Some perspective on IBM: For the June 30^th through September 30^th 2013 period, IBM reported a profit of $3.68 per share. For the June 30^th through September 30^th 2014 period, IBM reported a profit of $3.68 per share. Each share of third-quarter profit is the same year-over-year. And, though, nobody is talking about it now, IBM is still expected to earn $16.04 in annual profit for 2014, compared to $14.94 last year. Though it has gone completely undiscussed in the past several days, IBM is still on target to post profit per share growth of 7% when you compare 2014 against 2013.

Why, then, is everyone speaking so negatively of IBM, which has the real-world impact of seeing the price decline by 15% over the past three months?

Five things primarily have been a cause for concern among people who have an ownership stake in the firm:

1. The revenue for the third-quarter came in at $22.4 billion, which was lower than Wall Street expectations.
2. The earnings per share missed by $0.63. The consensus estimate, taken as an average of Wall Street estimates that omit certain extremes, anticipated $4.31 per share in profit, rather than the $3.68 that materialized.
3. IBM’s backlog fell 7%, however, the company still has $128 billion in servicing work to perform.
4. The company has abandoned its roadmap (set by the previous CEO Sam Palmisano) to achieve $20.00 in earnings per share by 2015.
5. Laying off employees has been a tool to achieve profit growth in recent years, and CEO Ginny Rometty indicated that will continue into the future. Obviously, this affects employee morale—it’s hard working for a place that regularly refers to employees as a cost, as in the phrase “The costs need to be cut.”

Every quarter it seems, some analysts on Wall Street get uncomfortable with IBM’s sluggish revenue reports. In an interview on CNBC, CEO Rometty mentioned that she would not disclose any conversation with Warren Buffett (who counts IBM among his “Big Four” investments, alongside Coca-Cola, American Express, and Wells Fargo), but anticipated he would say, “Focusing on revenue is like focusing on the empty calories.”

It is a distinction that matters—sometimes people forget that revenue calculations only refer to the amount of money that you take in. If you own an ice cream stand that sells 10,000 ice creams per summer for $3 each, you’re bringing in $30,000 in revenue. If you have to spend $25,000 hiring ice cream vendors, paying for the ice cream truck, and buying the ice cream in bulk from a vendor, your profit is $5,000. It is from that $5,000 you can extract from the business and pay your bills, go on vacation, or donate to charity. When fast-growing businesses can’t figure out why the company’s treasury isn’t overflowing with cash, it’s often referred to as “intoxication with sales” to describe a company’s undue focus on growing revenues rather than profits.

IBM is probably the biggest example of a company where revenue figures and profit figures do not closely align. This is because IBM has been growing profits by cutting costs and reducing the share count through large repurchases, rather than growing revenue. When I saw IBM’s downward price action since the earnings release, my reaction was “Really? How is this revenue report any different from all the other bad revenue reports we’ve seen over the past ten years?”

In 2004, IBM posted $96 billion in revenue. This year, IBM will post somewhere around $97 billion in revenue. There’s basically been no revenue growth over the past decade. Yet, costs have come down substantially due to productivity gains and layoffs (the morality of which is a very interesting side question that probably deserves its own post) so that IBM has doubled its profits over the past ten years, from $8.6 billion to a little over $17 billion. In addition to those growing profits, the company has reduced its share count from 1.6 billion to 997 million.

In other words, while revenue has stagnated at IBM for the past decade, this has concurrently happened: IBM went from generated $8.6 billion in profits that had to get divided into 1.6 billion pieces, to now generating $17 billion in annual profits that get divided into 997 million. That’s why the profits per share have gone from a little over $5 per share to almost $16 per share today. If you owned 100 shares of IBM in 2004, it was generating $500 in look-through profits on your behalf. If you spent each and every dividend over the past decade along the way, and were still sitting on those 100 shares, they would be producing $1,600 in profits on behalf of your ownership. That is assuming you did nothing to add to your position such as reinvest dividends—revenues stagnated, and your profits per share tripled.

The current dividend yield offered by IBM is a historical high; even during the Great Recession, the dividend yield average for the year was only 2.0%. The dividend has been growing at a rate of 19% annually over the past decade, and earnings have grown by 13% annually over that time. And revenues have stagnated over this ten-year interval—and yet, the earnings and dividends keep piling up (and despite a dividend growth rate that is growing quicker than profits, IBM still only boasts a payout ratio of 25%. This low payout ratio explains why the company has been able to retire and destroy so much stock over the past decade, making each share you own represent a greater claim on the company’s overall profits.

As CEO Rommetty pointed out, the company’s cloud operations have been growing at a 50% rate; the catch, though, is that it only accounts for $4.4 billion worth of the company’s business at the present time. The company has a profit margin of over 16%.

Moments like these with IBM, McDonald’s, and BP are useful in that they provide opportunities to gauge whether your personality gauges well with value investing. On almost every investing forum I’ve ever read, someone starts a conversation by way of introduction, saying, “I’m a value investor.” If you make that statement, and intend to do it properly, that means you are either buying companies during bad economic times in which just about every stock is declining by 20% or more, or you are buying a company during normal or good economic conditions that is working its way through problems. IBM is obviously a candidate for the latter situation.

When I was at Washington & Lee, I was friends with a very smart guy who routinely showed up five minutes late for class. One day, about halfway through the semester, the teacher got mad at his tardiness and chided him for his lateness. Sure, it’s better to arrive on time or early. Sure, it’s better for a company to grow revenue. But it’s not a requirement for a successful investment. The guy who regularly showed up late was plainly intelligent, and had established a pattern of both showing up late and doing well on the testing material. IBM plainly has some great profit sources ($18 billion in profit across over 1,000 product lines), and has established a pattern of reporting stagnating revenues while still growing profits per share.

This latest earnings report is the latest iteration in a trend that has been true for at least the past decade while the company still delivers satisfactory investment returns. The company is trading at something like 10x profits right now. That means, theoretically, the company could pay out $10 in profits to you as the shareholder for every $100 that you invest. The company wouldn’t do that, but it’s a nice exercise to remind you that you’re dealing with real profits that can be purchased at a cheap level. This 2.7% dividend yield is a generational high. The earnings per share keep climbing. This is a great opportunity to do some value investing, and let’s hope IBM’s executives retire even more stock now, while the price is low and the beneficial effect for shareholders can be greatest. This is the season for value investors to turn their eye towards IBM, McDonald’s, BP, and GlaxoSmithKline—they’re great companies working their way through problems that are very solvable and, frankly, not that bad when you consider the scope of their business operations.

One of the obstacles that prevents people from being successful investors is that buying stocks tends to lack the tangibility that owning a small business (like a storage unit or cash wash in your community) or real estate can provide for an investor.

When it comes to stocks, it’s an acquired taste to reach the point where you think in terms like these, “Each share of McDonald’s earned $3.67 in 2008, $3.98 in 2009, $4.60 in 2010, $5.27 in 2011, $5.36 in 2012, and $5.55 in 2013, while returning between 47% and 56% of those profits to shareholders in the form of cash dividends over that time frame.” Instead, the initial impulse is to think, “Oh no, the stock fell from the $60s to the $40s in 2008, better sell because this isn’t working.”

Unless you spend a lot of time studying this stuff, it’s easy to think of the stock market as an arbitrary place where things go up and down—after all, that’s what happens on the day-to-day basis, while ignoring the fact that they represent ownership interests in a business.

That’s where I think dividends come in—when you can see the cash coming in each year, it’s a nice reminder, “Hey, there’s a business here, rather than just two or three letters on a screen.” When someone finds himself owning a nice piece of real estate is generating $1,000 per month in rental income after all expenses are accounted for, and assuming the headaches from the tenants are minimal (and this can be a huge if, depending on the location), you’re not going to freak out because the price of the property fluctuated from $150,000 to $140,000 when you look up estimated values of the property online. You know what you own, you receive value from the rents, and the tangibility of the whole experience can be a nice deterrent against short-term thinking.

The problem for investors in the public markets today is that it’s hard to reach a situation where you can get dividend yields that roughly approximate what you’d be generating from owning rental properties or a high-cash producing asset outright.

Imagine having a situation where the GDP declined a percentage point or two, commodity prices slumped, the broad stock market experienced a decline of 20% or so, and the price of BP overshot on the downside to something like $30 per share. It doesn’t feel like it at the time, and you wouldn’t know it from watching CNBC or following most financial news outlets, but that would be the opportunity to lock in the path to riches.

In BP’s case, the $2.34 dividend would give investors an initial yield of 7.8%. We haven’t seen that since the oil spill brought prices down to $27, and again, no one would be talking about how great it is at the time, but could you imagine locking in those shares. With a rental property, it takes hard work and the hassle of dealing with tenant repairs and filling in tenant vacancies to get annual returns in that range. If you could get your hands on BP stock for $30 per share, you’d be able to write your check, and do nothing thereafter while you’d be able to approximate the riches of someone who is out there grinding it out for those kinds of returns.

It’s potential situations like that which explain why investors like Charlie Munger, Seth Klarman, and Donald Yacktman, and Buffett too, like to keep gigantic sums of cash on hand. There is a lot of wisdom in staying fully invested because your assets are always working for you to produce cash, but there’s also an intelligent rationale for a shrewd investor to stack cash up to strike when a good opportunity arises. Usually, the window of opening for good deals is only a couple months or a year at most, and it’s reasonable to want more money than you could generate from a two-week paycheck to be able to invest into the market at that time.

Imagine writing a check for $30,000 worth of BP stock at that time to add 1,000 shares to your account. You’d be collecting $2,340 in immediate dividends. If you were able to reinvest them while prices were so low, you’d pick up 78 more shares and then have 1,078 shares heading into next year’s dividend increase. If BP management raises the dividend to, say, $0.61 per share, you’d suddenly be collecting $2,630 in annual dividends without having to do anything additional, while your yield-on-cost rose to 8.76%.

It’s funny—when Buffett goes on tv and talks about how he likes stock market declines and general pessimism not for the very real harm they cause to the economy but rather the prices produced in the stock market, he gets a patronizing look from everyone in the vein of, “How can anyone want to see stock market declines?” Yet, when you run the numbers, that’s where the money gets made.

Conoco, Royal Dutch Shell, and BP have a long history of shooting a bit more than necessary when stock market corrections arrive. When things go down 20% among non-cylical companies, you tend to see those high-quality assets go down 30-35%. You prepare for that situation by building up cash and then writing a check when the low prices present themselves. Buying oil stocks tend to work out well over the long-term when you buy at fair prices, but if you are able to buy any of those three companies at something resembling low prices, you end up getting the kind of annual income that usually only exists in the private markets.

The added advantage of getting high initial dividends is that the experience becomes much more tangible. When you own something that immediately pays you $60-$75 per year on every $1,000 that you invest, you’re not going to sell when the price falls. You’re going to find it easy to enjoy the asset and keep collecting the dividends.

Generally speaking, it is wise to hold investments that pay out high streams of dividend income inside the confines of an IRA, so you can avoid those frictional taxes that take a tax bite out of each dividend payment and limits your compounding engine (though there is also wisdom in owning something like Starbucks in an IRA because IRAs have contribution limits and getting large capital gains inside the account can be useful, too).

Usually, the blue-chip stocks that are candidates for consideration are things like tobacco (Philip Morris International), telecom (AT&T), and oil (Royal Dutch Shell, BP, and sometimes Conoco). You don’t get an opportunity to diversify into the health-care field all that often, if you’re looking strictly for high income candidates: Johnson & Johnson has a present dividend yield of 2.77%, Abbvie yields 2.97%, Abbott Labs yields 2.08%, and Pfizer is a bit better with a 3.66% yield. But GlaxoSmithKline is a notable exception.

It’s not something you’d want to own if you required an absolutely rising payout each year (you should stick with Colgate-Palmolive, Coca-Cola, Procter & Gamble, and Exxon if that is your objective), but it is a nice holding if you approach things like a business owner because that’s what GlaxoSmithKline’s dividend policy calls for: it pays out a certain percentage of profits each year, and because health-care firms with drug arms experience fluctuations in profits, it comes as no surprise that the dividend comes in fluctuations as well.

The company, which trades at $44 per share and currently earns profits of $3.50 per share, trades at a P/E ratio of 12.85 so that current investors get an initial earnings yield of almost 8%. This cheapness is a product of current business challenges. The company has cut the price of one of its signature drugs, Advair, and this has contributed to declining revenues—GlaxoSmithKline is generating as much revenue now as it did in 2005 (and this isn’t a situation like IBM where you have buybacks and productivity gains to offset stagnating revenues—GlaxoSmithKline made $8.5 billion in annual profit in 2005 and makes $8.7 billion in annual profit now).

What is intriguing about the company is this: The HIV division is growing at a rate of 15% annually coming out of the recession, and the boneheaded supply disruptions in the United States that led to 6% declining sales over the past three years is on the mend. Furthermore, the dividend is quite high at 5.6%, putting it well above historical norms (in the 1990s, the dividend yield didn’t cross 2.1%, hovered above 3% during the 2000s, and didn’t hit the 5% mark until the financial crisis).

It’s somewhat difficult to model the annual dividend growth, because while the dividend goes up nicely over just about every five-year rolling period, there are many instances where the year-over-year comparisons are negative. For instance, the dividend payout went from $2.17 to $1.71 if you compare the 2008 to 2010 period. That could be obnoxious if you use rising dividend income as a psychologically satisfying tool to measure annual forward progress. On the other hand, if you measure the 2008 to 2014 period, the dividend income increased from $2.17 to $2.87, so the overall trajectory is upward. GlaxoSmithKline is the type of investment for investors that have the attitude, “This company will pay out a good chunk of income relative to the amount of capital I initially invest, though the amount will vary with time.”

My back-of-the-envelope math for GlaxoSmithKline is something like this: Say you start by receiving a 5.6% initial dividend yield on your income (because that’s what you’d get today), and the average dividend growth rate is 5% over the next decade (it may come in the form of 12% raises and 4% cuts, but we’re talking a blended average based on what it has done post-merger).

Here’s how it would work out: If you purchased $5,500 worth of GlaxoSmithKline in a Roth IRA (the current annual maximum), and paid $44 per share, you would get 125 shares of the $100 billion healthcare giant paying out $358 in initial annual income that is free to compound without any interference from Uncle Sam. If that $358 in annual income grows at a rate of 5%, you would collect $5,111 in annual income over the following ten years. That’s 92% of your initial investment amount returned, without any dividend reinvestment. If you plowed the dividends back into more shares of GlaxoSmithKline along the way, you could conceivably have received a dividend amount equal to your initial investment by year seven or eight.

There’s also a lottery ticket dimension to any healthcare investment, in which case R&D development leads to a break-out drug patent that greatly increases profits on short notice, and you get 7-9% dividend growth for a while. You wouldn’t make an investment that hinges on a development like this, but you also shouldn’t object to putting yourself in situations where you not only do you have a good chance of good returns, but you  have an outside chance of excellent returns as well.

A lot of people don’t have much patience for this company right now because of the foreign accusations of bribery and a modestly declining revenue figure over the short-term. That’s why you get the 5.6% dividend. But despite all of this, it’s still a company pumping out $8-$9 billion in annual profits across hundreds of different profit sources. With earnings growth and dividend growth in the mid-single digits over the coming decade, you can do very well from an income generation standpoint. For a patient investor that likes lots of income but doesn’t mind some fluctuations, GlaxoSmithKline seems worthy of further investigation.

Over the past ten years, Coca-Cola has increased its profits from $5.0 billion to $9.2 billion. The profits per share have increased by a little more than that (from $1.03 to $2.10) due to a stock repurchase program that has reduced the number of ownership units you have to share the profits with from 4.8 billion to 4.3 billion. The company has increased its cash on hand over the past two years from $13 billion to $18 billion. The soda giant’s sales have gone up from $21 billion to over $46 billion during the 2004-2014 stretch. And plus, you collected a rising cash payment during each of those years we’re examining (and it’s a streak that now goes back more than half-a-century in total).

And yet, the price of Coca-Cola stock has declined over 5% this week. Why? Because the company missed analyst expectations by $140 million. That’s right—they brought in a little under $12 billion when the Wall Street consensus expected a little over $12 billion. It’s nuts; we seem to have entered this bizarro world where investors are intolerant of the fact that we have economic business cycles, and companies don’t grow revenues and earnings per share at a 10% rate annually into perpetuity. Profits went down from 1998 to 1999, only went up by $0.03 from 2001 to 2002, only went up $0.05 the year after that, and $0.06 the year after that. The company’s revenues barely went up from 2004 to 2005, but yet, experienced significant growth from 2007 to 2008 (earnings per share increased from $1.29 to $1.51, and revenues grew from $28 billion to just a tad under $32 billion).

It’s the nature of business. There’s a sportiness to the earnings reports of even the highest caliber companies, and you would be wise to take advantage of the temporary ebbs in the business cycle to add to your position, rather than waiting for the company to fire on all cylinders: When do you think you’ll be able to get a good deal on Coca-Cola stock—when the company reports sales that are stagnating, or when the company reports profit growth of 12%?

Someone who bought shares of Coca-Cola on October 21^st, 2004 would have compounded his funds at a rate of 10.62% annually until October 21^st, 2014, increasing your wealth by a rate of 2.74 if you held the stock in tax-shielded form like an IRA. Every $10,000 would have grown to $27,400. And this is a ten-year period that included all the things mentioned below—years that included modestly growing revenues and barely increasing profits per share. Heck, even this year, Coca-Cola is on pace to grow its profits from $2.08 to $2.10, and the per share dividend collected increased from $1.12 to $1.22.

This is what’s supposed to make investing fun—even in the bad years, Coca-Cola’s profits generally hold up (increasing modestly or declining modestly) and the payout ratio is flexible enough that you can still receive dividends that are growing faster than the inflation rate even during the rough years of the business. The current business difficulties, if you can call it that, facing Coca-Cola are perfectly characteristic with what Coca-Cola has done in the past ten years and still managed to deliver total returns just north of 10% annually (as an FYI, the current yield on Coca-Cola is 3.0%. The years 2008 and 2009 are the only times in the past generation when Coca-Cola had an average initial yield of over 3.0% over the course of the year. There aren’t a whole lot of high certainty places in the world where you can get 3% initial income attached to a very high probability of 8% annual dividend growth or better over the long term).

It’s a shame the financial literature out there right now misjudges the opportunity that exists in IBM and, to a lesser extent, Coca-Cola right now. If you’ve googled Warren Buffett’s name at all this week, almost all the headlines are about how he has supposedly lost $2-$3 billion in Coca-Cola and IBM this week, and a small minority of them even go as far as to suggest that he’s losing his edge as an investor. It would be humorous if not for the fact that honest, hard-working people actually make financial decisions in response to that kind of stuff.

Coca-Cola has a ten-year earnings per share growth rate of 8.5%. IBM has a ten-year earnings per share growth rate of 13.0%. The current criticisms of IBM and Coca-Cola discuss conditions that both companies have faced throughout the past decade, and still managed to deliver good returns to shareholders.

This is why I have a love-hate relationship with advances in financial information technology. On one hand, it’s great that someone just starting out can open an account with Loyal3, and start buying Berkshire Hathaway stock with $10 purchase minimums for a cost of $0. It’s a sign of progress for American society that the path to wealth-building so clearly exists if you acquire the knowledge and set aside a little capital to invest. On the other hand, we have a 24/7 news cycle that reacts to every quarterly report, such that it’s rare you find anyone around anymore who can say stuff like, “Yeah, I’ve owned these shares of Emerson Electric for the past 25 years.” When you have information blasted your way all the time, and some of it is negative, it’s extraordinarily easy to dispose of an excellent lifelong holding because you made the mistake of projecting short-term bad news far into the future when really all you’re looking at is the typical ebb and flow of the business cycle.

One thing I wanted to do this afternoon is talk about the rare class of company—ExxonMobil, Wal-Mart, and IBM come to mind—that has no choice but to repurchase shares of the company’s stock. If you read much investment commentary on the company, you will walk away with the impression that IBM has no plans for growth or moat-building and is surviving slowly on the use of existing cash flow to retire stock to create an illusion of progress.

To understand why IBM makes the capital allocation decisions that it does, I find it wise to keep IBM’s size in mind. IBM is one of those two or three dozen firms in the world that when you buy an ownership stake, you are really buying into something that is the size of a small country. For instance, the company is going to generate about $97 billion in revenue or so this year, conditional upon the next quarter’s report. As a point of reference, the entire country of Libya produces $95 billion worth of goods and services in a year. The entire country of Morocco produces $95 billion worth of goods and services each year. The entire country of Puerto Rico produces $105 billion worth of goods and services per year. So when we talk about IBM, we’re talking about something that has an output roughly the size of Libya, Morocco, or Puerto Rico.

Pretend you’re in charge of running IBM. You want to continue the company’s legacy of doing something, and on the investment side, you eyeball that the historical return of S&P 500 stocks is around 10% per year. You acknowledge that IBM is a behemoth in size, but you set the target of delivering 11% annual returns to shareholders—you want people who part with their hard-earned money to show you the ultimate act of trust by tying their economic fate to your stewardship to be rewarded at a rate above what you’d get with a plain S&P 500 Index Fund.

You note that, although the current dividend yield is 2.7%, this is unusually high, and most starting investors usually receive an annual payout of 1.5% when the stock is fairly valued. This means that, assuming the stock is fairly valued, you must grow profits per share by 9.5% over the long haul to get those 11% returns.

Let’s say that one option is to try and reinvest all of the cash flow that does not go towards the dividend, trying to achieve 9.5% annual revenue growth that translates into 9.5% annual profit growth (this would be the product of big spending and sales intoxication in which you take “must get bigger” to be your primary investment imperative). To grow revenues 9.5% in one year, you’d have to produce $9.21 billion in fresh goods and services over the next twelve months while also retaining the $97 billion that you’re already generating. In other words, you’d have to add one-ninth of the Moroccan economy to your production in a given year. The Bahamas has the GDP of $8.3 billion. To achieve 9.5% revenue growth, you would have to add more than the annual production of every man and woman in the Bahamas economy to achieve that growth. Achieving that kind of revenue growth in one year would be extremely fortuitous, doing it every year: impossible.

A stock repurchase program, on the other hand, guarantees certain results. Sometimes, this can be a problem. If you have money to allocate, and you think there’s a 50% chance you can get 8% growth, why go through the hassle and uncertainty of building new factories, hiring new workers, and rolling out new products if you have a guaranteed path to 6% earnings per share growth via stock buybacks?

As a broad economic principle, stock repurchases can discourage management teams from intelligent risk-taking that can grow an economy through new products and services, as well as give people new jobs. Why take that gamble when you can just buy back your own stock? As a matter of social and economic impact, stock repurchases disproportionately benefit the investor class, and only benefit the broader economy to the extent you take the dividends or capital gains caused by the increase in profits per share and actually consume things.

But, when a stock is quite undervalued, few things can deliver returns quite like a share buyback. IBM earns around $16 per share in profits, and trades at $160. That P/E ratio is 10. This is ripe for wealth creation. IBM buys back and retires about $3 billion worth of stock per quarter, though it does vary. Imagine if IBM continues its current practice and the price of the stock stays low at $160. IBM is a $160 billion company. Even if profits stayed the same, the repurchases alone would increase your share of the profits by 7.5% over the coming year. Without factoring in growth, the current 2.7% dividend yield + 7.5% buyback yield (which would go up as the price of IBM stock goes down, and would go down as the price of IBM stock goes up). That’s a 10.2% annual return, assuming the continuance of present conditions without factoring in actual business growth. That’s why IBM is stuffed in the portfolios of famous value investors across the country. You don’t need a whole lot to go right for IBM to deliver satisfactory returns over the coming years five to ten years.

Now, you might be thinking—hey, it doesn’t have to be either extreme between capital investment and buybacks. You could invest more towards organic growth, and make it a balanced attack with buybacks. And plus, it would be evidence of an inefficient operation for a company to need 9.5% revenue growth to achieve 9.5% profit per share growth. Consumer staples grow revenues by 4-5% annually all the time, and easily turn it into 7-9% profit gains.

There are two responses to that:

First, I don’t think people truly realize how cheap IBM has gotten. During the worst of 2009, IBM traded at 10.9x earnings. Now, it’s at 10x earnings. This is the time to strike via buybacks, because the valuation of the stock allows the management team to greatly increase earnings per share when the stock exhibits price weakness. Just look at what happened during 2009 for evidence: IBM grew its earnings per share from $8.93 in 2008 to $10.01 in 2009, and that is because the company was buying back stock at 10-11x earnings. It may not seem like it now, but this price decline in IBM is where the earnings per share growth gets turbo-charged, and the results will be obvious in the coming years (it just doesn’t seem so obvious to many people right now).

And second, I don’t think people realize how much IBM is dedicating to future investment. The buyback narrative has taken such a hold that investors don’t seem to examine IBM’s research-and-development budget anymore. They spent $1.35 billion on research and development in the past ninety days. They spent $1.45 billion on R&D during the ninety days before that. And the company spent $1.50 billion during the first quarter of this year. And last year, they spent over $6 billion in R&D. Their budget is exceptionally strong, and they continue to pour money towards organic growth. The problem has really been the switch from 30% operating margin businesses to 20% operating margin businesses as a result of large businesses switching from hardware to the cloud (though the cloud presents security risks that will reveal themselves in the coming years).

IBM is currently repurchasing stock at 10x earnings. As the price of the stock has declined, the margin of safety for prospective owners has increased. And when IBM repurchases stock at lower prices, your margin of safety continues to increase. I would be disappointed if IBM announced any kind of slowdown in their buyback program right now, because repurchases at 10x profits are what make investors rich. Given Buffett’s detailed explanation of his preference for lower IBM prices to buy back the stock in his initial letter after the IBM purchase, I imagine that’s what he has counseled CEO Rometty after the recent earnings report.

Since 1900, there have been two sets of conditions in which it has been extraordinarily difficult to be a long-term, buy-and-hold investor. Those were the Great Depression conditions that surrounded 1973 (no duh), and the 1973 bear market in which the earnings of even great non-cyclical companies (think Pfizer, Johnson & Johnson, PepsiCo, Coca-Cola, Procter & Gamble) collapsed. 2008 is an honorable mention if you were an investor in the financial sector.

With many blue-chip stocks cutting their dividends in half and earnings falling by at least that much (and prices falling by 75% or more), you couldn’t assess the present fundamentals of the company and see that the prices were irrationally cheap—maybe in the narrow sense that you saw that the prices plummeted more than profits, but it had to be weird to see AT&T go from earning $4.88 per share to $2.8 per share, Procter & Gamble go from earning $3.25 per share to $1.79 per share, and so on. If that’s what the dominant firms were doing, you can guess how the rest of a stock portfolio might have fared.

In ’73, you saw corporate profits decline 25% across the board for most S&P 500 firms, presenting a milder case of the Great Depression where a portfolio containing 3M, Colgate-Palmolive, Procter & Gamble, Coca-Cola, Exxon, and Emerson Electric still got to see dividend increases throughout.

When I get asked about what the worst-case scenarios for blue-chip dividend investors can look like, that’s what I have in mind—dividend cuts and collapsing earnings that require you to think out to five, maybe even ten, years ahead to see the rebound in earnings power because the dividends being mailed to you are on the decline and when you checked out the annual report, you would see substantially lower reported profits.

Hard investing conditions require broad dividend cuts and a decline in profitability to match that.

I mention this because sometimes I wonder whether the general prosperity (from a stock market perspective) of the 1980s, 1990s, and parts of the 2000s have created false expectations for consistent linear growth in the 9-10% range and created a willingness for investors to ignore the inevitable fluctuations in the business cycle to discard otherwise excellent companies that aren’t perpetually performing to expectations.

You’re seeing investors nowadays talking about discarding McDonald’s and IBM from their portfolios because they don’t like McDonald’s stagnating store growth in the United States or IBM’s inability to grow its revenue. These aren’t difficult business conditions, relatively speaking. Heck, McDonald’s is growing earnings per share by 5% annually, and IBM is growing earnings per share by 7-9% annually. These businesses are growing the profits that each share earns, and you can see it right before your very eyes, and yet, there is a vocal minority of shareholders that are talking about liquidating their ownership positions.

If you get bothered by a business that is growing while we are in a generally upward moving market, you should reconsider your commitment to stocks. Seriously, if those facts bother you, what on earth would happen if a 1933 or 1973 condition showed up? The kind of person who gets worried and sells a McDonald’s or IBM position while they are growing profits per share is likely going to dump his holdings when real adversity—in terms of dividend cuts and collapsing earnings—show up sometime in the next few decades as is inevitably the case.

Maybe it would be good if you learn that stocks aren’t your thing, sell now while there is no real damage, and pursue a life in real estate or something that doesn’t contain frequent quotations because if the current business conditions are bothersome to you, what would you do when something truly terrible for your business holdings happens?

For the past couple of days, we have discussed the ways in which IBM can prove to be a superior investment going forward, despite the narrative that’s become familiar to many—the technology service firm has been having trouble growing its revenues. Because of IBM’s low 25% dividend payout ratio, and its extensive commitment to repurchasing stock that is currently in the 10x earnings range, you can easily way a way IBM can prove to be a lucrative long-term investment even while its revenues stagnate.

Now, I want to talk about another excellent company where the opposite is true—revenues are having trouble growing, and it tells you something about the current state of Kraft’s “internal compounding engine” since the Modelez spinoff.

Here’s what I mean: In 2011, Kraft generated $18.6 billion in revenue. In 2012, Kraft generated $18.3 billion in revenue. They went down a little bit more to $18.2 billion in 2013. And though 2014 isn’t over yet, it looks like the revenue is on target for somewhere in the $18.2-$18.4 billion range, somewhere below the 2011 figures.

When revenue is stagnating, there are three ways you can grow profit per share: (1) you can cut costs, (2) you can increase productivity or expand into businesses that have higher profit margins, and/or (3) you can repurchase stock.

Kraft has been doing the two first two in the past three years—in a sign of the times, they have laid off some employees, modestly improved productivity output due to factory consolidation, and traded out some minor businesses and acquired a few as well. That’s why the profit per share has increased from $2.75 to $3.15 from 2011 through 2014 (I took the average of what Wall Street expects for the fourth quarter and added that to the first three quarters of actual reported profits) despite revenue figures that have not improved.

The third option—stock repurchases—does not exist in Kraft’s case. IBM buys back something like $3 billion worth of stock per quarter. And thought the amount and the repurchase price vary somewhat, IBM averages retiring 1.5% of its outstanding stock every 90 days. That’s an important offset to stagnating revenue. In the case of Kraft, you have modest share dilution such that the profit pie is currently split up into 594 million pieces (compared to 592 pieces in 2011).

Kraft pays out a dividend of $.55 per share, or a current commitment to give out $2.20 to shareholders each year. If the company makes $3.15 per share in profit this year, the dividend will account for 70% of profits. They make $1.8 billion in profits per year—and about $1.26 billion of it gets deposited in the accounts of shareholders as a cash dividend, and the other $500+ million is retained to grow the business.

They got saddled with some debt after the spinoff—they currently have $10 billion in debt on the books, and they’ve been wise to cut that by $1.5 billion in the past two years (you don’t want to head into a rising interest rate world where you have significant chunks of debt that needs refinancing down the road). The problem is this—when you’re in a slow growth business selling Kraft cheese, Oscar Mayer meats, and the faster-growing Maxwell House coffee brands, have a meaningful debt load, and are sending out 70% of your profits to shareholders as a dividend, you are going to struggle to achieve a high profit per share growth rate.

What are the implications of this? I can think of three.

One, if you already own Kraft, it makes sense to continue doing so. It’s not some hardship in life to own a company with an extraordinarily high quality of current profits even if its future rate of growth appears to be less than spectacular. You’ve got a 3.89% yield based on current profits (and you’d be collecting a higher yield on your invested capital if you’ve been an owner of the company for awhile) that will march upwards over the course of your lifetime.

If you ever reached a point where you could live entirely off of Kraft income—and I know there are some of you who have been long-time owners of Altria who picked up shares of Kraft, Mondelez, and Philip Morris International just by refusing to hit the sell button throughout the lucrative spinoffs in the past six years—you would have it made. Financially speaking, you would have won at life because you could spend your time doing whatever you wanted because your passive ownership interests could singlehandedly support your lifestyle. (It’s not as crazy to draw up these scenarios as you’d imagine if you came to your Kraft share by way of the Altria spinoff—you were compounding your wealth at a rate of 15-22% annually depending on your investment time, so if you made a substantial financial commitment to the stock or had been an owner for over 20 years, your Kraft dividends alone would be making more than the average American household’s income per year).

If we suffered through another Great Depression type of scenario, the profits would not fall by that much. Dividends would still get paid. Heck, they did during the actual Great Depression. It’s inconceivable to think of a scenario in which North Americans (that’s what the Mondelez spinoff did—it made Kraft a North American grocery company) stopped consuming cheese, meat, and coffee. Collecting high-quality cash and deploying it elsewhere, or using it to support your lifestyle, has a useful place in any portfolio. Kraft is a great friend to have around when these generational recessions show up.

The second implication—when you’re dealing with something that has a slower compounding growth rate—think utility companies, telecom companies, and large grocers, you get superior returns by having discipline when you buy the stock. Someone buying Visa can be less disciplined with their initial starting price; that’s the fun thing about finding companies growing at 15% per year (you can pay $225 instead of $200, and you’ll still be very happy ten years down the line). When the growth rate is slower, overpaying hits you harder as the price of the stock can justifiably stagnate for three, four, five years at a time as it takes a while for the earnings to catch up to the valuation.

And third of all—it’s a reminder that the right stock selection depends on your personal goals and what you’re trying to accomplish with your funds. For a retiree looking for stable income, choosing Kraft is going to be more attractive than a U.S. savings bond if you’re at a point in your life where you don’t get worried by volatility with your high-quality holdings—I’d much rather be committed to Kraft’s 3.89% dividend that will go up annually if my alternative is a 3.05% Treasury yield that will remain static. For accepting volatility, you’re getting a payout that will increase faster than inflation and make you a bit richer each year. For the “safety” of a Treasury bond, you get a static payout that will be able to buy just a little bit less each year due to inflation.

That being said, not everyone is a retiree looking for stable income. If your time horizon is measured in 10+ year holding periods, and you want to make singular decisions today that will go on growth autopilot to make you richer at a nice clip with a high degree of certainty, it makes more sense to focus on Becton Dickinson, Visa, Disney, and compounds with internal compounding engines that are above 10% per year. For someone who needs to spend their dividend income soon, those stocks make less sense. For someone looking to build paper wealth and have a higher dividend yield on invested capital years and years down the road, they make a lot of sense.

In short, if someone is looking for income now, has owned Kraft for a while, or is looking for diversification in that “I want to build a fifty-stock fortress” kind of way, Kraft makes perfect sense. If someone has limited funds, and is trying to be selective about maximizing their compounding rate in a high certainty way, you will be able to find better growth opportunities than Kraft. The appeal of something like Kraft right now depends entirely on what you’re trying to build with your financial life.

Over the course of the January-October snapshot of this year, shares of Amazon have tumbled 30% (recently settling into a range in the $280s, below its recent high of over $400 per share). Two of you have written to ask me whether this is an opportunity purchase a growth stock investment at a value price.

My answer? This is a situation that firmly belongs in the “too hard” pile, an idea borrowed from Charlie Munger. One of the things that is an important with investing—among other things—is to figure out your circle of competence and stick to making decisions there. I can look at the extent of BP’s oil reserves, take a look at the likelihood of a big settlement/measure its potential effect on the company, and figure out that it’s wise to purchase the stock in the low $40s if you have a 10+ year time horizon in mind. The amount of money you make from reinvesting the dividends along the way, plus the capital appreciation, seems so likely that I’d rather spend my time focusing on building on strengths there rather than making actual financial decisions on things I don’t understand as well (really, the vastness of BP continues to be underestimated in most financial commentary I read on the company—its current profit engine is to the tune of $14 billion per year, even with all the asset sales, it is still 7x as profitable as the legendary American grocer Kraft that I just wrote about).

Amazon, meanwhile, remains perplexing because it keeps growing all this revenue but is unable to convert that revenue growth into profits. There’s no doubt that the business keeps getting bigger and bigger—its revenue has grown at a 29% annual clip during the 2000s and 2010s. It went from generating $6.9 billion in revenue in 2004 to having a realistic chance of crossing $90 billion in revenue this year. Each share went from representing $17 in revenue in 2004 to almost $200 per share in 2014.

The problem? Those revenue gains have not, and do not, get converted into profits that can be extracted from the business. In 2010, Amazon made $1.1 billion in profit, and that proved to be the high—things have steadily drifted downwards since then, with Amazon essentially expected to break-even this year (most recent profit forecasts expect $10-$50 million in profit this year, a mere rounding error when compared to Amazon’s market cap figure of $132 billion). Its current profit margin is 0.4% (Wal-Mart’s profit margin, in contrast, is 3-5% depending on the item).

There’s a compelling pro and con side to those predicting Amazon’s future:

The pro side argues that once Amazon achieves thorough market domination, it will have eliminated so much of the competition, and will have become such a habit of customers, that it will be able to raise prices without losing many customers. This is the coiled spring Amazon theory—all these revenue gains represent potential profit that could materialize very quickly once the time for price hikes come. This is why you see some analysts predicting that Amazon will make $8 billion in profits five years from now.

The con side of the argument will respond by saying this: The reason Amazon has been able to achieve its growth is because it essentially runs its business at cost. If it tries to reach for profits, people will just drive five minutes to Wal-Mart, or browse Craigslist or Ebay to get the item they want. The reason Amazon doesn’t make a profit is because its business model doesn’t lend itself to high profits—if it raises prices to pass on dividends or share buybacks to its shareowners—it will lose significant market-share. For the past ten years, analysts have been predicting lucrative profits down the road in a couple years, but that hasn’t come. Maybe it’s because Amazon can’t.

Furthermore, the valuation on the stock doesn’t lend itself very well to a margin of safety concept—let’s say Amazon does make $8 billion in profits in 2019, and trades at 25x profits then (a recognition of the upper limit valuation range for mega-cap, mature companies). That gives you a $200 billion market cap valuation range. In this regard, the $400 to $280 price decline does make Amazon more attractive; when Amazon topped out as a $188 billion company in January, it seemed to be priced in at its potential fair value five years from now (under optimistic conditions). Now, with a $130 billion market value, you can at least see a path to positive returns five years from now if things worked out according to a realistic best-case scenario that took its market-cap justifiably to the $200 billion range in 2019 (Note: normally, I wouldn’t use market cap changes as a proxy for total returns, but since the company has been keeping its share count mostly static in recent years and doesn’t pay out a dividend, it makes for an accurate comparison of investor returns. When these conditions change, market cap would quickly become an inaccurate tracker of investor returns).

Even though Amazon stock is more attractive than it was earlier this year, I still share similar thoughts concerning the stock. Analysts continue to expect Amazon to make significant profits a few years from now, and I think it’s worth keeping in mind that this is a rosy projection we’re talking about—after all, Amazon has never sustained profits above $1 billion per year for two years in a row. That’s a problem when you’re talking about companies with a valuation north of $100 billion. And even if those profits do come (which is speculative, but not wildly so) someday, you’re still going to have to deal with an eventual valuation in the 25x profits range. Could Amazon post very high profits five years from now and trade at something like 40x profits? Sure, of course. But the number of things that need to go right are substantial enough that buying Amazon stock still seems to go against the spirit of everything Graham and Dodd advised.

One of the advantages that comes with the turf of buying and holding a particular stock for a long period of time is that you hopefully become familiar with it in a way that someone taking a cursory look at the stock may not notice.

For instance, it is well known in the investor community that Disney typically spends four times as much money repurchasing stock as it does paying out dividends. This fact, coupled with the Disney Board’s decision to pay out the dividend annually, can partially explain why income investors looking for retirement income avoid the stock altogether. There aren’t a whole lot of people in the world who can look at a 1% yield and say, “Yeah, that’s something I can rely upon for retirement.”

Another reason why someone might get deterred from the stock is that, at first glance, the buyback appears to be ineffective: Disney had 2 billion shares outstanding in 1998, and now has 1.75 billion shares outstanding in 2014. For a company spending $4-$5 billion repurchasing stock each year, you’d like to see a share count declining faster than that.

If you are really paying attention to Disney closely, as someone might be if they have been holding the stock for years and years, then you would know what Disney is doing here: they are aggressively taking shares of its stock off the market and then using to make targeted acquisitions that increase total profits without adding to the number of stockholders entitled to the profits.

Look at what Disney has been able to acquire over the past two decades, partially using its stock to do so:

• 1993: Miramax Films

• 1996: Capital Cities/ABC (including ESPN)

• 1996: Baseball’s Anaheim Angels (renamed the LA Angels of Anaheim in 2005)

• 2001: Fox Family Network (now ABC Family)

• 2001: Saban Entertainment (owners of the “Power Rangers” series)

• 2004: The Muppets (but not Sesame Street)

• 2006: Pixar

• 2007: New Horizon Interactive (creators of Club Penguin, now called Disney Online Studios Canada)

• 2009: Marvel Entertainment

• 2010: Playdom

• 2012: Lucasfilm

Of those 12 acquisitions, 2 have been sold (Miramax and the Anaheim Angels), and 1 saw some of its assets sold (Saban Entertainment). The rest are still part of The Walt Disney family.

The only data I currently have on hand are Disney’s financial statements since acquiring the Muppets (but not Sesame Street) in 2004. At the time, Disney’s profits were $2.2 billion. Now, due to all of these acquisitions, Disney’s profits have ballooned to an expected $7.5 billion by the end of 2014. Disney’s secret sauce is that they have able to increase profits 3-4x times in a decade but the share count actually declined somewhat over that time due to the buyback.

That’s something that can be easy to miss if you’re not paying close attention—at most companies, we’re trained to associate stock buybacks with lower share counts which give you a higher claim on the profits for the shares that you own. Disney’s strategy tweaks that principle a bit; the stock buyback allows Disney to gobble up other companies that add to overall profits without having to expand the share count commensurately. In other words, when Disney does something like buy LucasFilm, they use repurchased shares to do so—those $300 million in annual profits continue to be divided in 1.8 billion ways instead of having to divide them in 1.9 billion ways if the share count actually got diluted.

I understand why income investors avoid Disney, and it’s hard to call declining to purchase a particular stock a mistake (if you buy Exxon, Nestle, or Berkshire Hathaway instead of Disney, and hold for 25+ years, your life is going to be fine), but I think Disney has a lot more appeal than its typical lack of love from income investors would suggest. The assets are high-quality, it can add meaningful diversification to a portfolio because there are no other media companies I can think of that fall into the “buy and hold for the rest of your life” category, and the dividend growth is spectacular if you stick around for a while.

Instead of thinking from the perspective of the current 1% yield, think of this: Ten years ago, Disney was paying out 19% of its profits as dividends (very similar to the 22% figure now). At the time, Disney was trading at $20 per share while paying out a $0.21 annual dividend. That 1% yield is very similar to what we see today. Yet, Disney is now paying out a dividend in the amount of $0.86 per share, giving you a 4.3% dividend yield on the amount of money you set aside ten years ago. As compensation for waiting ten years to get a 4% yield from your invested capital, you also got a stock price that more than quadrupled, turning $25k into $100k without factoring in the dividends over the decade. With Disney, most of your wealth will be on paper due to its longstanding buybacks over dividends preference, but you can do all right from a yield-on-cost perspective if you stick around for the while, and you could convert that to a whole lot of income if you stick around holding the stock for a while.

When investing, it’s important to get the question you’re trying to answer right. When I discuss investment opportunities that look particularly intriguing, I am not making the statement: “This is the cheapest price the stock will ever see.” I don’t attempt to answer that question because it’s something I never could get right—it involves predicting what *other people* will do at a particular point in time, and at best, it’s something that would never amount to more than speculation.

Instead, I try to answer this question: If I were to purchase the stock today, what would be the amount of profits that the company will be generating 10+ years from now, and then relate that answer to (1) my degree of conviction and (2) the price of the stock today.

Take something like Warren Buffett’s purchase of Wells Fargo throughout the financial crisis. During the absolute low of 2009, the price of the company’s stock hit $7.80 per share. When you hear that Buffett added Wells Fargo to the Berkshire portfolio during this time, you might assume that he was able to buy the stock near these prices—I know that was my initial assumption, but that wasn’t the case. When you look at the quarterly reporting figures for Berkshire Hathaway, there was never a quarter where Buffett averaged purchasing the stock in the single digits.

His cheapest conquest? In the first quarter of 2009, Warren Buffett bought about 12 million shares at an average price of $14.24. In 2007—before the financial crisis hit even started bringing down the prices of banking stocks—Buffett found it wise to pay $35.56, $35.17, and $35.62 for three batches of Wells Fargo stock that added 70 million shares to Berkshire’s rolls.

Here was a situation where you had the most famous investor, who is one of the best stock-pickers in the world, pay 5x the price of what the stock would trade at just two years later. But here’s what happened: by the end of this year, those shares he bought at $35-$36 will pay out $7.03 in total dividends and currently trade at a price of $51.20 per share. He bought on the eve of the second-worst financial crisis in the past century, and yet, he still earned a 65% return in seven years on his money. Those returns will continue to accelerate in the coming years as Wells Fargo gets its dividend in order and the earnings per share growth translates into a higher justifiable value (unleashed by things like rising interest rates, the re-growth of Wachovia, and expanded loan portfolios).

And, of course, once the financial crisis happened—Buffett continued to buy. He bought aggressively in the $20 range in both the final half of 2009 and throughout 2010. This proved quite beneficial—it knocked the average cost basis of Berkshire’s shares down to the $20 range. Berkshire currently owns 483,470,853 Wells Fargo shares that have a cost basis of $11.871 billion. That means Buffett averaged down from his purchases in the $30 range to get his average cost down to $24.55 per share.

If you’re someone who doesn’t anticipate ever having the skill set of predicting short-term price movements, this seems like a highly intelligent way to behave:

One, you identify a company that you plan to own for a very long time. In Buffett’s case, it is out of necessity. It’s hard to move 483 million shares of something without affecting the price. And plus, selling would trigger a tax event—and the permanent deferral of taxes is one of the underrated yet substantial reasons why it makes to approach the altar without a divorce in mind (you get to avoid all the breakup fees).

Two, you identify a price point at which it makes sense to buy. When you look at the company’s future earnings power, and make an estimate of what the fair value will be and the dividends paid out over that time will be, you view the decision to allocate capital as a singular event. Does buying Wells Fargo at $35 per share make sense? Will you be satisfied with the results in 2017, 2027, and so on? In Buffett’s case, the answer was a resounding yes.

Third, and this is where most people deviate from the Buffett approach—you don’t let future price downturns cause you to regret your buy decision. You don’t program yourself to say, “Dang, why’d I buy that stock at $35 when I could get it for $25.” Instead, you say, “I’ve been handed this opportunity to increase my ownership position with an added margin of safety, and I will either purchase more from available cash or reinvest dividends to take advantage of this moment.”

Certainly, there are times when price declines don’t simply mean a stock is getting cheaper—it can mean that the fundamentals are deteriorating as well. But even in these cases, the price often declines at a rate faster than the fundamentals. To use an obvious example, BP’s oil spill obviously lowered the company’s growth prospects compared to an alternative universe in which the company didn’t have to sell $35 billion in assets to meet legal obligations. But the price went from $60 to $27 in 2010. The earnings power may have been affected by 20%, but the actual price decline was somewhere around 50%. As a result, it would have made sense to add BP even though part of its earnings power had been comprised, because the price decline had been more substantial than justified by the damage done.

Incidentally, this is why the bulk of my finance writing focuses on established companies with great historical dividend track records that sell a wide array of profitable products for which the long-term demand is unlikely to diminish. It’s because these are the companies in which you can have high certainty when you choose to average down. Life’s a lot easier when you buy McDonald’s at $90 and know you would buy it at $80. It’s a lot easier when you buy BP at $48 but would be more excited to buy it at $40. It’s a lot easier when you’d buy Coke at $40 but would buy a lot more at $30. As far as self-reflection goes, there’s a lot of wisdom in asking yourself whether you’d buy more of a stock if the price went down. It immediately cuts to the heart of how well you understand a particular business, and how seriously you take the principle of increasing your margin of safety.

It’s one of the most intriguing questions when contemplating long-term portfolio planning: What role should finance stocks play when you’re planning to buy things that you intend to hold for 10+ years? On one hand, the demand for things like asset collecting (mutual funds, ETFs, etc.), short-term credit (credit cards), and longer-term lending (bank stocks) is an area that will have perpetual demand. There will always be people directing other people’s investments, there will always be people borrowing money on credit, and there will always be people needing long-term loans to start a business, continue funding a business, buy a home, or whatever requires an infusion of meaningful capital.

On the other hand, financial firms carry a management risk—you can easily overleverage yourself to improve near term results, while setting yourself up for total implosion in the event that an extended economic downturn shows up. If you’re selling cookies and crackers, it’s hard to mess the business up. When the amount of liquidity and capital is inherent in your business model, the perils of short-sighted management carry extra-destructive effects.

This evening, I want to discuss how I would broadly address these colliding forces when thinking about building a fifty-stock portfolio that aims for an annual turnover rate as close to 0% as possible. But first, the usual qualifier: You should always make investment decisions within the boundaries of companies that you personally understand. It’s entirely unnecessary to do anything beyond that. In a $13 trillion American economy, you only have to carve out your little slice.

Take, for example, an excellent company I hardly ever mention: Lockheed Martin. If you had ever made a sizable investment in this stock—and preferably held for a very long time, it would have changed your life. Let’s say you bought $1,000 worth of the stock in 1977, 1978, 1979, and 1980, and intended to collect the dividends to spend however you wish shortly thereafter. If you were the typical American, this meant setting aside about a month of your pre-tax annual salary each of the four years to buy Lockheed. The attitude would be this: I’m going to use part of my income for four years to save my butt off, and then I’m going to use the next four decades to collect 160+ dividend payments from the firm as the defense business grows.

We are talking 5,037 shares of Lockheed, without dividend reinvestment. We are talking $7,555 quarterly dividend checks. We are talking over $30,000 in annual income, or roughly 7x the original investment amount. You can see why small business owners that generate $10,000+ above their living expenses each year, and use the remainder to invest, end up creating decamillion-dollar estates over the course of their life without much self-deprival outside of the early years. It’s the nature of compounding when you plant investment trees like this two or three dozen times in your life. Keep in that mind if finance stock investing isn’t your thing—you could be a random dude that bought Lockheed Martin, a stock rarely mentioned in dividend circles, and you’d be living a financially secure life off the dividend income if you’d been a long-term holder. The options to create wealth are boundless.

That said, here’s how I’d approach finance stock investing in a portfolio that consists of dozens of stocks:

I’d want to own two excellent mutual fund firms: In my case, I’d choose Benjamin Franklin and T. Rowe Price.

I’d want to own two excellent credit card companies: In my case, I would choose Visa and Mastercard.

And I’d want to choose 2-3 super high-quality banks: In my case, I’d choose U.S. Bancorp, J.P. Morgan, and Wells Fargo.

(Side note: I’d also choose two insurers that could internally compound capital well—namely, Berkshire Hathaway and Markel, but neither currently pay a dividend, and may be outside the scope of interest for those of you who come here for the site’s namesake premise).

Franklin Resources has been growing its profits 17% annually over the past decade. It made almost a billion dollars in profit in 2009, a time during which many financial firms were collapsing, requiring bailouts, and/or diluting shareholders. The dividend has been growing at a rate of 14.5% annually over the past ten years, and the dividend currently only amounts to 10% of the company’s overall profits. Franklin Resources is one of those life-changing companies for people that know about it; since 1984, it has compounded at a rate of 28% annually. That’s better than Altria. Heck, that’s better than Buffett at Berkshire. Do you realize what that kind of sustained compounding engine does to one’s financial picture? It turns $10,000 in 1984 capital into a little over $18,000,000 today.

It’s what Charlie Munger alluded to when he talked about companies that permit you to sit on your rear and collect the dividends as they come, knowing you’ve entrusted your hard-earned money to a place that will continue to work super hard on your behalf. It’s one of those companies where you secretly open up an obscure IRA, buy a few thousand dollars worth of Franklin Resources stock, click automatically reinvest the dividends, and completely forget about it for twenty years, allowing it to escape to the back recesses of your mind until one day you check the account and go, “Holy crap! I’m loaded!” It’s got a 19.3% return on total capital; it’s one of those investments you make and then leave well alone—meddling with it by selling will only cause you to later reach for the Tums when you pull out the calculator and measure what could have been.

T. Rowe Price is another investment cut from the same cloth. It has no debt at all on its balance sheet, and currently earns 21.3% on total capital. They, too, are on that small list of companies of where a modest investment held for a good chunk of time could be life-changing. Only $5,000 worth of T. Rowe Price stock, purchased twenty years ago, would be $134,000 today. It would have taken you $39,000 and twenty years to become a T. Rowe Price millionaire. Such an excellent, rarely discussed company.

The other two, Visa and Mastercard, you have heard me discuss ad nauseam. Particularly Visa. That’s because the margin of safety offered by the stock has steadily increased. Year-to-date, the price has declined 2.7%. In January, it was making $7.59 per share. Now, the price is 2.7% lower and it is making $8.80 per share in profits (while boasting a pristine, debtless balance sheet). When you buy now, you get 15.94% more earnings for a 2.7% lower price compared to January. That’s why it’s been the darling stock of this website—the earnings keep growing, but the price of the stock is not keeping pace with it. The P/E ratio is only 24x profits, which is low for a company of its growth caliber. Heck, there are retirees out there buying utilities that grow 5-6% per year at a valuation rate of 20x earnings. They get a higher dividend yield right now, and might feel good about that, but they are forfeiting so much future growth that the total wealth differentials will become enormous over time when you measure the opportunity costs. On the other hand, if 4% dividends give you more money that you need to spend per year, no need to get mad at life. You’ve won.

As for Wells Fargo, JP Morgan, and U.S. Bancorp—they are all trading at about fair value and their payout ratios have normalized (compared to something like Bank of America and Citigroup, which will give shareholders sharper dividend hikes in the coming years to catch the dividend up to what it ought to be as a percentage of profits). I’m not sure why someone would prefer U.S. Bancorp to things like Procter & Gamble and Unilever—you get the same future growth prospects and similar valuations, and yet you are able to eliminate financials risk entirely. If Wells Fargo were at $35 per share, I’d understand the appeal of loading up on it a lot more.

It seems to me that Franklin Resources and T. Rowe Price, as well as Visa and Mastercard, offer such superior growth rates (with profit levels that held up well during the recession) that they merit a place in a well-rounded long-term portfolio. Their business models aren’t susceptible to blow-up the way traditional banks are, and given their abilities to navigate the recent financial crisis successfully, they seem well positioned to handle future crises as well because they carry low debt and have vast economies of scale. The high-quality banks don’t offer the discounts that they did in past years, and seems that delaying their addition to the portfolio at this point seems wise—given that you can build a portfolio of companies with similar growth characteristics outside the finance sector entirely.

Lately, I’ve been studying the companies that don’t have perfectly linear records of dividend growth, but have a strong tendency to give owners lots of cash for decades on end, especially when adjusted for the amount of money you have to invest (e.g. I’ve been looking at the companies that typically offer an initial yield north of 5% or so and offers a dividend that is generally higher every business cycle compared to the last).

My studies keep bringing me back to BP, because the company is beyond huge (it’s going to generate $14.5 billion in net profit this year, about 50% more than Coca-Cola as a frame of reference), has often served as Britain’s proxy equivalent to Exxon Mobil as the stock that you hold forever as you pass it down from generation to generation, and is one of the fair value stocks left in the market because people are hung up on the oil spill in 2010 even though BP is going to be fine in the long run because even after having to sell off a third of its business, the remains still generate almost $15 billion per year in annual profit.

In 1998, you could have purchased BP stock for $20 per share.

Since then, before and through the oil spill, the dividend scenario would look like this:

$1.45 in ’98.

$1.31 in ’99.

$1.35 in ’00.

$1.43 in ’01.

$1.57 in ’02.

$1.53 in ’03.

$1.66 in ’04.

$2.09 in ’05.

$2.30 in ’06.

$2.54 in ’07.

$3.30 in ’08.

$3.36 in ’09.

$0.84 in ’10.

$1.68 in ’11.

$1.98 in ’12.

$2.19 in ’13.

$2.33 in ’14 (estimated).

Each share purchased in 1998 would have gone on to generate $32.91 in dividend income for shareholders from 1998 through 2014. No, it hasn’t been a Colgate-Palmolive, Coca-Cola, or Johnson & Johnson type of experience where you get the smooth linear dividend increases coming your way each year (as you can see that 1998’s dividend income didn’t get surpassed until 2002, and the current dividend is at about the 2006 levels), but it’s very good at giving you lots of cash over long periods of time as compared to the amount of money that you actually invest.

If you spent $75,000 to purchase 3,750 shares of BP stock at $20 each in 1998, you would have collected $123,412 in dividends over that time frame. You could have used BP stock to build positions of almost $25,000 in each of the other big five oil companies in the world—Exxon, Chevron, Total SA, Royal Dutch Shell, and Conoco. Depending on when you selected Conoco, you would have also gotten spun off shares of Phillips 66 somewhere in there.

Or, I don’t know, you could have reinvested the dividends back into BP and collected another 3,100 shares, so that you would have 6,850 shares pumping out $16,000+ in annual dividend income. You’d be collecting over 20% of your purchase price annually in the form of BP dividends, even though the ride was bumpy along the way.

That’s the part of investing that I find the most interesting. If you mentioned BP as an investment to most people, they’d probably think of the oil spill and think it’s a terrible stock to own. But if you’ve been around awhile and putting the dividends to productive use, you could have either built a super collection of oil assets or you’d be collecting almost a third of the average American household’s annual income from your annual BP dividends alone.

This is why I stress that it’s important to have a cash cow, two, or three somewhere in your portfolio. It doesn’t have to be BP—it could be Realty Income, AT&T, GlaxoSmithKline, or when the price comes down a bit, Royal Dutch Shell. A sizable investment in one of those companies can be life-changing because they constantly give you options to make new brand new investments, build up private cash reserves, or use to make your life more enjoyable.

Well, Visa’s had a heck of a day. At the time I’m writing this, the price of Visa stock is up $20 per share (almost 9%) to $234. The cause for ebullience? Good earnings, and continued excellent prospects ahead. The company’s profitable margins continued to increase, going from 61% last year to 64% this year. Volumes are up 11%, year over year. The company is repurchasing an additional $5 billion worth of stock. Annual earnings per share growth still hovers around the 15% mark. The China State Council approved plans to open banking clearinghouses, and successful penetration of the Chinese market could prove highly lucrative to Visa shareholders.

The sharp price action today, incidentally, reveals yet another virtue of having a business ownership mindset where buy-and-hold is not only a given, but the starting premise from which all person investment decisions flow. Price gains that are the result of fundamental business improvements come in short, sharp bursts. A business growing profits at 1% per month doesn’t reflect that in smooth, 1% monthly gains. The typical large-cap American firm returns what, 10% as a historical average? If today’s Visa gains hold, the stock market actors essentially gave Visa owners a year worth of returns in a single day. That’s where trite sayings like “it’s not timing of the market, but time in the market that counts.” That’s vague enough to do us little good as investors, but it grasps at this truth—rapidly growing businesses do not deliver price gains with predictable timing (though sometimes it can be predictable that sharp price gains follow the release of great earnings reports).

It reminds me of a time this summer when Visa released its earnings and the price went down to $200. I wrote at the time that the margin of safety for those considering the stock just increased—you had a higher base rate of profits combined with a lower stock price. At the time, one reader got frustrated, saying, “Tim, if the business is so good, why’d the price of the stock go down?” That line right there encapsulated everything about someone does not treat the existence of the stock market as a convenient place to pick up ownership in a business. Equating the current price of a stock with the value of a business is a timeless human error—if Isaac Newton could lose seven thousand pounds, and cause his niece Catherine Conduitt to lose twenty-thousand pounds, on a misplaced bet on the stock of the South Sea Company stock (believing its one year price change from £100 to £980 per share was a proxy for 980% growth), we are all vulnerable to letting price fluctuations overtake rational analysis. But if you keep an eye on historical P/E ratios, err on the conservative side with growth projections, and stick with businesses you thoroughly understand, you can fight back against the possibility of reversion to emotional bias.

With Visa’s price advance today, I am more concerned about Visa’s valuation now than I have been since I’ve started writing about the company. A price of $234 is on the very high end of “okay valuation.” If the price crosses into the $260s this year, the wisdom of buying Visa starts to diminish because, in my opinion, a valuation of 30x profits would bring on a negative margin of safety (meaning, at some point, the price of the stock would permanently revert to the 20-25x profits range, so your actual returns would be less than the growth rate of the credit-card firm). If that were to happen, and depending on the extent of the overvaluation, you might be having a situation where the company might grow by 15%, but give investors annual returns of 12%.

Someone buying an overvalued Visa might still have a fair shot of beating someone in a S&P 500 Index Fund, but your safety in the event of disappointing earnings would be gone—if Visa grew at 4-6% annually for a few years, you might have to deal with moderate justified paper losses because, after all, a shift in valuation from 30x profits to 20x profits involves a 33% paper loss that would overwhelm 4-6% annual gains. The Wall Street aphorism “Priced to perfection” starts to come to mind if Visa stock sees another $20-$30 in gains this year.

Also, price increases will diminish the value of Visa’s stock repurchase program, meaning the share repurchases would have a lower positive effect on the growth in earnings per share. Yes, this is a small nitpick because Visa’s organic revenue and earnings growth has always been “the story” with this company—the buyback program is not central to Visa’s long-term returns.

All in all, Visa is a refreshing holding because it is one of the few companies out there delivering double-digit revenue growth in a way that investors can predict with high certainty ahead of time. Most companies I discuss here on the site have had a rough time growing revenues lately—and yes, there are ways around sluggish revenue growth that can make a company a successful investment. There’s something wonderful about owning a still decently valued company growing top-line revenues in the range of 12-16% annually. It’s the bedrock of forceful compounding.

I have been dialoguing with a reader who recently inherited 2,000 shares of Altria and 2,000 shares of Philip Morris International after her dad’s passing. Alongside the inheritance, she received the instruction from her dad, “Don’t sell either stock for the rest of your life.” The legality of the question isn’t worth exploring; courts generally don’t pay mind to the continuance of investments after they are distributed post-death, with the possible exception that some jurisdictions permit restrictions on selling ancestral family homes that have clear sentimental value and are intended for the use of multiple beneficiaries.

Of course, the social and psychological issue is much more fun to explore, anyway. The question I’d want to answer is this: Why do you think your dad gave you this instruction?

Without knowing much about your dad, I would hazard a guess that these two psychological forces are at play:

My first thought is this: when a stock is successful for a long enough time, it starts to take on a security blanket kind of appeal. Your dad has owned the best stock he could have purchased in the 20^th century. Nothing comes close to Altria’s 17% annual returns from the 1920s until the 2000s, and if you held the stock for longer than ten years—it doesn’t matter whether it was fifteen, twenty, or twenty-five years—he has trounced the S&P 500. When an asset takes care of you like that, why would you ever let it go?

The other reason why he probably gave you that warning? Cash flow. Once someone gets automatic cash flow as a meaningful component of their life story, it becomes addicting. You never want to let it go.

Have you heard the stories of what it was like in Winston, Salem, the headquarters of RJ Reynolds, during the heyday of the domestic tobacco industry?

In the 1920s, R.J. Reynolds created a Class A stock—known locally as anticipation stock—designed to put all voting power in the hands of the workers. It paid an extraordinary rich dividend: 10% of all profits in excess of $2.2 MM. Workers clamored for the new issue, and many used their salaries to buy all the Class A they could. The annual dividend payment became a kind of local holiday, a time local car dealers and luxury purveyors eagerly awaited. The story was told of a Winston Salem tyke who received a horde of presents on Christmas morning, only to begin weeping uncontrollably. He said he’d had his heart set on Class A stock.

What triggers the brain to cause a child to cry when he doesn’t receive Class A Reynolds stock as a Christmas present? At the other side of life, what triggered your dad to say “don’t sell the Altria or Philip Morris” stock as his final economic instruction to you?

It’s about the realization that your daily life is lived through the amount of cash you have in your bank account to pay for things, and investments that don’t pay dividends can only make you richer when you relinquish your ownership stake at a higher price. A cash-generating asset, meanwhile, has a much greater contributory effect as you go through life: it aids your cash flow every ninety days, and if you choose well, by a greater amount each year.

Let’s not even talk about Altria and Philip Morris International’s stock price. Let’s just discuss what they do as an ongoing matter for their owners. For most of 2014, Altria was paying $0.48 quarterly. Those 2,000 shares were yielding $3,840 per year. Those 2,000 shares of Philip Morris International typically were paying out a $0.94 quarterly dividend, giving you $7,520 in annual income.

Combined, those Altria and Philip Morris International shares have been averaging $11,360 in cash per year. That is $946 per month—I have no idea what your dad’s financial situation was like, but let’s pretend that was the “average American household” in that he brought in $53,000 per year, or $4,400 per month. That extra $900+ plus per month was a godsend. Because of his business ownership interests in Altria, he could have chosen live a spending life 15-25% above what he was earning just by selling his time for labor. That $900 per month is a permanent way to buy extra groceries, make the mortgage payment a little easier, or automatically build up a savings fund in a rainy day kind of spirit.

When people find themselves owning income-producing assets for a long time—it could be AT&T, ConocoPhillips, GlaxoSmithKline, BP, Royal Dutch Shell—there are a fair amount of them out there if you know where to look, they can see the immediate benefits of ownership in making life easier. They don’t have to sell the stock to benefit. They don’t have to stare at a stock screen all day praying it will go up so they can sell it and spend the proceeds on something in a one-time, never-again-to-be-repeated kind of way.

When your dad told you to never the sell the stock, it was likely him looking out for your long-term interests, rather than your immediate interests. Sometimes, when people get their hands on money, especially that they did not earn as a result of their own labor, they take the cash and spend it. A car gets bought, a vacation gets made, whatever. That decisionmaking is not wrong. It’s not evil. But it also does not make things easier for the future version of yourself decades down the line. When someone is trying to tell you to keep your hands on an income producing asset, they are trying to give you a gift that you will benefit from in 2014, 2015, 2016, 2017, 2018, 2019, 2020, 2021, and so on.

In June, I wrote this article titled “Just Not Worth It: Stay Away From American Realty” that expressed my concern about American Realty’s Chairman Nicholas Schorsch, who is the architect of the mega-growth American Realty Empire and once sought mega-compensation to the tune of $92 million for meeting what I consider to be low hurdles to receive significant chunks of the “incentive bonus” amount (things like deliver 7% annual returns while the dividend yield is above that amount).

He is one of those investment characters that I put into the category of the more I find out, the less I like. His nickname is “Slick Nick.” You don’t earn that nickname by volunteering extra shifts at the soup kitchen and giving until it hurts when the Sunday collection basket comes around. You find genteel REIT analysts saying things like, “Mr. Schorch is a charming man that plays loose with the facts”; that’s a Southern way of saying “That guy is a liar.”  Schorsch has made a lot of money by setting up broker-dealers to advertise both his traded and non-traded REITs to clients, and he collects a 1-3% fee (sometimes he has tried to double that). His philosophy seems to be “as long as I find a way to keep those dividends coming, I can do whatever I want behind the curtain.” His fee structures for non-traded REITs are so opaque that FINRA is debating new disclosure rules in response to his practices. He angered his investor base by promising that he wouldn’t issue new shares at $12 a piece (because he said that the company was worth much more than that), and he went out and issued new shares shortly thereafter.

These are the contextual things I have in mind when I heard about Brian Block and Lisa McAlister were at the forefront of an error that overstated a measure of profitability by $0.02 (according to the company, Block and McAlister made an honest error in the first quarter, and then massaged a few numbers in the second quarter to cover up their incompetence). It’s not the amount involved is substantial—after all, we’re talking about $23 million in the scope of an $8 billion operation.

Rather, it’s a culture of sloppy numbers—not that long ago, they claimed that a $1.5 billion deal would have $100 million in fees, and not until after critical hedge fund managers cried foul about the lasciviousness of it, did the American Realty executives say, “Whoops, we meant $10 million.”

Here’s the thing: If they are telling the truth, this would be a wonderful buying opportunity. Reinvesting a 11-12% dividend yield into shares of a stock that is trading at only 80% of reported book value is a formula for creating wealth. It is value investing. American Realty is a substantial landlord to gas stations, banks, drug stores. If that $0.0833 remains intact for the next few years, American Realty could be one of the best investments you’ll ever make in your life. The assets are real (Walgreen and Red Lobster do pay them rent!), but there is also a substantial debt burden as well (that’s why American Realty is able to do all these deals—they pay top dollar to make acquisitions, and finance it with debt that has low monthly payments).

If someone buys the stock in the name of value investing, I get it. The shares are extremely beaten down. If there are no new developments, this could likely be the stock price low. Collecting $1 per year in dividend income on a stock trading for $9 can turn into something substantial quickly if you reinvest along the way. Heck, I did something similar once before when I bought Bank of America at $7-$8 per share. So I get it.

But there are two Benjamin Graham rules that I take seriously when investing, and get treated like more than mere aphorisms—they are thoughts meant to be mulled over, again and again.

One of them is that you shouldn’t in anything that you don’t understand. That’s why my articles are generally limited to some of the largest and most visible companies in the world. I understand how Nestle makes a profit selling Toll house cookies. I understand how Fanta syrup converts to profits in Atlanta at Coca-Cola’s headquarters. I understand how refining and packaging petroleum makes Irving, Texas the home to what is normally the most profitable firm in the United States, ExxonMobil. I understand how selling Gillette razors for $10 each (which cost $0.50 to produce and ship), over and over again, makes Procter & Gamble shareholders rich.

When I study American Realty, I can’t figure out the company’s normalized cash flow. There’s been too many acquisitions in too short of a time for me to get a handle on anything resembling normalized profits. I see the $0.08333 dividend that gets paid out each month, and I can’t clearly identify the relationship between the debt deployed and the source of the cash flow. It’s regularly said that the triple net lease sector of the real estate market is the easiest stuff to understand, and even dummies can figure it out; well, for this particular company, I can’t.

The other thing is trust. Benjamin Graham once said that if you can’t trust the numbers, you automatically should remove that investment from consideration. After all, it is a study of the numbers that lead you to find an investment attractive in the first place—if you can’t have confidence in the numbers, you stay away. Some people have total faith now that Kay is CEO, and see the company’s self-disclosure about the accounting error as proof that internal controls are working. They see the extent of independent auditors checking the books, and confirming the revisions, and have total faith in the company. If that is you, then I understand why you would choose to invest in ARCP.

But that is not me. If I was an ARCP owner, I would not find it surprising to learn about excessive management compensation, tripped-up secondary share offerings, or other ambiguous fees coming to light. I don’t like Schorsch’s capital raising approach where he hires stockbrockers to recommend his products, and then, after the mom-and-pop customers pay a fee for buying the shares, the commissions get split between Schorsch and the broker. Real estate growth is funded through debt because you have to return 90% of your net income to keep your tax classification status as a real estate investment trust, and since you don’t have much retained earnings to grow—you access the capital markets. Schorsch has chosen to do it through kickback arrangements that seduce mom-and-pop investors via the veneer of a high dividend yield. When I hear the CEO Kay say, “Shares are so cheap we might sell assets to repurchase shares,” I can’t help but speculate, “No, you’re going to sell assets to raise cash to keep paying out the dividend because your cash flows are weak compared to the debt load, and you need to keep that dividend payment intact otherwise the price of the stock will crater.”

When you invest, I want you to have fun. I want you to collect $2,000 each year in Conoco, Exxon, and Chevron dividends that will grow to $4,000 in 2021 and $8,000 in 2028. I don’t want you opening the Wall Street Journal with one eye in the morning, waiting to see what American Realty investment is up to next. I recognize this is a complicated situation. Someone looking at the hard assets here, and the liquidated value of them, might hold his nose and buy here (on the other hand, there is so much debt, and so many secured creditors ahead of common stockholders, who knows?). I’m definitely not disclaiming the possibility shares of the stock will rise in coming years, and buying the stock today could be one of the best times to make a highly lucrative investment. I definitely recognize that possibility. For me, it’s a matter of not being able to predict what the regular cash flows are, and not being able to relate that to the debt and the dividend on a comparative basis. For me, it’s also about trust. When we buy stock, we are passive, absentee owners. We are trusting our hard-earned savings to the stewardship of someone else. I get why people have 99% of their wealth in Berkshire Hathaway—Warren Buffett and Charlie Munger are the kind of people that invite reliance. I don’t feel the same way about things run by Nicholas Schorsch. Do your homework and read the candid takes of what happened when he was forced out of running a REIT in Pennsylvania, and maybe you’ll agree.

Since 1900, there have been two sets of conditions in which it has been extraordinarily difficult to be a long-term, buy-and-hold investor. Those were the Great Depression conditions that surrounded 1973 (no duh), and the 1973 bear market in which the earnings of even great non-cyclical companies (think Pfizer, Johnson & Johnson, PepsiCo, Coca-Cola, Procter & Gamble) collapsed. 2008 is an honorable mention if you were an investor in the financial sector.

With many blue-chip stocks cutting their dividends in half and earnings falling by at least that much (and prices falling by 75% or more), you couldn’t assess the present fundamentals of the company and see that the prices were irrationally cheap—maybe in the narrow sense that you saw that the prices plummeted more than profits, but it had to be weird to see AT&T go from earning $4.88 per share to $2.8 per share, Procter & Gamble go from earning $3.25 per share to $1.79 per share, and so on. If that’s what the dominant firms were doing, you can guess how the rest of a stock portfolio might have fared.

In ’73, you saw corporate profits decline 25% across the board for most S&P 500 firms, presenting a milder case of the Great Depression where a portfolio containing 3M, Colgate-Palmolive, Procter & Gamble, Coca-Cola, Exxon, and Emerson Electric still got to see dividend increases throughout.

When I get asked about what the worst-case scenarios for blue-chip dividend investors can look like, that’s what I have in mind—dividend cuts and collapsing earnings that require you to think out to five, maybe even ten, years ahead to see the rebound in earnings power because the dividends being mailed to you are on the decline and when you checked out the annual report, you would see substantially lower reported profits.

Hard investing conditions require broad dividend cuts and a decline in profitability to match that.

I mention this because sometimes I wonder whether the general prosperity (from a stock market perspective) of the 1980s, 1990s, and parts of the 2000s have created false expectations for consistent linear growth in the 9-10% range and created a willingness for investors to ignore the inevitable fluctuations in the business cycle to discard otherwise excellent companies that aren’t perpetually performing to expectations.

You’re seeing investors nowadays talking about discarding McDonald’s and IBM from their portfolios because they don’t like McDonald’s stagnating store growth in the United States or IBM’s inability to grow its revenue. These aren’t difficult business conditions, relatively speaking. Heck, McDonald’s is growing earnings per share by 5% annually, and IBM is growing earnings per share by 7-9% annually. These businesses are growing the profits that each share earns, and you can see it right before your very eyes, and yet, there is a vocal minority of shareholders that are talking about liquidating their ownership positions.

If you get bothered by a business that is growing while we are in a generally upward moving market, you should reconsider your commitment to stocks. Seriously, if those facts bother you, what on earth would happen if a 1933 or 1973 condition showed up? The kind of person who gets worried and sells a McDonald’s or IBM position while they are growing profits per share is likely going to dump his holdings when real adversity—in terms of dividend cuts and collapsing earnings—show up sometime in the next few decades as is inevitably the case.

Maybe it would be good if you learn that stocks aren’t your thing, sell now while there is no real damage, and pursue a life in real estate or something that doesn’t contain frequent quotations because if the current business conditions are bothersome to you, what would you do when something truly terrible for your business holdings happens?

For the most part, you could live your entire life by only purchasing stocks headquartered in the United States without sacrificing anything in the process by avoiding international securities. Feel the need for Anheuser-Busch or Heineken? You’ll do just fine or better owning Brown Forman. Feel the need to own BP or Royal Dutch Shell? Things can work out awfully swell for you if you stuff your portfolio with Exxon, Conoco, and Chevron. Want to own GlaxoSmithKline? You can take care of business by owning Johnson & Johnson.

None of this is meant to rag on those international firms. They are excellent. As part of a conservative portfolio aimed at building and preserving wealth, they are excellent stocks for consideration in such a portfolio. My point, rather, is that for someone building a portfolio of 25 stocks with the intent of truly holding them undisturbed for 25+ years, you could receive comparable returns just by focusing on the American versions without sacrificing much of anything either in terms of growth or quality.

There is one company that is an exception: Swiss-based Nestle. It is probably the one company that is not located in the United States that rises to the point of being indispensable. It is of slightly higher quality than what you could get in the United States through Kraft or General Mills (although both of those companies are lifetime holdings in their own right) and offers a higher long-term growth rate because it has a more decentralized business model, has better management, and higher returns on equity that lead to better long-term wealth creation.

People don’t want to deal with surrendering part of their dividend to taxes if held in a retirement account, and they don’t want to deal with the fuss of tax credits of held in a regular taxable brokerage account. Those concerns are understandable, but it is causing those types of investors to miss out on owning one of the five best businesses in the entire world. It’s truly one of the few dozen places where you can say things like “I’m going to hold this stock for the rest of my life and do what I want with the dividends, then pass it on to my kid, and then hope she passes it on to her kids as well.” Do a search of all the products owned by Nestle, and you’ll see what I mean.

The dividend is only paid out annually, and due to currency conversions, doesn’t always go up, and this deters a lot of American investors from owning a great business.

You can see Nestle’s ADR dividend history here.

It is easy to get caught up in the peculiarities of the dividend—the fact that it is annual instead of quarterly, doesn’t grow linearly but does grow consistently if you think in rolling five year periods, and involves slightly more tax complexity than what you’d get from your plain vanilla American holdings—but the problem is that you miss on great wealth creation.

By 1991, it was the largest European foodmaker. It was no secret to anyone that Nestle was a dominant business that would be around for a long, long time to come.

Someone who sunk $25,000 into Nestle in 1991 would own shares worth $246,000 and have received $146,000 in total dividends. In exchange for letting your investment grow quietly for over two decades, you got to collect in cash over six times the amount of money you originally set aside to buy the stock. You could use the value of the stock to buy a nice house. The value of everything put together is rapidly approaching $400,000, making Nestle an investment that has increased your wealth 16x over the past two decades.

If you put it all back into Nestle, the results get even wilder. You’d have almost 5,200 shares of Nestle. In 2014, Nestle paid out a dividend of $2.42 per share. You would have received $12,584 in cash from your Nestle dividends alone this year, putting you across the 50% yield-on-cost mark. Half of the cash you set aside in 1991 would be sent your way as just a share of 2014’s cash profits. If you were still reinvesting, imagine the wealth machine you’d have steamrolling ahead, rolling into freshly created shares that would make your dividend check even larger next year.

This is why I like to focus on substance over the procedural. If you are interested in long-term investing, nothing is more important than getting the company right. Who wants to see quarterly dividend checks get reinvested into Wachovia year after year, only to see years—decades!—of hard work all disappear in the abyss of the financial crisis in 2008. If you park long-term capital into Nestle, there’s no question that you are getting the company right. I would hate to see someone buy a stock with a higher starting yield, a slightly less complex tax situation, or quarterly dividend payments, only to see that other company experience financial difficulties ten to fifteen years down the line. Nestle is so good at long-term growth, and of such high quality, that it is worth dealing with some moderate estate planning inconveniences when you step back and realize that it is going to be here half-a-century later chugging out dividends for its owners.

Although I generally limit my writing to companies I like and I choose to focus on ways to make money with them, I have occasionally commented on businesses that do not seem likely to be profitable many years from now or companies that have such a high valuation that either a significant fall in stock price is inevitable or it will take many years of growth before the stock price can advance from such a lofty base—with Amazon being a prime example.

Usually, when I mention something like that, I receive the question, “Well, if you don’t like Stock X, why don’t you short it?”

As far as I am concerned, shorting a stock is the exact opposite of dividend investing in a way that benefits get transformed into obligations. For most of 2014, Altria paid out a $0.48 quarterly dividend. If you become a part owner and intend to hold for the long haul, who cares what the price is? There is no urgency for anything to happen—in fact, if you truly understand that wealth gets built when you reinvest at lower prices, you would actually be comfortable with the stock price falling because the reinvested dividends gobble up new shares that will produce higher income, and because the cigarette-maker regularly repurchases its own stock, you actually benefit. And if the price of the stock increases, well, you may enjoy the comfort of knowing that if you decide to sell, you will be able to get more money from it.

The point is this: when you buy an ownership interest outright (which investment jargon calls a “long” position), you don’t need things to happen regarding the stock price. As long as the business grows, you will be rewarded with growing dividends along the way (this is especially true when you are investing in a company that has been raising dividends for 20+ years). And if a business grows at 10% annually, you will get total returns around that mark, provided your starting price was fair.

When you enter the world of short investing, you are introducing time as a crucial element to success. If, for whatever, you decided that Altria was only worth $25 per share and decided to bet against the company—you need that stock price to fall as quickly as possible to ensure your investment return.

Why? Because you have to cover the dividends. For every three months that pass, you’d have to pay out $0.48 each quarter. And worse yet (for someone owning a stock short), you would have to pay the advancing dividend out of your own pocket. Suddenly, you’ve put yourself in the position where are you responsible for $50 on every $1,000 you invest to pay out to shareholders as a tax on waiting for the company to come down to your price, and this “tax” grows with time if Altria continues to increase its dividend.

And then there is the matter of what is called “assess-ability.” Given me thirty seconds before you fall asleep. In the old days, some stocks (like American Express) were assessable and if you were an owner, you were required to occasionally make payments to the company itself if the Board deemed it necessary. S&P 500 companies don’t do that anymore—the worst case scenario is that your stock goes to $0. The consequence is this: the limit of your loss is what you put into the investment.

This limitation disappears when you enter the world of regular stock shorting. If Altria doubles its stock price, you double the amount you owe, without even factoring in the substantial dividend. If it triples in price, so does the amount you owe. And so on. Sure, there is a practical limit (the price of Altria won’t increase one-hundred fold in the next year), but there is no theoretical boundary. The stock you are shorting can always go a dollar higher, and increase your obligation by that amount.

I’m not saying it can’t be done—when you look at the early results of Warren Buffett’s partnership, you will see that he shorted one stock for about every ten to fifteen that he owned outright. On the other hand, he stopped doing that in Berkshire accounts, so maybe he realized that making good money with less risk and emotional hassle is its own reward. As for Munger, I couldn’t find enough details in his early accounts to determine whether he experimented with shorting, but later in his career, he said that he didn’t want to “participate in human misery”, and decided against shorting stocks on principle.

What had the greatest impression on me when I gave shorting stocks a fair chance to see if it made sense philosophically was this: I read about Lawrence Tisch, the legendary value investor and father of James Tisch who runs Loew’s, and how he began shorting the S&P 500 in 1997. He was correct—large American stocks were overvalued—but it wasn’t until 2000 that his prediction proved accurate. Because he was a high-profile investor, he had to endure similar criticism to what Buffett received—“here’s another old man not ready for the internet age.” I wouldn’t want to deal with the psychological headaches of waiting—needing—my theory to come true. “Needing things to happen now” does not strike me as compatible with stock-market investing, and so I choose to avoid it entirely.

Besides my own personal preferences, there are a few other reasons why I choose to devote this site to the selection of individual stocks for long-term ownership positions rather than long-term index investing. One of them is this: There are times when the collection of stocks that make up a particular index are overvalued, but you can find individual companies within the index that are not too expensive.

For instance, the historical median range for the S&P 500 is a valuation of 14.57x earnings. The historical mean range is 15.52x earnings. Even if you accept the premise that technological and individual productivity gains can justify slightly higher P/E ratios over time due to the implication that more cash can be extracted from the business (thus meriting the high valuations), we are still only talking about a justified shift towards a permanent 16-17x earnings range. Right now, the S&P trades at 19.64x profits. At a minimum, the average stock in the S&P 500 is 13% overvalued. At a maximum, using the historical median range, the average S&P 500 stock is currently 25% overpriced.

In short, at the moment of initiating a long-term investment, we want to avoid overpaying so we don’t inherit a 1966-1981 type of situation in which the average Dow Jones component returned -0.4% annually. It wasn’t that American businesses didn’t grow during that 15+ year stretch, but rather, the growth was soft in the low single digits and the average American stock was overpriced in 1966. Combine soft growth plus valuations with a negative margin of safety, and you end up going fifteen to sixteen years without realizing a gain on an investment. The wise selection of fairly valued or on sale blue-chip stocks can help you sidestep the fate of spending a third (or more) of your investing life without gaining anything.

What is interesting though is that there were some stocks during that stretch that an individual investor could have chosen that didn’t doom you to mediocre returns—heck, the old Philip Morris returned over 21% annually from 1966 through 1981.  Johnson & Johnson got you 8% annual returns over that time frame, Coca-Cola got you 7%, Procter & Gamble and Pepsi delivered around 6.5% over that time. The point? Even during times when the stock market is overvalued, there are still obvious blue-chip companies out there that can give you solid returns even if the rest of the market is expensive and companies in general are due for a slow-down in earnings (I say this with high S&P 500 P/Es in mind, and the fact that we have gone five years now without an economic recession in the business cycle).

So what can you buy today that is extraordinarily high quality, boasting a dividend yield above that of the S&P 500, and is not overvalued? To me, a lot of signals point towards Chevron, the second largest oil giant in the country based on San Ramon that currently has a $220 billion market capitalization.

The vastness of this oil giant is truly staggering. It produces 1.81 million barrels of oil and oil equivalents per day. It owns 7.1 billion barrels of oil in proven reserves, and has over 24 trillion cubic feet of natural gas in proven reserves as well. The most recent estimated value of its reserves is $176 billion. It pumps out about $20 billion in annual profits per year. To get a handle on its vastness, you could own the entire Clorox company for $13 billion. Every seven or eight months, Chevron pumps out enough profit to buy out The Clorox Company in its entirety.

It has $16 billion in cash on hand. During the absolute low of the financial crisis, this is a company that generated $10 billion in profit. It’s going to be around for a very, very long time. It has a AA credit rating, meaning there are only three companies in the United States that currently can boast better credit worthiness (Microsoft, Johnson & Johnson, and competitor ExxonMobil).

Viewed independently, the price of the stock has declined 13% since its July highs to currently sit at $117 per share. The current valuation is 10x earnings during a time of slightly weak oil prices. That catches my attention—this doesn’t mean Chevron is on sale, but it does mean that someone buying Chevron today will be buying one of the top twenty firms in the world at a fair price. From my vantage point, there’s nothing wrong with that, particularly when most other stocks are overvalued (for instance, in 2009, I would be more insistent that the stocks I’d purchase would be on sale, for 2014 I’d settle for buying something at fair price as long as the company was of extraordinarily high quality).

We’ve all heard that Warren Buffett quote about the preference for buying a wonderful company at a fair price rather than buying a fair company at a wonderful price. That’s one of those biblical investing quotes that deserves mulling over, again and again. Why would Buffett say something like that? It’s because of this: When you buy a company that is of decent quality at a wonderful price, your advantage is gone once the price rises to fair value. You then have the responsibility to get out of the stock at the right time, and if not, you will be setting yourself up for mediocre returns from the point the fair company reaches fair value onward. The wonderful company, meanwhile, constantly grows and grows. Profits in 2019 will be substantially higher than profits in 2014, and profits in 2024 will be much higher than profits in 2019. Fair value estimates are constantly being revised upward in light of new growth that gets reported. In other words, there is no obligation to leave your position: the longer you hang on to the stock, the more you get rewarded. This is especially true with a company that grows its dividend every year, like Chevron does.

Right now, you can get the stock for a yield between 3.50-3.75%, depending on the price fluctuation. You get double the initial yield of the S&P 500, plus an earnings per share growth and a dividend growth rate that is superior to the average S&P 500 company. Right now, it pays out a quarterly dividend of $1.07 per share. By my estimates, the quarterly dividend will rise to $1.15 per share next year. Imagine putting in a limit buy order for Chevron at $115 per share. If/when it gets executed, you would have an immediate dividend yield of 3.72%. If next year’s quarterly dividend hike is to $1.15 like I anticipate, you will be collecting 4% of your initial investment throughout the 2015 year.

What’s so great about that is you won’t be sacrificing future capital gains for yield. Imagine someone buying Altria right now. For most of its history, it’s been a deeply undervalued stock. Right now is one of the few times when the company is expensive. Yeah, you get a 4.19% yield from Altria right now, but you are losing something as well: The current P/E ratio of the stock is 22x earnings, and over the long-term, it will likely drift towards 15-17x earnings to reflect the risk inherent in volumes declining by 4% and the common-sensical observation that you don’t see people around smoking as much. That risk is not currently priced into the tobacco maker’s stock.

Chevron, meanwhile, has a historically high dividend yield right now. For comparison, during 2008 and 2009, Chevron average a dividend yield of 3.8%. The current yield of 3.6% or so isn’t much below the Recession-era price you could get on the stock. The year 2003 was the only time Chevron ever went a whole year yielding 4.0%. Otherwise, ever year from 1998 through 2014, the average yield was 2.7-3.5% (except for a brief period in 2010 when the stock yielded 3.6%). The current decline in the price of oil and other liquid chemicals has provided a fair value entry point for the stock.

Also, Chevron has the stated objective in its annual report of growing production by 20% between 2014 and 2017, with heavy projects in Australia and the Gulf of Mexico expecting to come on line in 2016 and start affecting bottom-line profits in 2017. To the extent that I can put on my Gretzky helmet and skate to where the puck will be rather than where it is now, I would anticipate significantly higher earnings and dividend payouts three to four years from now when the prices of commodities recover and Chevron’s heavy capital investments start coming to fruition.

The dividends have been growing at 9.5% annually for the past ten years. The payout has been increasing annually for three decades, making it one of only two energy firms in the world (the other being Exxon) that have the vastness of resources and the disciplined capital allocation strategies to keep giving owners more and more money each year, despite operating in an industry (commodities) that must endure significant fluctuations in the products being sold. The long-run total returns are impressive for this company, regardless of the long-term measuring period that you use: the ten-year returns for the stock are 13.13% annually, the twenty-year returns for the stock are 12.08% annually, the thirty-year returns for the stock are 13.27% annually, and the forty-year returns for the stock are 12.86% annually.

In the super short term (next few months to two years), I have no idea what Chevron stock will do. Oil prices could fall to $50 and the stock could fall to the $80s, or oil prices could mark a swift recovery and the price of the stock will be in the $150s before you know it. I offer no prediction for those interested in a short term trade. But, for those looking for safety, growing dividends, and possibly great total returns over the next five to twenty years, Chevron fits the bill.

If you’re in a position to reinvest, those high dividends that are growing have a sneaky way of boosting your income and total returns in a way that is not readily apparent from looking at a stock chart. From 1994 to 2004, investors in Chevron could have gotten a starting yield of 4.0% that grew at 8% annually for the next twenty years. That’s close enough to the conditions that exist today to be analogous. During the intervening twenty years, the price of the stock went up from $22 to $116. Nice. But if you reinvested, you also got 274% of your invested amount in the form of dividends. If you invested $100, you received $274 in dividends over those twenty years. If you invested $1,000, you collected $2,700 in dividends over the next twenty years. If you invested $10,000, you collected $27,000. You get it.

This means that, for those that reinvested, you doubled your share count over that period. Not only did you see each share increase in price from $22 to $116 over the twenty year period, but you doubled the amount of shares to your name that now trade for $116 each. That’s a heck of a boost to keep in mind. Your yield-on-cost would now be 36%, giving you $360 in annual dividend income on every $1,000 invested in Chevron twenty years ago.

A lot of times, the quote about buying a wonderful company at a fair price is used as a justification to buy an expensive stock when an investor lacks patience. Actually, that isn’t the worst strategy in the world, but you’re still forfeiting some of your potential capital gains to the extent that the stock is overvalued. In the case of Chevron, you are getting a fair deal when you buy today. You won’t have a margin of safety in terms of price, but you won’t be forfeiting anything either. You’ll be achieving total returns that mirror the growth of the business plus the dividends paid out. Given the high-quality of Chevron’s business, and given the expensiveness of everything else, that catches my attention. For someone looking to deploy a large sum of capital in something that is safe, has a yield twice the S&P 500, is slated to grow, and isn’t overpriced, Chevron seems like a very attractive candidate for “buy it and forget it” investing right now.

When John Bogle ran his regular “Ask Jack” column, he addressed a reader question about portfolio rebalancing and mentioned that he didn’t engage in the practice himself, and offered this data to readers:

Hi, Mr. M,

Sorry it’s taken me so long to respond to your thoughtful note.  Busy!

We’ve just done a study for the NYTimes on rebalancing, so the subject is fresh in my mind.  Fact: a 48%S&P 500, 16% small cap, 16% international, and 20% bond index, over the past 20 years, earned a 9.49% annual return without rebalancing and a 9.71% return if rebalanced annually.  That’s worth describing as “noise,” and suggests that formulaic rebalancing with precision is not necessary.

We also did an earlier study of all 25-year periods beginning in 1826 (!), using a 50/50 US stock/bond portfolio, and found that annual rebalancing won in 52% of the 179 periods.  Also, it seems to me, noise.  Interestingly, failing to rebalance never cost more than about 50 basis points, but when that failure added return, the gains were often in the 200-300 basis point range; i.e., doing nothing has lost small but it has won big.  (I’m asking my good right arm, Kevin, to send the detailed data to you.)

My personal conclusion.  Rebalancing is a personal choice, not a choice that statistics can validate.  There’s certainly nothing the matter with doing it (although I don’t do it myself), but also no reason to slavishly worry about small changes in the equity ratio.  Maybe, for example, if your 50% equity position grew to, say, 55% or 60%.

In candor, I should add that I see no circumstance under which rebalancing through an adviser charging 1% could possibly add value.

Use your own judgment, but perhaps these comments will help.

Best,
Jack

I can relate to Bogle’s logic. If your investment in Coca-Cola, Nestle, or ExxonMobil triples in twelve years, it’s hard for me to appreciate the logic that selling 20% of the stock and putting it into a second-tier holding is some kind of victory that merits applause for intelligent risk management.

The Pareto Principle seems to apply to all areas of life—if you own 25 stocks for twenty-five years—you’ll probably be able to pinpoint five or so investments you made that advanced you towards your goals a whole lot more than the others. And if a particular investment does well from 2014 through 2039, then it shouldn’t be terribly shocking if it had appreciated significantly by 2019, 2024, 2029, and so on.

Maybe I’m biased because of the anecdotal stories I hear from readers who say “Man, I wish I didn’t sell that Altria and Conoco back in the day” or “I once sold Disney stock because I thought VHS movies would get replaced, can you believe that?”

Take a look at this list of the original “Nifty Fifty” stocks. Those blue-chip companies held up much better than someone would realize just by taking a cursory look at the names and guesstimating about whether they still exist (e.g. Lubrizol got purchased for a lot of money by Berkshire Hathaway, Schlitz Brewing got purchased for a lot of money by the Stroh Brewing family, Sears Roebuck had all these spinoffs like Discover and Allstate that built wealth on their own, etc.).

Unless you’re old and have like 50% of your wealth in one stock or something extreme that suggests that you wouldn’t be able to diversify away from relying on 2-3 stocks just by deploying the dividends elsewhere and making fresh cash investments from your job elsewhere, I think the best way to rebalance is to divert dividends elsewhere.

If you are middle-aged and have 25% of your portfolio in Chevron, you can dilute the effect of your Chevron holding by letting the other 75% of your portfolio automatically reinvest and grow, and then taking your Chevron dividends to put elsewhere. And boy, will Chevron give you a chance to make new investments elsewhere: the company has paid out $17.55 in cash dividends for every share that you held from 2010 through 2014. If you were sitting on 2,000 shares of Chevron, you got $35,100 in cash that you could deploy elsewhere to gradually make new investments.

The reason why I came to this conclusion is this: (1) I do like the general principle that diversification seeks to promote. You don’t want failure at two or three businesses to have an outsized negative influence on your quality of life. But I have a competing interest to satisfy: (2) I want to keep solid investments intact. If I own a superior business, I don’t want to relinquish it just because, well, it’s been so successful. Diverting dividends is a gradual process to rebalancing (which can be sped up if you have a high savings rate from your job of new cash to add to your portfolio) that lets you increase your revenue streams without ever having to actually give something up that you might be kicking yourself for later.