is one of the “Big Six” publicly traded energy firms in the world, because the French government is fond of taxing the business highly and American investors have to deal with filing separate paperwork to recapture some of their dividend that the French government takes out for the payout (and, in the typical IRA, you don’t get any kind of dividend recapture/refund for the French tax, although the rules for self-administered pension funds are more favorable).

This dividend doesn’t go up every year because, as is custom with most European companies, dividend payouts match profits in that year, and so you don’t get the Americanized effect of a smooth dividend payout that goes up with every year. That’s another reason why American investors, particularly retirees, don’t have much of a desire to go near the stock.

But as an income stock for an investor—that is, someone that wants to regularly receive reliable chunks of income from an investment and deploy it elsewhere, Total SA is invaluable.

If you could go back to 2003, you could see that Total SA could be purchased for $30 per share. Compared to the price today, it’s nice to see that you doubled your investment from the change in share price. But the dividend is where the real action is.

In 2003, you collected $1.17 in dividends. Then, the dividend payout went like this: $2.19 (2004), $1.84 (2005), $2.19 (2006), $2.81 (2007), $3.10 (2008), $3.28 (2009), $2.93 (2010), $3.11 (2011), $2.98 (2012), $3.13 (2013), $3.30 (2014 estimated). That’s right; you would have collected more in Total SA dividends since 2003 than the price required to buy the stock. You would have paid $30 for each share, and collected $32.03 from 2003 through 2014.

Some of you write to me expressing an interest in being capital allocators—you want to spend your days making investments. If you aren’t bringing in a lot of investable income from a business you run or your own labor, then you’re going to want companies that fit the profile of Total SA. The building blocks of a portfolio of someone that wants to be a capital allocator are things like GlaxoSmithKline, Royal Dutch Shell, AT&T, Altria, Reynolds Tobacco, BP, Conoco Phillips, and of course, Total SA. Over ten, fifteen, twenty years, they give you lots of income to make brand new decisions.

With Total SA, the story is always the same—slow growth in the 5% range perpetually expected, constant fear of French taxation, and so on. I don’t see this to diminish or to discredit those concerns, but Total SA rarely has experienced blistering growth since becoming the signature French company, and the company is paying 20% higher taxes now than it did in 2003. In other words, the fears come true, and you still collect more total dividend income than the amount invested in 2003.

Finding these cash cows early in life is a blessing because you are constantly being given a chunk of change to deploy elsewhere—think about what you could have done with those Total SA dividends over the past eleven years. Someone with 1,000 shares of Total SA in 2003 would have collected $32,030 to build positions in Disney, IBM, Becton Dickinson, Visa, and so on. And, of course, those new purchases would be paying out dividends of their own as well. Things are so much easier when you get something like Total SA on your household balance sheet in a meaningful amount at the earliest age possible.

One of the ridiculous components of the annual “Forbes 100 List” that outlines the richest people in the world is that it is written with the frame of reference that every member of that list is actively trying to get richer over time. In the case of Carlos Slim, that is undoubtedly true. In the case of Bill Gates, that is undoubtedly false.

When Microsoft went public in 1986, Bill Gates owned 46.7% of the stock. Microsoft is now a company in the $350 billion range. Had Gates decided to let his ownership stake silently compound without any interference from him, he would be sitting on a $163 billion fortune (and that is before taking into account Microsoft’s dividends), permitting him to likely live out his days as the richest person in the world.

Instead, Gates has chosen to get serious about charity, selling off his ownership stake to save lives. The other thing he is doing is selling Microsoft stock to diversify his wealth into things like Minnesota’s electric power company Otter Tail.

One of the perennial questions that I receive from readers is this: Should you reinvest your dividends automatically into the company that paid them out, or should you pool them together to make new investments altogether?

The answer to that question is always some form of “it depends” but I will say this: Microsoft is exactly the type of stock that is well-suited for conservative accounts to take their dividends and pool them together for investment elsewhere. It has a growing dividend that will give you more and more cash each year to make new investments, but given its reliance on tech products (e.g. Microsoft must keep up with the times whereas all Hershey has to do is keep making chocolate) it could be wise to derisk the stock by allocating your dividends from Microsoft elsewhere.

How might this scenario play out?

Imagine if, five years ago, you saw Microsoft trading at $20 per share for a valuation of only 13-14x profits. Even though the stock subsequently fell to the $14-$15 range as part of the general selloff associated with the financial crisis, you saw that the company had a treasure chest of tens of billions of dollars, and you figured Microsoft Word and all his friends would be part of our world for some time to come.

Here’s what would have happened: if you bought $10,000 worth of the stock for 500 shares total, you would have collected: $0.52 in both 2009 and 2010, $0.64 in 2011, $0.80 in 2012, $0.89 in 2013, and at least $1.12 in 2014 (I assumed a $0.28 payout for the final quarter of 2014, but Microsoft typically raises its dividend by that point so the exact figure should be a little higher).

Each share of Microsoft that you owned would have collected $4.49 from 2009 through 2014. For someone who paid $20 per share, you would have gotten a little over 22% of your investment amount back in the form of dividends. If you scooped up 500 shares, Microsoft’s Board would have paid out to you $2,245 that you could have used to start building a position in a company that you know will be around decades from now pumping out dividends for shareholders, like Hershey. Then, you’d also have $2,245 worth of Hershey stock generating their own dividends for you as well, and that’s how a virtuous cycle gets set in motion.

Over the next five years, things could get even more interesting as Microsoft’s dividend has a fair chance of crossing the $2 per share mark. At that point, you’d be receiving $1,000 each year to make new investments elsewhere (the basis for that projection is that Microsoft still continues growing at the mid single digits and also boosts its dividend payout amount from the 30-40% range to something closer to 50%).

At that point, you could just hook up your Microsoft shares to a separate bank account, run an automatic investment program through Computershare to buy Exxon (or whatever you end up selecting) to the tune of $83 per month. The exact specifics and details of your strategy may vary, but it is entirely possible to reduce the technology risk inherent in being a Microsoft owner while using the growing dividends to build up a mini blue-chip portfolio of your own elsewhere.

When Microsoft announces its annual dividend raise, you can do likewise by increasing the amount of your monthly investment into the blue-chip stock that you select. I could easily envision a world in which someone with sizable chunks of stock in Apple, IBM, and Microsoft takes dividends from those stocks and sets up perpetual monthly investment into Nestle, Exxon, and Dr. Pepper free of charge through Computershare or whatever transfer agent you’re dealing.

That being said, worrying about dividend allocation isn’t really something that deserves attention until the dividend checks start to reach the hundreds of dollars. Fretting over the optimal way to allocate $5 in quarterly Microsoft income is just a waste of mental energy and perhaps fees depending on the circumstances, and at that stage, your time should be spent improving your savings rate so you can get more money to invest each month.

In Bill Gates’ case, he takes the Microsoft dividends and deploys them elsewhere into new investments and charitable contributions. He also sells Microsoft stock regularly as well, but that’s because if he only re-allocated dividends alone he’d still die with over 90% of his wealth in Microsoft. For the retail investor sitting on a few hundred or even thousand shares of Microsoft stock, it seems wise to appreciate it’s growing dividend over the long-term while recognizing that IBM has been the only tech company that has sense to own generation after generation, and to hedge against this tech risk by using the dividends to purchase high-quality companies against the possible that Microsoft may not automatically be a cash cow forty years from now.

When you study the personal lives of most great value investors, be it Charlie Munger, Warren Buffett, John Neff, Richard Cunniff, Bill Ruane, or Donald Yacktman, you will find that among the many things that they share in common, one of them is this: they have all been internally motivated. When you get your hands on biographies of their lives, you get the impression that even from an early age, they didn’t really care a whole lot what other people thought of them. They weren’t needlessly combative or anti-social, but they weren’t afraid to fade away and do their own thing.

This passage about Warren Buffett, written by Alice Schroeder in Snowball, is probably the most concise explanation of what I’m talking about:

“Warren also spent a lot of his spare time as a child hanging around at his father’s stockbrokerage house reading everything he could get his hands on. As a tenth birthday present, he asked his father to take him to the New York Stock Exchange in person. The young Warren was hooked from day one and loved everything he saw and experienced. He decided then and there that he wanted to be rich and set a goal to be a millionaire by the age of 35. This was a reasonably audacious goal for an eleven-year old kid to be making in the middle of The Great Depression but Warren was adamant. Warren said, “Money could make me independent. Then I could do what I wanted with my life. And the biggest thing I wanted was to work for myself. I didn’t want other people directing me. The idea of doing what I wanted to every day was important to me.”

The implications of reaching the point where you don’t let the judgmental/negative opinions of others affect your decision-making come with two significant advantages, both in terms of investing and your savings rate.

On the investing side, if you only limit yourself to purchasing stocks that you yourself truly understand, you will be able to hold onto them when they become unfashionable. And trust me, if you have any chance of holding onto a company for 10+ years, you will have to prepare for a moment when your holding becomes unfashionable.

Someone who bought McDonalds in 1995 had to get through 1997 and 2002-2003 when the national conversation turned to explicitly targeting McDonald’s as the culprit for the nation’s obesity epidemic (heck, McDonald’s doesn’t even sell Super Size fries anymore—our nation didn’t say the answer to the problem is to exercise restraint and refrain from buying the 1,000+ calorie side, but instead blamed the company for offering it until McDonald’s eventually caved and took it off the menu). Yet, holding through those rough political patches when the talking heads were ridiculing McDonald’s would have proven a highly lucrative endeavor, as every $1 invested in 1995 turned into $7.70 today with dividends paid out but not reinvested.

Heck, even long-term owners of General Mills had to deal with the problem of stagnation as flour and Cheerios remained highly lucrative and profitable, but the growth component was slumping for a bit. From 2000 to 2004, the dividend just froze at $0.55. And before that, the growth limping along at a rate of a penny here, a penny there each year. Since about 2004, though, the company has gotten its act together by making selective acquisitions that add immediate value to total profits generated, and that’s why every $1 invested in 1990 would now be worth $9.50. It’s one of those situations where a $10,000 investment held for twenty-five years ends up producing around $3,000 in annual dividend income per year. But it takes an independent streak to sit back and say, “Okay, I’m reasonably diversified, while those Exxon shares are jacking up their dividend now, I still have a balanced attack. Lo, and behold, when Exxon’s profits were tanking in 2008 and 2009, General Mills was there to pick up the slack.” Successful independent thinking recognizes that everything has its season, and it’s necessary to have patience while you wait for your objectives to be realized.

The other area where independence is important is when it comes to your savings rate. One of the tricks to wealth accumulation is receiving a raise or some kind of increase in household income that isn’t accompanied by an identical rise in household spending. The wealth creation process gets turbo-charged when you are able to prolong the amount of time where you can keep your spending constant after seeing your salary increase. Making $60,000 per year and spending $45,000 per year gets wealth built at a very nice rate, but if your salary increases to $80,000 and your spending goes up to $65,000, your wealth creation story remains the same. It’s when you keep that spending in the $45,000 zone after a pay increase that you have those “whoa, where’d all this money come from?” moments.

A lot of people can’t do that, because they feel the need to “prove” that they “made it” to someone. Thinking like that is bad not just for Aesop fable type of reasons, but more importantly, the only one you are harming is yourself. You’d be treading water at a time you could be swimming faster towards your goals, and I’m reminded of what one of my best friends says right before he is about to accomplish something significant, “Sometimes, I just have to get over my own bullshit.”

If you’re not someone who naturally possesses a fierce streak of independence, then you should ask yourself a few questions when you’re about to do something out of social conformity rather than what you truly want. First, ask yourself: What could I do otherwise with this money if I were seeking my own happiness rather than trying to impress someone else, and is the tradeoff worth it? That will stop most inquiries right there. If that isn’t enough, then you should ask yourself: What were the results the last few times I did stuff like this? Was I satisfied with the results? Taking ten seconds to just *stop*and*think* can curb a lot of bad behavior that got developed out of habit.

Everyone always talks about how Munger made these billions, or Buffett made those tens of billions. The end result is nice. But look at their demeanor as they go through the journey. They’re often laid back and satisfied with trusting their own judgment, and are able to live entirely on that inner evaluation of value (how else do you think Munger drove a beat-up yellow car that was decades old after his divorce?). If you follow in their path, you’ll be able to hold stocks through the turbulence that is inevitable with long-term investing, and be able to maintain higher savings rates than you otherwise would be able if you were seeking to impress others. It doesn’t get talked about a whole lot, but that inner sense of independence creates an outer shell that enables men like them to make great strides in their formative years that creates the results they desire, the ultimate byproduct of satisfaction and happiness.

One of the social theories out there that seems intuitively appealing (at a minimum) is the notion that the market conditions that exist at the time you came of age has an outsized influence on your subsequent behavior. If you find people who have lived through the Great Depression, they have socks hidden throughout their houses with balls of $100 bills in them. The post-death inventorying of the possessions of their estates is a macabre Easter egg hunt where you stumble upon assets in the most unexpected of places. Because of the widespread availability of credit and lack of society-wide severe economic hardship, Americans coming of age during the 1990s aren’t conditioned to make savvy street-smart economic preparations like that.

If this kind of thing does affect your psychology, it could be useful to try and step back from yourself to see whether you’re being unnecessarily conservative or aggressive with your investing habits. For instance, complete avoidance of the stock market is a common characteristic of Depression Era survivors (you can easily envision a guy in his 40s building a portfolio of REIT investments and being thankful that he doesn’t have to actually operate the real estate, while a version of himself that endured the Great Depression would demand the hard real estate so that he can experience the psychological affirmation of driving by the property and seeing that it is “there”).

If someone wasn’t psychologically equipped to handle the daily price quotations inherent in stock market investing, that’s a good thing that you know yourself because bad results occur when you tell yourself that you can handle realistic worst case scenarios when that is not actually the case.  That’s where all that dreaded “sell low” stuff enters the picture.

How do you overcome an innate emotional bias? Well, if you’re persuaded by logical accounts of history, I would review this passage by Mark Hulbert in an April 2009 New York Times article, a month after the S&P 500 hit its most recent market bottom:

Historical stock charts seem to show that it took more than 25 years for the market to recover from the 1929 crash — a dismal statistic that has been brought to investors’ attention many times in the current downturn.

But a careful analysis of the record shows that the picture is more complex and, ultimately, far less daunting: An investor who invested a lump sum in the average stock at the market’s 1929 high would have been back to a break-even by late 1936 — less than four and a half years after the mid-1932 market low.

In the early 1930s, you had deflation and you really high dividend payments, so the worst economic catastrophe in the past six hundred years had you at breakeven in four years (and this is assuming you had the worst timing possible in human history at the time you made your lump sum investment). If your reaction to that kind of information is along the lines of, “Well duh, of course it works out. Celling cereal, soda, toothpaste, hamburgers, milk, bread, paper, medicine, and petroleum at a profit always gives you something to do, so of course things move directionally up over time”, then you already have the temperament to deal with sharp price swings.

I even have to step back from my own financial writing from time to time and wonder if I have any biases that would be preventing me from having the best understanding of the investing art possible. For instance, I have spent very, very little time in my life studying bonds compared to common stocks. I suspect if I had come of age in the 1970s and entered a world of 19% mortgages and 15% savings accounts, who knows what this site would have been like? “Why Get 10% Annual Returns From The Stock Market When You Can Get 50% More From Putting Your Money In The Bank?”

I’ve found the best way to remedy against potential is to always go back to Benjamin Graham’s classic question: “On what terms, and on what price?” With most bond offerings connected to the U.S. government, you’d be lucky to get a percentage point above inflation over the long term, assuming historical rate of around 3.4% remain the standard. They may be useful for preserving wealth, but at the present terms, they are not useful for building wealth.

But I do always try to adapt. For instance, I’ve come around to the notion that it could make sense to hold non-dividend stocks for the long term if the profit quality is high, the growth rate is satisfactory, and you can see that capital is being taken care of well: companies that, in my own research, meet this criteria are Berkshire Hathaway, Google, and Autozone. In the case of Berkshire, the focus would be on the quality of the profits, with Google the focus would be on the growth of the profits, and with Autozone, you’d be focusing on the company’s decision to systematically reduce the share count through buybacks instead of paying out a dividend. See, this dog picks up a new trick here and there.

In a way, I’ve been pleasantly surprised that dividend growth investing still remains popular on many forums, even though we are approaching a fifth consecutive year of stock market gains. I mean, think about what the 1982-2000 bull mark did to the art of income investing; what kind of weirdo would be focusing on 1% and 2% dividend yields when stock prices are going up by 12% annually? My guess as to why dividend growth investing seems to be still catching on is that, people who bought shares of Chevron, Exxon, Nestle, and Emerson Electric during the recession are seeing dividends that grew in bad times and are now growing at faster rates as the economy recovers.

Once you have five or six years of dividend growth under your belt, especially with reinvested dividends, it’s hard to turn away from dividend investing because you’re seeing how your cash flow is automatically improving on your behalf in a significant way. If you got in on Chevron six years ago (during the early stages of the crisis before the price really declined), you would have seen your dividends grow on a $15,000 initial investment into a little over $1,000+ annually today. And the story is only in the third inning; Chevron has years and years of adding to this performance ahead of it. When you see how a meaningful amount of capital at an opportune plus six years of patience can start putting money in your pocket, the experience of success that comes with truly trying to understand a business and actually reap the rewards of business ownership can overcome initial biases caused by coming of age during either a time of cratering or ballooning stock prices. Once you realize it’s not about price, but rather, about actual business ownership, all of the nonsense that dominates the popular debate about the stock market starts to go away.

I spent a large portion of today studying businesses that collapsed due to high, fixed costs. I studied why General Motors failed. I looked into the failures at Border’s and Barnes & Noble. The more I try to figure this whole investment thing out in the broader context of life and business, the more I realize: cash flow is the lifeblood of success.

It sounds extreme, but it’s the conclusion I’m coming towards: don’t have $200 in monthly cash flow to cover your food costs? Yeah, that’s going to make you miserable, although perhaps leaner. Don’t have $1,300 coming in to cover your rent/mortgage? See how much you like those “it’s the experiences and people that matter, not money” inspirational quotes that show up on Twitter. Don’t have $150 to cover the electric/water utility bill? See how many of those people and experiences you have when you haven’t bathed since the 27^th.

In the cases of General Motors and the book stores, you had a situation like this (numbers made up for illustrative purposes): those businesses needed $700 million to keep operating each quarter—regardless of how many customers they had or items got sold, that cost was required. If you make $400 million over that quarter, you lose. If you make $600 million, you lose. If you make $699 million, you lose. You have to access the debt markets or create new shares to continue with the status quo.

Now, when things are going well, the business looks much more interesting—those $700 million quarterly costs didn’t rise that much as sales increased. If you brought in $1 billion, cool—you have a $300 million profit. Now, if things went really well and you brought in $2 billion, that $700 million fixed cost may have only gone up to $800 million. So you’d get $1.2 billion in profit.

In other words, although the costs would go up a bit with high sales, the general principle that emerged was this: You have a fixed amount of requirements, and until you reach that point, all business is terrible. But if you can get the tide to turn, then almost of those increases in sales can go straight to the bottom-line as profit.

A household budget operates in a similar way—you might tally up all of your expenses and realize you spend $5,000 per month while you earn $6,000 every month. While that spending/income differential remains your status quo, how you allocate that $1,000 difference is going to amount to being the lifeblood that seriously change your life.

Imagine if that was your family’s financial situation in 1998, and you took that $12,000 spread between what you earn and what you spend and you chose to buy a block of Conoco stock. With reinvested dividends, you would be sitting on 820 shares of Conoco today, with 410 shares of Phillips 66 as well. Conoco pays out a $0.73 quarterly dividend, so you would be collecting $2,394 each year form that. In the case of Phillips 66, the payout is much lower because the company is only paying out a third of profits to shareholders as a dividend, so you would only be collecting $820 each year from that decision, although I would expect that would grow more lucrative with the passage of time.

Decisions like these transform household budgets—that single decision to buy Conoco now results in $3,214 in annual income, giving you $267 per month. At its heart, that’s what income investing is all about. If you are making $6,000 per month and spending $5,000 per month, that one Conoco decision helped the spread become $6,267 in monthly income, increasing your difference to $1,267 each month. And, of course, Conoco and Phillips 66 aren’t done raising their dividends yet, so this effect becomes more pronounced with time.

Why doesn’t everyone do this? Because it requires you to do three things right: (1) you have to choose a cash-generating asset that will continue to throw off cash for a long time; (2) you have to wait several years for the dividend increases to mix with the dividends that actually get reinvested, for the full effects of the income growth to occur; (3) and you have to avoid the temptation to increase spending as soon as more income comes your way. Those are the challenges that stand in the way of pulling something like this off.

Still, imagine what can happen if you hold that $1,000 difference steady, while you slowly build a collection of Conoco, GlaxoSmithKline, Royal Dutch Shell, BP, AT&T, and Philip Morris International to add to your dividend portfolio. You do that for a couple years, and it takes on a life of its own. Just by carefully choosing six cash-generating companies to split those $1,000 monthly contributions towards will easily result in $2,000 dividends from each within ten to fifteen years. You could easily have a situation where six years of saving $1,000 per month could be sending you more monthly cash in aggregate than you’d get from Social Security checks. Even if you spent the dividends along the way, the nature of compounding starts to go haywire after the fifteen year mark so you’d end up getting substantially richer during your retirement years. Do the math yourself, and look what happens to compounding figures during years twenty through thirty.

A common psychological trait that most people share is a desire to experience forward progress—the harnessing of that trait, after all, is one of the reasons why it is much easier to stick with an income investing strategy over long periods of time.

If you own a diversified basket of assets, and contribute to it regularly, and reinvest, it is almost guaranteed that you will increase your income year after year, seeing the wealth-building process unfurl before your eyes. Someone who judges himself according to the amount of income that his household income each year will experience the psychological satisfaction of seeing the amount of income that his household generates go up year after year, whereas it’s hard to craft a strategy that builds wealth over the long haul while also allowing you to see your net worth increase in a year like 2009.

For better and often worse, most people also associate spending more with progress. And when you have to go backwards, a lot of bad emotions like resentment, anger, and frustration start to creep in.

If I told you that a couple was moving from a $250,000 house into a $500,000 house while another one was moving from a $500,000 house into a $250,000 house, and you had to guess which couple would get divorced within the year, which one would you bet on?

Obviously, there are a lot of good reasons why people successfully purchase smaller homes, and there’s a lot of people who bite off more than they can chew with their home purchase decisions that can lead to financial difficulties and fighting. But there’s also a lot of people who would associate the downsizing with going backwards in life and it would lead to heartache that could have been avoided.

A great technique in the wealth-building process is to try and keep household spending constant, or at least increasing at a slower rate, than the changes in household income. If you’re spending $50,000 per year and see your household income rise from $70,000 to $80,000, good things can happen when you take that extra $10,000 and invest it.

That’s the funny thing about writing about investing so much—even though I spend a lot of time here talking about individual stocks and particular investments to make, what’s really important is your household savings rate. That’s going to determine your future much more than the particular success that you have in the aggregate with your stock-holdings.

If your household saves $300 per month and earns 10% for thirty years, you end up with $678,000 at the end of the period. If you get your savings rate up to $600 per month for thirty years, you only have to earn 6.7% to end up with that same $678,000. In terms of how you allocate your energy, most people are going to get more bang for their buck finding a way to increase the amount of their household savings rather than trying to find a way to get that extra percent on investment returns.

In the financial writing sphere, frugality is a very popular topic right now—it’s all about cutting costs. But handled wrongly, and it can be associated with a deprival lifestyle. If I had to pick my style of how to save $10,000, I’d rather do it by increasing my income $10,000 than by reducing my expenses by $10,000 (although from a tax point of view, reducing expenses is almost always more efficient). Sure, root out the ridiculous expenditures from your budget, and take a hard look at recurring monthly expenses that may be unnecessary, but I think the most psychologically satisfying way to do it is by deliberately structuring your life so that when more money comes in, you keep your focus on holding expenses steady and resisting the impulse of lifestyle inflation.

If you get nothing else from reading the articles on this site, you should pay attention to the strategy advocated by business scholar professor Robert Novy-Marx, whose philosophy can be summed up as follows: “Buying high quality assets without paying premium prices is just as much value investing as buying average quality assets at discount prices. Strategies that exploit the quality dimension of value are profitable on their own, and accounting for both dimensions of value by trading on combined quality and price signals yields dramatic performance improvements over traditional value strategies. Accounting for quality also yields significant performance improvements for investors trading momentum as well as value.”

You should his essay here, titled “The Quality Dimension Of Value Investing.” It’s a slight modification of growth at a reasonable price investing. The point of Novy-Marx’s research is this: companies that possess the highest quality assets are those that experience the highest increases in gross profitability (for those lacking the technology to measure gross profitability, top-line growth can serve as a decent proxy) for long periods of time.

The point is this: If you buy low-quality assets that contain so-so growth potential when they are trading at a discount, you experience the benefit when the stock moves from $20 to $30 (or whatever it takes for the company to come up to fair value), and after that, you’re left with a mediocre asset. And if you buy a high-quality stock at something like 50x earnings or more, so much of the company’s future growth has been factored into the stock price that even if the company grows quickly while you own it, the eventual decrease in the P/E ratio will take away the returns you would otherwise get by looking at the earnings per share growth rate of the company or something like that.

While the best spot for an investor is when he can buy superior businesses at discounts, those 2008-2009 type of circumstances only come along for three or four short periods of time in a typical investor’s life. Generally, only people like Charlie Munger who have significant productive investments already at work can afford to let cash positions build up for years on end, as he made clear in a recent Wall Street Journal interview when he said that he hasn’t made any stock investment in the past two years.

Novy-Marx’s theory provides a useful foundation for those looking to make investments in normal times: find companies with significant top-line growth that are trading at fair valuations, and focus your energy there.

That’s why Visa has been such a darling for those of you who have been following my writings for a while. The company doesn’t play games with its balance sheet to stimulate growth—the business itself earns such lucrative returns relative to investment that the company ends up becoming a must-have investment. Just look at its revenue figures since becoming publicly traded in 2008—the credit and debit company posted revenues of $8.08 per share in 2008, $9.12 in 2009, $9.64 in 2010, $11.30 in 2011, $12.85 in 2012, a sharp gain to $18.29 in 2013, and expected revenue per share around $20.00 in 2014. That’s exactly the kind of asset you want to own if you’re trying to build a fortune while employing a strategy of buy-and-hold investing.

There are other cool things I like about the company—it has no debt, preferred stock, pension obligations, has a low dividend payout ratio, funds its stock buyback program out of already existing profits, and so on—but at the heart of it, the appeal is this: the company experiences very significant growth while requiring relatively small capital investments to fund that growth. The brand equity is strong—we all know that the payment processing networks are dominated by Visa, Mastercard, Discover, and American Express, and the barriers to entry into the credit processing game are high. They provide extensive fraud and risk management, and use their large size and deep pockets to deter others from offering their own processing—even if you buy things with a click of a button instead of a card, you will still use a Visa network because individual companies won’t want to take on the potential liability for when things go wrong.

I’m working on an upcoming post on how investors should position themselves for rising interest rates, and the gist of the argument is this: low growth and high yield assets like energy MLPs may have trouble delivering exceptional returns, because the risk-free Treasury rate will become relatively more attractive. That’s why you’ll want to focus on companies with the highest growth rates—because an increasing earnings base acts as a countervailing force against bond rates that go from 3% to 5-6% (or whatever the final resting point may be for this upcoming business cycle). The Novy-Marx theory focuses on the relationship between top-line growth and fair valuations, based on the premise that top-line growth is a reliable indicator of a highly productive asset. For someone looking to take big strides in their net worth and dividend income in the coming decade, the answer seems to be that you want a portfolio stuffed with companies that share Visa’s characteristics.

Every so often, I get an e-mail from a reader curious to know what company will be the next big player to shake up or join an industry. In response, I very rarely have something new to add to that conversation because I think it’s likely that Coca-Cola will be the next Coca-Cola, PepsiCo will be the next PepsiCo, and Dr. Pepper will be the next Dr. Pepper. Translation: The industry leaders in the beverage sector today will likely be there ten, fifteen, twenty years from now. It’s been no secret that I think they possess the brand equity and vast distribution networks to be around for a long, long time, and that is why they get mentioned as long-term investments here at the site so frequently.

But occasionally, there is a newcomer that is on the cusp of attaining blue-chip status, and it can be lucrative to recognize that opportunity while the rapid growth is continuing before the permanent settlement in the 8-11% annual growth range happens. The company I’ve had on my mind lately is Gilead Sciences, which seems to be in the late stages towards transitioning to that no-brainer pharma stock that you see in conservatively managed accounts, alongside Johnson & Johnson, Abbott Labs, Abbvie, GlaxoSmithKline, Pfizer, and a few others.

For those who are serious investors, Gilead is no new kid on the block, as it’s market cap is over $100 billion. However, it still hasn’t reached that point yet where a casual street investor thinking of buy-and-hold stocks off the top of his head will be familiar with the company. I suspect that once it gets around to initiating a dividend sometime between now and the next ten years, the company will start to show up as a potential investment on the screens of most dividend investors, pension funds, insurance companies, and so on.

The top-line growth at Gilead over the past decade has been absurd, in a better-double-check-these-numbers-because-that-can’t-be-right kind of way. Sales have grown by 40% annually over the past decade. Over the past five years, sales have grown by 28.0% annually, cash flow has grown by 24.5% annually, and earnings have grown by 22.5% annually. If Coca-Cola is the poster child for what dividend growth investing is all about, then Gilead Sciences is the poster child for what growth investing is all about. Every dollar invested into Gilead over the past ten years has turned into $13.28, creating a situation where a $75,000 investment into Gilead ten years ago could pretty single-handedly fund a nice retirement nest egg now valued at $995,000 (and since that would all be in the form of unrealized capital gains, there would be no tax to pay until you sell the stock).

My main concern right now is mostly about valuation. Back in July, I wrote this article for Seeking Alpha titled “Gilead Sciences Has A Realistic Path To $100.” Well, that didn’t take too long to happen, and the stock is now trading at $106 per share. Part of me wonders what the consequences would be starting a position here without a margin of safety in the stock price. The nature of pharmaceutical investing is this—companies come in and out of favor as a result of its drug pipeline. GlaxoSmithKline rocked it out in the ‘80s, and now it’s looking for that magic touch again. Pfizer dominated during its patent of Lipitor days, and now it’s searching for that next magic drug to propel earnings forward. In the case of Gilead Sciences, you are looking at a company that is rolling through an uninterrupted string of good news victories for its pharmaceutical pipeline. Heck, it’s now charging $1,000 per pill of Sovaldi for those that will be taking the Hepatitis C-fighting drug (although there are a lot of circumstances in which an individual can get the drug much cheaper).

For those with a value investing bent, you get your margin of safety when you establish positions either: (1) during general market pullbacks of the 2008-2009 variety, or (2) company specific bad news that leads to overreactions in driving the price down, creating an opportunity for long-term investors to plant their seeds when no one wants the stock. It’s the kind of attitude that would lead value investors to have a preference for buying Pfizer after Lipitor goes off-patent, Eli Lilly sees 15% declines in revenues, GlaxoSmithKline sees accusations of bribery and flatlining revenues, or something happens to drive the stock price down. Gilead Sciences has been hitting its stride for ten years running, and it’s hard to argue with someone who is following a strategy of patience—looking for a disappointing drug rollout, a couple quarters of low growth, or some other event to cause the price of the stock to dip before going in.

The pro side of the argument would be something like this: Gilead has a realistic chance of posting revenue growth in the 12-15% annual range over the coming ten years, and even if the stock is a little pricey now, someone who buys today could still experience 10-13% annual returns, better than what you’d expect from the S&P 500 as a whole. It has patents on some key drugs for at least the next six years, and as it is beginning to flex the muscle you’d expect from a $100+ billion company, a formidable research & development operation is emerging, which is now funded at a rate of 13% of sales. The company has unbelievable relationships when it comes to getting doctors to prescribe Gilead-produced drugs, and buying Gilead in the 2010s smacks of buying Johnson & Johnson in the 1950s, when the company was already large and pricey, but so dominant that it was primed to deliver returns of 12% annually for a long time thereafter.

Sometime in the next month, I’m going to get around to completing posts on Charles Barkley and Steve Harvey, with the discussion point being that both men have very shrewd financial lives and breadth of intelligence that is significantly different from the images that they hold out of themselves in the media. You see Charles Barkley making goofy quips on TNT during basketball season, or turn on the television to see Steve Harvey going after the cheap gags and laugh lines on Family Feud, and you could superficially reach the conclusion that these men are not professionally savvy but reached their positions as a result of a quirk of luck. But if you look at how they position some of their assets, diversify their revenue streams, and listen to the general philosophies they live by personally and use to direct their investments, you will be immediately struck at just how superficial appearances can be deceiving. I still have some more research to do before I get around to that post, so for now, check out this awesome awesome awesome video of Steve Harvey using general observations to give life advice.

I’ve spent part of my day studying General Mills (sexy, I know) because the company sells products like flour and Cheerios that are immediately recognized as indispensable. The stock never seems particularly cheap, and no one ever talks about buying it despite (1) the easy-to-understand business model, (2) an uninterrupted dividend history dating back to the 1890s, and (3) a track record of compounding at 12.5% annually over the past three decades, leaving behind in the dust almost every hedge fund that exists in America net of fees.

Someone who has steadily been committing to buying $300 shares of General Mills every month since 1983 would find himself in the interesting position of owning 22,200 shares of the cereal and breakfast product giant (of course, setting $300 in 1983 would be the equivalent of setting aside $700 today, but hopefully someone in real life would be able to increase their investable contributions over time).

What if you reach retirement age with those shares of General Mills stock? How does the story unfold for someone who is living off the dividends?

Well, the current dividend is $0.41 per quarter, or $1.64 per year. In the first year, you would be collecting $36,408 in come from the famed cereal maker.

Come next year, General Mill’s quarterly dividend should be at least $0.44 per share, based on the company’s track record of dividend increases and my assessment of its corporate health. That works out to $1.76 per year. Even though you are collecting the cash generated from your investment, you find yourself gradually getting richer: you are now collecting $39,072 each year.

By 2016, the quarterly dividend could likely be somewhere around $0.48 per share, or $1.92 annually as General Mills continues to do what it has done successfully for a century and a quarter. Now, your collection amount would be $42,624.

If the dividend goes up to $0.52 per share in 2017, you’d bring in $46,176 over the course of the year.

If the quarterly dividend hits $0.56 per share in 2018, you’d get $49,728 that year.

By 2019, and with a $0.60 quarterly dividend, you’d be collecting $53,280.

None of those projections are particularly ambitious—it assumes that General Mills grows its dividend a bit lower than its historical precedent. And obviously, you know by now that this article isn’t advocacy putting all of their money into General Mills. Instead, it’s an illustration of what life can look like when you have a diversified portfolio filled with companies that share General Mills’ overall characteristics.

And although we are all creatures of the time we inhabit (if I were writing in the 1970s, who’s to say I’d be writing about blue-chip stocks with 2-3% dividend yields when I could otherwise be writing about Certificates of Deposit yielding 11%), there is something very different about a portfolio of high-quality dividend stocks that differentiate it from a portfolio stuffed with US bonds or corporate bonds.

When you enter the world of fixed income investing, you are entering a world of either preserving wealth or lowering wealth at a very slow clip. Maybe you get an annuity that matches inflation. Maybe you have bond interest coming your way, and you only spend three-quarters of it, reinvesting the rest to boost your annual income. There are mitigating techniques like that, but almost nothing to give you significant raises above the rate of inflation.

That’s where the dividend growth strategy is at its best: even when you collect the dividends to spend, the organic growth of the business continues to make you richer. Did you see what happened to someone holding those 22,200 shares of General Mills over those five years? He went from collecting $36,000+ heading into 2015 to $53,000+ by 2019. Those dividends from General Mills went from offering about two-thirds of the typical American’s household income per year to generating something resembling the average annual income of a typical American household.

More importantly, even as you continue to spend, you go from receiving $3,000 per month to $4,400 per month. That’s why people with sizable portfolios take it as religious dogma that you don’t touch your principal when figuring out how to live off assets—by only taking your share of company profits that the Board of Directors sends your way while not diminishing your ownership stake, you start to see significant increases in the amount of money at your disposal each year that you can spend however you choose.

Generally, you reach this point by (1) developing a collection of high-quality assets at an early age, such as being a 35 year-old with a $150,000 portfolio consisting of a diversified collecting of 15-25 blue-chip stocks, or (2) if you’re late to the game, you try to change your household budget so you can come as close to saving $1,000 per month as possible, absorbing chunks of Coca-Cola, Colgate-Palmolive, Nestle, Procter & Gamble, and Johnson & Johnson that can start working for you immediately.

The formula for success is something like this: work your tail off to get 300 shares of Coca-Cola, 500 shares of General Electric, 200 shares of Procter & Gamble, 150 shares of Johnson & Johnson, and 250 shares of Colgate-Palmolive as early in life as possible. If possible, try to sit still and let them be for at least ten years, reinvesting dividends and enjoying the organic growth of the company.

People don’t think like that because it’s damn hard for a starter investor to get their hands on $400-$500 worth of Coca-Cola stock, and all they see are 10 shares sending them $3.05. Even if the dividend grows 10%, the dividend payment only grows to $3.35. That’s the deterrent. But once you reach a point where you are collecting $7,000 per year in dividends, that singular 10% dividend raise adds $700 to your income automatically, giving you two more dollars per day just for staying alive. Dividend growth investing with the best companies in the world becomes its own self-sustaining machine once you grind it out through the beginning days.

We’ll abandon the site’s namesake for the day and talk about times when it makes sense to buy shares of stock in a company that does not pay any dividends to shareholders. Generally speaking, the best candidates for these types of purchases are companies that offer a higher earnings per share rate than what you’d get from buying a traditional dividend stock.

After all, if you see a non-dividend paying company growing at 7-8%, why not just purchase BP and enjoy the added benefits of a high dividend that can reinvested and boost your annual income? Sometimes, you have a situation like DirecTV or AutoZone where the company is growing at a high-single dit pace, but is repurchasing stock instead of paying out a dividend, and thus can offer shareholders a total return in the 11-15% annual range.

One company doing this that does not get a lot of attention is Bed, Bath, and Beyond. The company has an outstanding pedigree despite not getting a whole lot of attention from the investor community. From 2004 through 2014, Bed Bath & Beyond increased its profits from $500 to a little over $1.0 billion.

You’d naturally think, “Oh, okay, so the price should have doubled over the past ten years.” But instead of paying out a dividend, the company has been quietly reducing its share so that the profits that had to be divided between 294,000,000 pieces in 2004 now only have to be divided into 201,000,000 pieces in 2014. The company reduced the share count by 30%, creating a situation where Bed Bath & Beyond has a 17% earnings per share growth rate even though the business itself only doubled its total profits over the past ten years.

Imagine if Bed Bath & Beyond was only owned by three people, each with an equal stake in the company. Over the past decade, Bed Bath & Beyond did the equivalent of buying out one of the partners so that the profits earned by the company only have to be shared between the two remaining owners. Spotting these situations as early as possible is a lucrative endeavor, and there’s a place for it.

The catch, though, is that there is no floor on the price of the stock to alert people to the irrationality of the price. You’ll never see Coca-Cola or Johnson & Johnson yielding 10% absent Great Depression scenarios because somewhere along the line—maybe it is 6% or 7% yield—people would stop to say, “Hey, this stock price decline isn’t right, things are way too cheap here”, and you see a floor put on the price of the stock.

Bed Bath & Beyond doesn’t give you that kind of assurance—from 2007 into 2008, the price of the stock fell from $43 to $16 per share. A lot of people, and I would wager the vast majority of the investor community, couldn’t deal well with that kind of volatility, especially absent a dividend. That’s why stocks like this aren’t for everyone.

However, if you looked at the company’s fundamentals, you would see that Bed Bath & Beyond was growing profits from $425 million to $600 million throughout the financial crisis. The business was making more money than ever at the time, but the price of the stock was falling by more than half. Having cash on hand and the ability to study the financial statements to see the growing profits is definitely a recipe for fast-track wealth; could you imagine if you had bought shares of Bed Bath & Beyond at $16 per share? The company isn’t exactly high-risk; it grows profits per share in nine out of every ten years, and in the years when it doesn’t grow profits, it’s of the 2006-2007 variety when earnings per share went from $2.15 to $2.10 per share.

I think purchasing Bed Bath & Beyond stock makes a lot of sense once you have an income infrastructure in place—when you’re generating $1,000 or more per month above what you spend, and you also have something coming your way giving you cash to allocate. At that point, it makes a lot of sense to fit the Berkshire Hathaways, AutoZones, DirecTVs, and Bed Bath & Beyonds into your portfolio because they offer something that you may not get with all of your dividend stocks—a higher earnings per share growth rate.

Every now and then, you stumble across a company that does not show up on the radar of many investors, often due to its size, lack of a dividend, or decidedly unsexy business model that nevertheless ends up producing a whole lot of money for people that start a position in the stock and hold on to it for a few years. One company that falls into that category is Autozone.

What has the car part replacer done over the past ten years? Two things have happened at this business: one, they have rolled out new stores across the United States, increasing the store count from 3400 to a little over 5000. This has enabled the company to grow its profits from $500 million per year to a little over $1 billion per year. Given that there is no dividend, you might imagine that shareholders have doubled their money over the past ten years.

But there is more to the story than that. Way more. Instead of paying out a dividend, the company has had an enduring, unstoppable, relentless—whatever word you want to use—commitment to reducing ownership units of its stock. Ten years ago, the Autozone business was divided up into 79 million pieces. Now, it’s divided into 32 million pieces (and if you want to go back to 1998, the company had 150 million shares outstanding then, meaning about four out of five shares have been retired over the past sixteen years. That’s crazy, crazy good).

So the people who have owned shares of Autozone for a long time have benefited from two nice things coming together over the past decade—growing profits mixed in with free cash flow being used to get rid of other owners that could lay claim to the stock’s profit so that each year the company’s profits have to be split up among fewer owners. I’ll put in the clearest form I can: In 2004, Autozone made $500 million that had to get divided into 79 million pieces, so that buying one share of Autozone stock represented $6.32 in profit. In 2014, Autozone made $1 billion in profit that only gets divided into 32 million pieces, so that each share of Autozone stock that you buy represents $31.25 in profit.

Over the past ten years, the profits per share that Autozone has generated have quintupled, even though the business performance has only doubled. The remaining part of the growth has come courtesy of the stock repurchase program.  Companies like Autozone are nice niche investments to have in the taxable account of a portfolio, because they silently compound quickly without drawing any tax consequences because U.S. domestic policy currently taxes dividends in regular brokerage accounts, whereas the capital gain does not get taxed until the time that you elect to sell.

The usefulness of carving out a few spots in a portfolio for the likes of Autozone is that the rapid growth can get converted into higher income at the time you decide you want to actually start collecting and spending dividends.

For example, someone who bought $25,000 worth of Coca-Cola stock twenty years ago would have $131,000 today, generating $3,785 in annual income. Pretty sweet, considering you had to do nothing over the past twenty years except collect the dividends and spend the cash. If, however, you chose to buy Autozone stock twenty years ago, and needed to start generating income today, you would have seen a $25,000 investment in Autozone twenty years ago grow into $531,000 today. If you converted that to Coca-Cola, you would have to pay taxes—say, 23.8%, and have $404,000 working for you in Coca-Cola stock immediately generating $11,675 in annual income.

Investing in a non-income generating stock does have its place, particularly when (1) you are investing in a taxable account, and (2) you have found a company growing profits per share north of 11% or so that is trading at a reasonable valuation, and (3) you do not presently have any purpose for which you would need to generate immediate dividend income. When those conditions come together, it makes sense to add things like Google, Berkshire Hathaway, Autozone, and a few others to your household holdings because they can serve the important purpose of building wealth much faster when economic conditions range from normal to good. And as an added bonus, the specific non-dividend stocks mentioned in this post also kept chugging out reliable profits during the 2008-2009 downturn as well.

Realty Income is an interesting company for a couple of reasons: the starting yield is usually high, with investors throughout much of its publicly traded life being able to establish a position with an initial yield of at least 5%. The dividend grows each year, which is an unusual characteristic once you leave the tobacco, telecom, and oil industries (although real estate can be a close fourth). And the dividends get paid out monthly, giving you the ability to instantly compound because your dividend income immediately buys new shares every month that then start paying out dividends all of their own.

As you can imagine, those factors combine together to produce pretty amazing results when you choose to reinvest your dividends back into the REIT.

First, let’s look at what Realty Income’s are returns are when you just add up the share price appreciation and the dividends paid out over the past two decades. For someone that invested $15,000 this time two decades you, you would have seen your shares appreciate in value by $60,000 while $47,000 in dividends get sent your way. That’s very impressive in its own right—how many places can you go where just by setting aside some initial money and doing absolutely nothing thereafter, you’d receive 3x the amount of money you invested over a twenty-year period? That $47,000 could have diversified a portfolio in its own right, giving you $15,000 positions in Exxon, Colgate-Palmolive, Nestle, or whatever other particular investment caught your eyes over the years. Plus, you’d have $2,000 in walking around money.

But what happened if you reinvested, choosing to delay gratification for a while to let Realty Income grow on its own for awhile, seeing what happens when you keep plowing and plowing those monthly dividends back into more dividends that start to take off all on their own?

Without dividends reinvested, Realty Income delivered annual returns of 11.3% per year over the past twenty years. With dividends reinvested, Realty Income delivered annual returns of 16.1% over the past twenty years.

Just how ridiculous is that five percent spread on a $15,000 investment, when it’s allowed to play out for twenty years? You would have collected $115,000 in total dividends, leaving you with $281,000 in total at the end of the period (all those additional shares plus the original shares you had working for you added another $150,000+ to your wealth totals over the period).

You’d be collecting $14,300 in annual income, bringing you very close to that hallowed moment when you receive more in annual income from an investment than you paid at the time you made it.

Why would someone ever give up an asset like this? I know some people are worried about rising interest rates, and it’s probably true that a sharp spike in rates could slow down the company’s funds from operations growth and bring the price of the stock down a bit for a couple years. The potentially ironic part for the long-term Realty Income holder is that those reinvested dividends at lower prices might actually create more wealth than otherwise as a lower price would create  more shares, boost the income, and turbo-charge the returns a bit.

What I find most interesting is that Realty Income’s dividend has only increased 96% over the past two decades. It just sort of meanders along, slowly mozying upwards. Most people hardly notice the stock at all. But when you take a 5-6% starting yield that is growing and keep reinvesting a chunk of it month after month, you end up having this situation where you get 16% annual returns with dividends reinvested for twenty years running even though the dividend is only on the cusp of doubling over that period. This is that area of investing where income investing can make you a lot richer than you’d think.

This is a rare topic that I haven’t gotten to address yet explicitly, and I’m glad I now get the chance—I recently heard from a reader who mentioned that she enjoys her job, is quite good at it, is certain of her job security, and does not see the point in investing.

It’s a perfectly fair question, and I’m glad she asked me it.

Here’s how I think about it.

Part of my explanation has to deal with seeking prosperity, and the other part of my explanation has to deal with ensuring survival.

First, let’s talk about prosperity. Because the writer said she worked in retail, I’ll use that as an example. Let’s say that you are the manager of a very small boutique clothing store, and you make $60,000 per year. For all of your hard work, you will get about $5,000 per month (and then you’ll have to pay taxes on it). At the end of the month, that’s it—if you want another $5,000 in January, you are going to have to give up 200 hours of your life to get it. And if you stop showing up, you will get $0. It’s over; every dollar that makes its way to your pocket hinges on your giving up time in that moment.

Now, imagine for a moment, that you own that same store instead of being an employee (and you are a heavily involved owner). You may put in the same amount of hours as the manager, you may perform work that is substantially the same as the manager, and you may even run a store that grosses $50,000 per year after taxes and paying all the employees.

There is a critical difference, though, between your situation and that of the manager earlier: you could take a nap for a month, and you are still the owner. You may have some catching up to do, and your business may start to hurt if you make this a habit, but you are in no way divested as an owner. Employees get fired by their bosses all the time; bosses don’t fire owners.

And even if you are a constant presence and put in just as money hours as the manager, your $50,000 per year is qualitatively different from that $50,000 earned by your manager. When the manager of the store decides she doesn’t want to do the boutique retail thing anymore, she has to move on, and sell her time to someone else to make money. If you, the owner, decide you don’t want run the business anymore, you have an asset that you can sell for $250,000-$500,000, depending on the quality of your business, interest rates, and the general economy at the time. The owner of something profitable gets a big payout at the end, a worker for a profitable business might get a cookie cake party upon leaving at the end.

Business interests are the key to prosperity in a way that labor is not. When you get $1,000 in labor, you have to go out and sell your time again if you want $1,000 more. When you get $1,000 per year in dividend checks from General Electric, you only have to avoid selling for the same thing to happen next year (and given that GE is raising its dividend substantially each year post-financial crisis, you are likely to get an annual raise around 10% as well).

Oh, and did I mention that this “automatic” money from General Electric gets better tax treatment than money generated from your labor, because you are paying double taxation in that the corporation has to pay a tax on its profits and then it has to pay another tax when it hands those profits over to you?

But there is even more of a difference beyond that. When your salary doubles, that’s it—you get the salary double. But when General Electric doubles its dividends (or, more precisely, doubles its profits), then you will also be able to double the amount you can sell the stock for, if that becomes necessary. Business income packs all these virtues together in a way that makes enrichment much easier than having to do it from labor alone.

Why not hitch your life’s fortunes to a wagon like that?

The other reason why someone satisfied with their job might want to pursue investing, and in particular, business ownership has to do with survival. Even if you’re satisfied with things right now, what if the market for your job changes? What if you get worse at your job, have a significant slip-up, and you are fairly fired by your boss?  Or worst of all, what if you are an excellent employee, and you are either asked to do something against your deeply held moral views or get fired for an arbitrary reason? Do you think it’s easier to be a woman of integrity with $35,000 in automatic dividend income coming your way, or someone with minimal savings and general reliance on your job to pay your mortgage, food, and utility bills?

Part of the reason why people invest is to get rich, and the other part comes from a recognition that you shouldn’t expect life to be a transition from one fortunate situation to another. At the very least, constant employment that brings you satisfaction shouldn’t be the assumption—it should be regarded as a blessing. If you are happy with things now and are not investing, the question is: Well, could you lead a more dynamic life if you had more money? And, on the other side, could you survive if your employer wielded power against you in a way you do not presently anticipate? This is the kind of thought process that triggers someone to begin investing in the first place.

If you own a conventional dividend company—let’s go with Colgate-Palmolive as an example—there are three techniques (buybacks, volume growth, and raised prices) to raise profits that principally flow from two sources (the volume growth and raised prices). In other words, if you sell toothpaste, the way you make higher profits is by increasing the amount of toothpaste you sell and/or raising the cost you charge your customers for each tube. If you do at least one of those successfully, you might also engage in a stock repurchase program that destroys some of the ownership units so that the remaining shares can lay a greater claim on profits.

In the case of tobacco stocks, you only have one tool in your arsenal: raising the price per pack of cigarettes. Selling more of the items is not an option, as smoking rates have been declining in the United States since the 1980s. In the case of Altria (which most famously sells the Marlboro brand, among others), volume shipments have been declining at a rate of 3.3% annually since 1983. The shareholder wealth that has been created over the past three decades has been the result of production diversification and the ability of tobacco companies to rise prices on the typical pack of cigarettes at a rate higher than what most investors thought the market would bear.

This over-reliance on price increases (rather than price increases + volume growth) is why the tobacco executives of yore made acquisitions for stable sources of revenue like the food giants. That’s why, up until the Kraft spinoff in 2008, a customer who went to the grocery store and bought Oreos and Kraft macaroni and cheese ended up sending profits to the treasury of the old Philip Morris. It was a strategy that recognized the eventual limitation of the tobacco industry, and it was a plan to avoid shareholder wipeout—tobacco executives acted intelligently on behalf of shareholders by planning a switch of sorts—the lucrative tobacco profits would be used to acquire food companies while the cigarette money was pouring in, and eventually, when tobacco profits started to decline, shareholders could switch to reliance on the food groups to take care of future growth and ensure adequate returns for shareholders.

As we now know, that’s not how the history worked out. RJ Reynolds got rid of Nabisco. Altria spun off Kraft, which then split itself in half from Mondelez. Activist shareholders correctly concluded that the price of the stock for food companies owned within a corporate shell of a tobacco company demands a lower market multiple, but they took that appropriate insight to conclude that unrelated businesses should be spun off from the parent tobacco companies. This created short-term profits in the form of a spiked price at the time the food companies were spun off, but it imperiled long-term shareholders because it made the remaining tobacco shareholders reliant on tobacco profits to drive the bulk of their returns (thus removing the safety valve that existed in the event that tobacco profits moved towards irreversible declines).

You would be correct to note that Altria today is still more diversified than just tobacco products. It is also smokeless tobacco products, has a 25-30% stake in SABMiller, and has some small winery operations that are so small they deserve nothing more than footnote status. However, it’s been the pulse of the times to spin off unrelated businesses. Look at Abbott Labs, spinning off Abbvie. Look at General Electric, letting go of Synchrony. Look at Conoco, spinning off Phillips 66. Kimberly-Clark, ITT, Fortune Brands, CBS, International Paper, Chesapeake Energy, National Oilwell Varco, Dover, Sears, Safeway, Murphy Oil, Marathon Oil, and Valero Energy are other companies that come to mind. I would fully expect that, at some point, Altria would either sell or spin off the SABMiller stake, in line with its 2008 decision to let go of Philip Morris International, and Kraft (which is now Kraft + Mondelez).

People often wonder what the worst-case scenario for tobacco investors would look like: the answer is something like this. Altria reaches a point where its brand of products can no longer raise cigarette prices at a rate that overcompensates for modest volume losses, and the long history of dividend hikes is forced to come to an end. Most likely, this would be accompanied by a strong drop in the share price.

Of course, current tobacco executives aren’t stupid. They maintain a 25% gap between the amount of profit that is retained and the amount that is paid out as dividends. From this gap, they repurchase some of their stock, meaning there are fewer owners that require dividend payments. This provides a boost of sorts: you get price increases in the pack of cigarettes plus the removal of 2-4% of the shareholders that would otherwise have a right to dividend payments, and this acts as a countervailing force against volume declines. Volume has been declining steadily at over 3% for three decades now, and that hasn’t prevented Altria from compounding at a 20.62% rate for three decades straight, turning a $10,000 investment into $3.5 million. With the exception of some tech companies, it’s the best investment you could’ve made in 1983. Nothing has historically compounded quite like it. But if you want to watch for warning signals, you should study the relationship that exists between Altria’s stock repurchases plus the added profits created by price increases, and then compare that figure against volume losses. A turn in that relationship is what would serve as the signal for permanent trouble.

*As an aside, that’s why I regard Philip Morris International as the ideal tobacco investment. They operate exclusively outside of the United States, and in some years, they report volume gains. Their business model does not yet possess the permanently downward sloping volume shipments that is characteristic of the American tobacco industry, and that’s what makes it more lucrative: Philip Morris International offers buybacks, price increases, and occasional volume growth as the components of its long-term wealth creation.

You know that deprecating saying that goes around about how the average American spends more time researching the right fridge to buy than studying investing? There’s a corollary to that that should be kept in mind as well: among people who study investing, there is almost no time spent making sure that the paperwork for disbursing the funds (either during life or after it) is done correctly.

The laws regarding the settling of estates, or pretty much anything involving dead people, often have strict rules that look to actual actions rather than intent because the person isn’t around anymore to say what they meant and all that’s left is a swearing contest between adverse parties confident that they know what the deceased individual really wanted.

Per this passage from Yahoo! Finance:

Before Leonard Smith lost his battle with cancer in 2008, he worked with his financial advisors and attorneys to make sure his children received the balance of his retirement funds when he died.

A single mistake, however, thwarted his well-laid plans. Family members realized a year after he died that his IRA beneficiary form was filled out incorrectly. Instead of specifically listing the names of his children along with the percentages designated to each heir, Smith wrote: “To be distributed pursuant to my last will and testament,” where the disbursement of funds was spelled out.

But Smith’s failure to complete the form correctly invalidated the document, making his surviving spouse the beneficiary by default.

“I had no idea that a will could be trumped by an IRA beneficiary form,” Deborah Smith-Marez, 50, Leonard’s daughter, told Yahoo Finance.

Smith-Marez and her siblings fought in court to recover the money, but the court awarded the $400,000 in the IRA to their father’s wife, who married Smith two months before he died.

Like Smith-Marez, many Americans are unaware that long-forgotten beneficiary forms can override wills and undermine their loved ones’ intentions.

One reason why I don’t focus on the frugality aspect of personal finance as much, and don’t really keep up with the leading frugality blogs in the finance field, is because I don’t accept the definition of their term that guides their advice. It almost always comes down to “cheaper is better” being the ultimate conclusion, and even among most frugal authors that explicitly state they are not pursuing cheapness, they still tend to reach their conclusions of what to do based on the result that costs the least.

I see it differently: I think money is a tool, and the responsibility is to maximize every dollar earned by putting it to the best use. The point is to find the balancing act between taking care of your present self and making decisions for your future self in such a way that an older version of you would be grateful to meet a younger version of you.

That’s why, on most frugal sites, you see advice like “this brokerage house only charges $4 per trade” or “you get 50 free trades here for free”, and the underlying bank isn’t well capitalized or didn’t even exist a few years ago. Personally, I’d rather pay $10, $15, or $20 per investment if it’s through a legendary, well-capitalized brokerage house because THIS IS ALL YOUR MONEY WE ARE TALKING ABOUT. Their institutional depth gives you a better product that is worth the extra few bucks, in my opinion (different rules apply if you’re looking to invest $50-$350 per month into individual stocks, because in those circumstances, high fees could frustrate the purpose of building wealth in the early days).

That’s my broader philosophy on the matter; specifically related to forms, I understand that they are no fun, but you need to take a moment (actually, more than a moment) to make sure that you get it right. When the stakes are high (say, the settlement of more than $25,000), then you need to be studying and double checking the necessary paperwork to make sure it’s proper. And if you’re in the six figures, I’d hire a lawyer to double check the work done by the other one. And I would become passably knowledgeable on the topic so that I could apply a good sniff test ahead of time to figure out whether it’s done right.

Wills and beneficiary forms are things that no one wants to think about, but you have to stop and give them their due diligence. What’s the reason why you’re building wealth? For some people, 100% of the purpose is about spending the money on themselves with no consideration of anybody else. If that describes you, fine, you get to ignore this post. But if you have specific intentions about what you want to happen to your money after you die, what’s the point of building wealth if you’re not going to make sure that the money goes to the right place when you can no longer use it? Casebooks of property and estate law are written about men like Leonard Smith who do things approximately right, but miss one precise detail, and then the product of their life’s work ends up going into the hands of folks you’d least expect.

One of the general truisms for investors during a sharp market decline of 20% or more like we saw in 2008-2009 is that, as long as you are a net buyer of solvent companies, you are bound to do well. The only type of scenario in which that wouldn’t be true is if you had a late 1990s type of situation where some companies became so expensive that even a 20-30% price decline didn’t make those companies cheap, but rather, took them from grossly expensive to slightly expensive.

Anyway, the question I’ve set out to answer is this: When there is a significant stock market decline, what is the most intelligent course of action that should follow?

First of all, I should note that if you avoid selling during market declines, you’re already ahead of the curve. And if your impulse is to buy more shares when you see the prices of profitable enterprises fall, you’re already destined for lifelong success.

Actively rooting for lower prices of companies that are simultaneously growing profits is a place most people will never reach—Buffett addressed it well when he discussed why he actually desires for IBM’s stock price to fall, given its extensive commitment to share buybacks that lead to higher earnings per share growth than would otherwise occur if the price of the stock happened to be higher. It’s a very counterintuitive notion that doesn’t become clear until you review years of records denoting reinvested dividends. I know that at least a few of you reading this have been dripping Procter & Gamble for decades—pull out your old statements, and compare the shares added to your account in 2007 compared to 2009.

If you owned 1,000 shares in 2007, you received $1,280 in income that got reinvested around $67 per share, such that you ended up with about 19 new shares. Not only would they be worth 19 x $83= $1,577 today, but they would have been generating their own quarterly dividends as well. If, instead, that $1,280 got reinvested at the $50 per share price that was typical for P&G during 2009, then you would have picked up 25 new shares instead. Not only would those shares be worth $2,075 today, but that would give you 6 additional shares would have received 28 dividends from the 2008-2014 stretch, which would still be continuing well into the future.

The most scholarly work discussing this phenomenon came from Dr. Jeremy Siegel’s Stocks For The Long Run in which the Wharton Professor pointed out that the former Philip Morris compounded at a rate of 17% from 1956 through 2006, despite only growing profits at a rate of 11% annually. Why? Because the stock was perpetually cheap as investors concluded that growth would moderate in response to perpetually declining volume shipments, and this false expectation created perpetually cheap reinvestment opportunities that turned a $250 investment into a million-dollar fortune over the course of four-plus decades. It’s an investment story unlike quite any other.

All those things being said, the question still remains: Once you reach a point where you conclude that you will be a net buyer during broad market declines of 20% or more, what is that you should specifically be buying?

Well, the bulk should probably go to the typical blue-chip companies that I discuss here—Procter & Gamble, Colgate-Palmolive, PepsiCo, Chevron, Exxon, and so on, because once you buy those shares, the permanent compounding starts to take place without you having to put in any additional legwork. Take Nestle, for example. The food and beverage giant has increased its dividend 5,000% over the past thirty years. If you were generating $1,000 in annual Nestle income in 1984, and said, “I’m going to spend every dollar in dividend income I ever receive from this stock and never again reinvest a penny”, you would now be collecting $50,000 each year from Nestle. The growth in the payments alone, from that single investment, would have brought you up to what the average American household generates per year.

It’s hard to go wrong investing in quality during market selloffs.

But I also think there is a place for cyclical companies that tend to get hit especially hard during selloffs because their profits temporarily dip, and this leads to them trading at much lower profits than they deserve.

Take Emerson Electric and Illinois Tool Works, for example. Illinois Tool Works saw its profits dip from $3.05 in 2008 to $1.93 in 2009, and this caused extreme panic selling. The price of the stock fell from $60 to $25. By the next year, profits rebounded to $3.03, and by that point, the price of the stock was back above $50 (and it now trades at over $83 today). As an added bonus, the dividend increased throughout this period, and so you got nice little kickers if you reinvested when the price of the stock was in the $20s and $30s.

In the case of Emerson Electric, profits went from $3.11 per share in 2008 to $2.27 in 2009, and didn’t fully rebound until 2011 when the earnings were $3.24. The price action of Emerson was remarkably similar to what Illinois Tool Works did: the stock went from $59 to $24, and the rebounded into the $50s in 2010. Like Illinois Tool Works, Emerson raised its dividend throughout this period (in fact, it’s been raising its dividend every year since the 1950s. It’s one of those hidden gem companies that doesn’t get much attention).

For those of you who want to be especially opportunistic during the next market selloff, you should find a place for high-quality cyclical companies. The price volatility is more extreme—and this is why it’s an art that’s hard to get right—you see a $25,000 investment turning into $14,000 which is simultaneously being accompanied by steep drops in profit, and not everyone has the stomach to work through it (especially if you buy early in the decline).

But you do receive something extra for putting up with that—the price gains are much more substantial, and can be predicted if you limit yourself to high-quality cyclicals with long-term dividend streaks, strong product backlogs, and a decent gap between the amount of money they pay out as dividends and the amount of cash flow they generate during the good times (intelligently managed cyclicals rarely have payout ratios above 60% during ordinary or booming economic conditions). If I had to put into an allocation percentage, I would think it wise to dedicate 75% of investable funds during a market decline to the highest quality non-cyclical companies that you can own for the rest of your life without requiring much monitoring or thinking, and the other 25% to more opportunistic investments that are trying to take advantage of companies that are unfairly beaten down. The rewards for getting it right are so great that it’s worth studying and developing a strategy ahead of time for how to approach the role of opportunistic investing during the next significant market selloff, whether that means you buy cyclical companies, real estate investment trusts, or energy MLPs with a portion of your cash.