Garrett, one of our key contributors, has been getting bombarded about cash flow so I decided to take a load off his shoulders and do a series showing how to create cash flow with Rule #1 stocks.
The secret to creating cash flow with long term investments is to reduce basis. Basis is the amount of money we have in the investment at any given time. Rule #1 strategy requires that we buy a business when its on sale. That means we've purchased it below its value. By doing so we expect that some day soon Mr. Market will reprice our investment to near its value and our basis will instantly be half of its selling price. That's the first level of protection and the beginning of creating a great cash flow.
The next step is to further reduce the basis over time. This is done with DIVs (dividends), DERs (derivatives) and BBs (buybacks). Of these, the BBs are the simplest since we have nothing we have to do to get the benefit except buy the right company with the right kind of CEO.
BBs
Buybacks are one way a CEO can get rid of excess capital - she can invest it by buying back stock from current investors at the market price. This is a great allocation of capital if the stock is selling at a discount to its value. Here's why: Let's say the value of the lemonade stand is $100 and there are 100 shares of stock owned by 5 people, 20 shares each. Each of those shares has a value of $1 but the market for lemonade stands is depressed and the shares are offered for only $0.50. If the CEO has an extra $20 she can try to invest that in a way that produces a 20% Return on Equity by expanding the business or, in this case, she can just buy back some stock and get the same result without all the work. She pays $0.50 per share with $20 and buys back 40 shares. Now the company only has 60 shares left and now is worth only $80 (since $20 cash is gone to pay for the stock). After the buy back, each share of stock has a value of $1.33 (80/60). That means the shareholders who didn't sell saw the value of their stock go up from $1 per share to $1.33 per share overnight. That's an instant 33% return for them. That's a much better use of the $20 than trying to make 20% on it. And from now on the earnings of the company will only be divided up among 60 shares instead of 100 so each share will earn much more every year. Buybacks when done right are create instant great returns for the remaining shareholders.
You should be able to see how the opposite is also true. A CEO who buys back stock when Mr. Market is pricing it too high is ripping off the remaining shareholders big time. Let's say the market is pricing our lemonade stand at 2 times its value, $200. Each share is selling for $2. Its still worth only $100. The CEO has $20 and buys back stock - 10 shares. The remaining shareholders have 90 shares for a company that is now worth $80. Now each share is only worth $0.89 (80/90). He's managed to change each shareholder's stake by -11% instead of growing their investment.
Its a waste of shareholder equity and the sign of a mercenary turning traitor if a buy back is done when the stock is selling above its value. Assuming we have an owner-oriented CEO who knows when and when not to buy back stock, what will happen over time is that the buy backs will increase our ownership of the business. This decreases our basis in the sense that we now have a higher stock price per share than we would have had otherwise. But it also decreases our basis another way:
DIVs
It increases our dividend (assuming the company is paying one). A dividend is a payout by the company to the owners, us. Theoretically its a payout of excess capital - that is, capital the CEO doesn't need for day to day operations or future growth. Its just sitting there doing nothing except lowering his Return on Equity so he wants to get rid of it by sending it back to the owners. The dividend reduces our basis because we've gotten cash back in our pocket from the investment. If I put in $1 and get back 5 payments of $0.20 each, I don't have a dollar in that investment anymore. I have the $1 back in my pocket. Done properly, dividends can alter Basis in amazing ways.
More on this key aspect of Rule #1 investing next time.
Now go play.
