This post is the Part II of a two-part series. Click here to read Part I.
Mr. Buffett’s BERKY (Berkshire Hathaway is Mr. Buffett’s Berky, for those of you who are just tuning in) gets its cash flow from businesses Mr. Buffett owns.
[I know that the cash comes from businesses that Berkshire Hathaway owns, but I’m setting this up as an analogy, so bear with me.]
The guys who run those businesses are well compensated for passing up the excess cash to Mr. Buffett’s Berky. In order to set the game up so that they will send him the cash, Mr. Buffett put his CEO’s on a compensation system that rewards high return on equity (ROE).
[NOTE: Or high return on Capital, which is a bit different. For the purposes of this post, it works better that we stick with ROE rather than ROIC, even though ROIC is better in the real business world.]
Because of the way Mr. Buffett set up compensation and rewards, the more cash his CEO’s get off their books (by sending it on up to the Berky), the lower the denominator that they are using to divide into their earnings to get ROE... thus the higher the ROE.
Good system. Keeps everyone working toward the same goal -- well run businesses and lots of cash to the Berky.
You can do this, too.Step 1: Set up Your Berky
Treat your job like a business that is owned by a brilliant investor. You. And you, just like Mr. Buffett, have a Berky. Yours just happens to be a self-directed IRA Berky, but it could be any sort of investment vehicle/account. You, like Buffett, are in the game to be a consumer of investments, and the Berky is your cash machine that is going to feed you cash that you can consume by buying investments.Step 2: Set up Your Company... and Calculate its Equity
Now let’s get your company working to fill the Berky. Let’s call the company you are running YOU INC. YOU INC is not the Berky. The Berky is the place that YOU INC is going to send money. You are going to use the Berky to consume investments. Keep this straight in your head!
YOU INC gets revenues (from your income) and has expenses (from your cost of living). What’s left over each week/month/quarter/year is YOU INC. earnings. Up to now, YOU INC has used these earnings over the years to buy stuff.
We’re going to call that stuff assets.
What you have there is the value of the YOU INC assets.
The value of what you actually own is called your equity.Step 3: Maximize Your ROE
Return on Equity, ROE, is the YOU INC earnings divided by the YOU INC equity.
In this case, the YOU INC ROE is 10%.
Now notice something important: If YOU INC only has $50,000 of equity and earnings of $10,000, then YOU INC ROE is 20%.
Notice that the lower your equity, the higher your ROE.
If you want high ROE, then you want your YOU INC equity to be as low as is reasonable and still have a good YOU INC.
So here we are, trying to get a higher ROE, and here comes the next paycheck. Out goes money for food and clothing. If we spend it all, we’ve sort of solved the problem. No increase in equity.
On the other
hand, the person who owns YOU INC and has the Berky that YOU INC is
supposed to send money to -- that guy isn’t happy, because there is no
money coming into the Berky. We spent it all.
If there is no money coming into the Berky, then there is no money for the Berky to consume. Oh. So consuming the money at the YOU INC level is a bad idea, while consuming it at the Berky level is a good idea.
Si. You got it, mon.
But also notice that the more cash YOU INC hangs on to by not spending it, the more the YOU INC equity increases... because one of the YOU INC assets is a bank account.
And, assuming your salary remains the same, the more this equity increases, the more YOU INC ROE DECREASES!
YOU INC saves the cash for a rainy day. Great. But what happens if you are being judged by how high your ROE is?Why Do You Need a High ROE?
Because a low ROE means you get fired by the guy running the Berky -- unless you can explain really well why you needed all that excess cash on hand to run YOU INC.
Getting fired is not good. We do not want to get fired from our own life. How can we keep the owner happy? By making sure YOU INC can’t hoard cash and spend it unnecessarily. Key word, that.
Think of the Berky as a special account. Unlike the YOU INC bank account, it does not get included in your assets (For the sake of our story. Do not let your accountant write me letters telling me I’m stupid).
Sending money to the Berky is as if you sent the money somewhere outside of your control. In that sense, it's like your own personal Berkshire Hathaway that you are sending the money on to (which is why I’m calling it a Berky in the first place).
The money/investments in your Berky are not going to be included in
your assets; that’s money that your business sent on up to the
genius doing the investing. That money is no longer under the control of YOU
INC. It's Berky money now, earmarked for consuming businesses.
YOU INC still has to have positive earnings, or you go broke. But obviously the more you can send into the Berky account, the smaller the assets and the bigger the ROE.
The bigger the ROE, the better the job
you are doing as an investor.
Imagine that you sell a couch and send the $400 on up into the Berky. You just removed an asset, so your YOU INC equity went down and your ROE went up.
The next month you let your friend pick up the check for dinner. You send the $200 you would have spent on up to the Berky. Your ROE just went up.
Keep doing that. Soon, you will have quite a little pile in the Berky.
Now you invest it. But you invest it knowing that the Berky is not going to stay empty. It's going to keep getting refilled. Every week, every month, every quarter it gets filled with more money that you are sending up from your business, YOU INC.
So now you buy Garmin at $43 and it goes down to $10 six months later.
You love Garmin at $43. Heck, you loved it at $90. Now it's at $10. But the Berky has been refilled since you bought Garmin at $43. So you buy more at $10. Same amount of money buys 4 times the amount of stock. Cool.
Let’s assume that you started with $10,000. You bought GRMN at $43. You got 232 shares. Now, assuming Garmin is worth say, $100, you had 232 shares worth $23,200.
Now, six months later, you reloaded the Berky with another $10,000 from good old YOU INC, but GRMN went to $10.
Now, because you have a Berky, you are a consumer of stocks. You WANT the price to go down so you can consume more!
GARMIN IS AT $10!!!! You are so happy. Now you can buy 1000 shares of GRMN instead of just 232. This is awesome. This is fantastic. You are jumping around the room because GRMN IS STILL WORTH $100.
Now you have invested $20,000 and have 1232 shares worth $123,000 instead of having 464 shares worth $46,400. Because GRMN went down to $10, you are getting rich!
Is this not brilliant? This is Buffett. And this is what made him billions.
And this is how you can get rich, too. It's not trading. It's long term and it's a different way to see things, but it works and it might be just the thing you should be doing, and just the way you should be thinking about investing.
But you have to do the homework. Do the 4Ms. Know your business and then go ahead.
Now go play.