Financial Freedom: The Accelerated Version

Achieving Financial FreedomThere are only a few essential steps to achieving financial freedom, yet most people do not take them.

This article is going to cover the basics on how to get there, but is also going to focus on one key change in mindset.

Essentially, most of the financial basics will allow you to be financially free in a couple decades or less. To accelerate that timeline, there’s one more kick you can use.

Master this, and you’re set.

What is Financial Freedom?

Being free, financially, means you have enough passive income to support your lifestyle. It could be a frugal lifestyle or a wealthy one; all that matters is that you can maintain it without working.

But an important note is that you can still be working and be financially free, you just don’t have to. Once you don’t need your job anymore, you can still work at it for extra income, and for enrichment. For example, there are physicians on my dividend newsletter. After all that medical school and residency, you can bet they don’t want to retire within 10 years! But they do of course want to be well off and live on their own terms.

Simple math shows that if you have a million dollars (which isn’t all that hard to get), and you extract 4% of it per year (via dividends, rent income, interest, capital gains) and it replenishes itself with better than 4% returns, then you can generate $40,000 in annual income, passively and forever. To get $80,000 instead, you’ll need two million dollars. So if your lifestyle is frugal, you can get by with less than a million saved and invested. For a more luxurious one, you’ll need a few million before you’re financially free.

Therefore, the definition of perpetual financial freedom is that your investments provide you with enough passive income to pay all of your expenses, and this passive income grows at a rate that equals or exceeds the rate of inflation. You never have to touch principle.

So let’s view it as a few different steps:

Step 1) Not Financially Free
You need a job to keep paying your bills. You may have an emergency fund and investments, but basically, your net worth will start decreasing if you lose your job and you can only maintain unemployment for so long.

Step 2) Partially Free
You have a very large pot of savings and investments. Not enough to pay your bills perpetually, but quite a bit. In addition, you have an alternative income stream. If you lost your job, you could keep working for yourself if you had to. Or, you already work for yourself, but you’ve got to keep hustling.

Step 3) Completely Free
You have that million or several million dollar portfolio, meaning that you can extract income from dozens or hundreds of sources to pay your bills, and you never need to work again if you don’t want to. You should still grow yourself and keep your skills relevant, but it’s all for fun at this point. Your wealth should actually grow over time, passively, even if you don’t actively contribute to it anymore.

The Three Variables

Across the full spectrum, from Warren Buffett to a minimum wage worker, wealth folds down to only three variables: income, expenses, and the rate of return on the difference.

Variable 1: Income
To optimize this variable, you either invest in specific types of education to become a highly paid professional, perform excellently at work and get promotions, start your own business that can scale hugely, or build a side income stream onto your existing day job.

Variable 2: Expenses
Optimizing expenses means minimizing them. There are some big wins here, like living in a modest house rather than a large one, keeping costs on automobiles low, living around a good public school system so you can send your kids there rather than to private schools, and traveling smartly rather than falling for tourist traps. Other wins include cutting energy costs, forming healthy habits to avoid unnecessary medical expenses, becoming hands-on around the house or with the car, etc.

Variable 3: Rate of Return
When your income is higher than your expenses, you can save and invest the difference. When this sum of money compounds over years and decades, the exponential rate of return is very meaningful. Someone who sticks to cash and gold won’t have much compounding ability. Likewise, someone who gets into bad habits with stocks and sells out of fear during market bottoms won’t have much compounding ability. The person who invests for the long term in index funds or value stocks has a good system for long-term wealth accumulation. If you take $100,000 and invest it at 6% per year, you only have $320,000 after 20 years. However, if you take the same $100,000 and invest it at 10% per year, you have over $670,000. More than twice as much.

The Basics (You Know These):

To be above average in terms of wealth, there are a series of steps that should be common sense, but generally are not all that common. Let’s get these out of the way before getting to the main point:

Start early.
Try to mitigate student debt by getting a job early and getting scholarships. If you don’t go to college, then obtain a skill set that leads to good work.

Learn the money basics.
Financial education is woefully inadequate in most places. In school you’ll typically learn how to dissect an animal, but not learn almost anything about above-average money management. So you’ll have to step out on your own on this one.

Read Millionaire Teacher, by Andrew Hallam. I’ve communicated with him, and he’s the real deal- an English teacher that became a millionaire in his 30’s through common sense. The book is concise, funny, and useful for a beginner. Regardless of your experience level it’s a solid read, and makes a compelling case for index funds. (This makes an excellent gift for a young adult, or anyone that isn’t particularly interested in picking stocks.)

If you ever invest in an individual stock, go to Berkshire Hathway’s website, and read the annual shareholder letters that Warren Buffett has written. The most successful investor in the world doesn’t write books; he writes annual letters to his investors.

And check out the tutorials on Dividend Stocks, the Dividend Discount Model, and Margins of Safety if you’re planning on ever picking individual stocks. And if you want the complete method, get the Dividend Toolkit.

Earn a good job.
If financial freedom and wealth are valuable to you, it’s key to get a job that pays well. The sciences, engineering, business, or professional paths (doctor, lawyer) are good bets and can be passionate and rewarding careers.

Picking other majors is fine, as long as you keep one thing in mind: college is for exploring but it shouldn’t be aimless, isn’t for everyone, and isn’t something just to do for $100k in student debt. Get a degree for a reason. If you have a job you love that pays moderately well, you can still achieve financial freedom rather quickly. Along these lines, if you enter the workforce without a degree but with an economically useful skill set or your own business, then you can be well-set for a wealthy future by making that a goal.

Learn marketing.
I’m not necessarily talking commercials and sales here; I’m talking persuasion. A fundamental lifelong ability of a top performer is the ability to persuade, motivate, inspire, and guide people to do things.

-Market yourself to a job interviewer. Turn the situation into one where you’re interviewing the company to see if they’re a good fit for you, not the other way around.

-Persuade your supervisor or client to go with your idea. Whether you’re an engineer, business person, lawyer, or anything in between, it’s a fundamentally useful skill to be able to explain your truths concisely and persuasively.

-Use your talents for entrepreneurship, charity, politics, social services, or whatever it is that piques your interest.

Spend less than you earn.
It shouldn’t have to be said, but you need to save a lot of money in order to become financially free. Don’t buy things for show, don’t tie your happiness to your material stuff.

“Give me health and a day, and I’ll make the pomp of Emperors ridiculous.”

-Ralph Waldo Emerson

That’s the one quote I put in the Toolkit. I’ve been asked before what he meant by that as though it’s esoteric, but the man is literally talking about playing around in the forest.

He’s saying go play with your kids, go for a hike, go for a run on the beach, take your significant other out mini golfing, teach yourself a new skill this week, go to the library and read a good book, help out with a charity event, play a sport.

For most people, income is viewed as the amount of money that can be spent. After bills and some basic retirement payments, all the rest is consumed! It’s a constant treadmill of consumerism and work for probably 90+% of people out there.

That doesn’t have to be you if you don’t want it to be. Spend what you need and want, but everything else is a resource. You’re not a person without a plan, where you just spend whatever you get after putting a little bit away. Instead, you know that you can save it up for an awesome opportunity years from now, or retire early, or become financially free. Play chess with your money, not checkers.

Don’t accumulate debt.
Student debt and mortgage debt = acceptable.

Credit card debt = of course not. Pay off your credit cards each month so you pay zero interest.

Save money in the right places.
-Contribute enough to your employer’s 401(k) plan to get full matching.
-Have a large cushion of cash set aside.
-If you’re under the income limit, consider contributing to an IRA.
-Then either put more into your 401(k), or start investing in a taxable account.

Diversify across cash, bonds, equities, and maybe real estate.

Another Key to Achieving Financial Freedom

If you follow those steps, you’ll do okay. You’ll make good money, save a lot of it, get a good rate of return that allows you to be financially comfortable, and eventually financially free, ahead of the curve.

But if you want to kick it up a notch, and it doesn’t matter how old you currently are, here’s another main thing:

Transform your passion from consumption to production.

What I mean by this, is to build or obtain a side income stream. Over the last century or so, developed societies have organized themselves around specialization. People get specialized in one professional area, and then focus on that. If something changes, and they’re no longer needed for that skill, they often don’t know what to do. Industrialization changed the game and led to specialization, and now globalization is changing the game again and highlighting the importance of flexibility.

It’s important to get really good at something. But it’s equally important to be a skilled generalist on the side.

If you have a career that required a very large investment of time and education, requires long hours, and pays very well (lawyer, doctor, executive, chief scientist, business owner), then a second income stream is less relevant. With that scenario, it usually makes more sense to reinvest time into your core work. But if you’ve got another type of job, like an engineer, manager, analyst, tradesman, or another profession, then you likely have a solid paycheck but also ample time on the side. These are good candidates for growing other income streams.

The Simple Math Behind a Second Income Stream

Let’s say you take home $75k after taxes, and spend $50k of it for expenses on yourself and your family. This leaves $25k for saving and investing each year.

Now, let’s say you find a way to add a $25k side income stream to that, after taxes. Now you’re pulling in an extra $25k net, for $100k total net income. If you keep your expenses the same, then you’ll be able to save and invest that entire extra $25k.

What this means is that your income only increased 33% ($75k to $100k), but your savings amount increased 100% ($25k to $50k). So bringing in that manageable extra income doubled your savings amount and essentially halved the amount of time it will take to achieve financial freedom if you keep this up for a while. Depending on how scalable and effective your income stream is, you could eventually even use it to launch full time into entrepreneurship.

How to Not Burn Out

It’s all a matter of habit forming.

What I’m not recommending is that you work 40 hours at your job and then work for another 20-40 hours a week at something you’re not necessarily fond of, and sacrifice your health, social life, and sanity to do it. The ironic thing about civilization is that we built up all this technology and organization, and yet we work more and have less free time than some hunter-gatherer cultures. So the last thing I’d want to recommend is to be a workaholic above and beyond what most people are.

Instead, the trick is to enjoy that side income stream.

After work and family, most people’s free time consists of television, shopping, aimlessly surfing the internet, and a couple hobbies. I certainly can identify areas in my own days that are not very productive. If you take a chunk of that- not all of it, just a chunk- and convert it from consumption to production, then your life can be richer both literally and metaphorically.

When you’re looking back at your life 10, 20, or 30 years from now, you’re not going to be sad that you missed a few shows or spent less time online or didn’t buy that widget you wanted. The things you’ll find important are: a) that you spent time with family and friends doing fun things and b) that you achieved something different, interesting, and worthwhile.

Here are some examples:

-In my state, volunteer firefighters don’t get paid anything. But in my friend’s state, he works as a part time firefighter in addition to his regular engineering job.

-A co-worker of mine who works as an engineer by day, spent some nights driving emergency vehicles. He doesn’t even need the money anymore, but does it because he loves it.

-Some people start unique business ideas. It doesn’t have to be some venture-capital backed plan to rival Facebook; it just has to be something that you enjoy that can bring in four or five figures or more per year, eventually.

-People have had success making high-quality crafts that they can sell on Etsy or in other places.

-A software engineer does some app design or freelance programming on projects that interest her on certain weeknights and weekends.

-Real estate is a common side business. Buying rental properties or fixing up houses for resale can be lucrative methods for building wealth and generating cash flow if you build a good system for it.

-Maybe you have a useful skill, like playing an instrument or performing well on standardized tests. You can turn this into a tutoring business, or teach some small group classes.

-I’ve had success with both freelancing financial writing for larger sites, and financial writing for this site.

The key here is that the hobby itself is production rather than consumption. Rather than viewing this extra income source as a burden, it’s fun. Even if that means leaving some money on the table- the whole point is fulfillment, not just dollars and numbers.

There are 168 hours in a week. A typical person might spend it as follows:

Unproductive Week

So we’ve got 8 hours/day for sleep, a 45 hour workweek (assuming roughly 9 hours a day, five days a week), a solid 4 hours/day for family or friends, 18 hours of random time per week (web surfing, tv watching, hobbies, gym, random stuff, and this could involve family/friends as well), and 3 hours/day of maintenance, which primarily consists of the frictional and necessary stuff: commuting to work, showering, brushing teeth, cooking, going to the doctor, paying bills, shoveling snow from your drive way, getting dressed in the morning, figuring out what’s wrong with your car, etc.

But if you can improve that, you can turn it into something like this:

Financial Freedom Example

There’s the same amount of sleep, work, and time for family and friends, but a few other things have been optimized.

First, less time in general was spent on random stuff: fewer tv shows, fewer video games, less web surfing, and so forth.

Second, some things have been mixed to optimize them. It’s the accumulation of a few “productivity hacks” or changes in how things are viewed. Here are some examples:

-Maybe preparing and eating dinner previously was in the maintenance category, but now you view it as family and friend time because you cook a high quality meal with your significant other, or friends, or parents/kids. You use it as a time to improve your knowledge of cooking, to create a real meal.

-Let’s say a hobby of yours is reading, and you also have a 45 minute commute to work. You can optimize this a bit by listening to audio books as you drive instead of music or a talk show. Because it’s the same path every day, you know it by heart and don’t have to worry about directions; you just have to be an observant and safe driver on a path you know like the back of your hand. I wouldn’t recommend a particularly heavy read, but if it’s a light read, this can work. Now, you’ve combined some hobby time and some maintenance time.

-You got in the habit of getting out of bed within 3 minutes of your alarm clock going off, when it used to take 20 minutes through numerous snooze attempts. Those 20 minutes were neither restful sleep nor productive time, and added up to 2 hours and 20 minutes per week or over 120 hours per year. So they were cut out.

-Maybe your ‘production time’ for building a side income involves your husband, wife, or partner, so it’s a joint effort where you’re spending time focusing on making something happen.

By optimizing the example week, 18 hours of productive time were added into the week, which is more than enough time to create a fun and lucrative side income stream to achieve financial freedom.

For example, if your earning power for this side income stream is only $10/hour, you’re still looking at $180/week, $720/month, or $9,360/year of gross side income.

If you can boost that to $25/hour, now you’re looking at $450/week, $1,800/month, or $23,400/year of gross side income.

For some people, there could be a skill that you can scale rather well, or that is nuanced enough that you can charge more for. If you can get $75/hour, then you’ve got a solid $70,200 per year with 18 hours a week of work on something you enjoy.

The details of how you can work your week will vary based on your age, responsibilities, job, partnership status, children, and so forth. But there’s almost certainly a way that you can increase productive time while also enjoying the week more.

The Takeaway

This method is so powerful because it figuratively kills two birds with one stone.

When offered the basic advice to wealth and financial freedom of “earning more, and spending less”, that sounds boring to people. It is generally thought of as a sacrifice, because people want to do things, and they’re being told to do fewer things, or cheaper things.

But by growing a side income as a fun hobby, you’re simultaneously boosting your income and savings rate, and reducing your consumption. Your reason to spend less on a car or television or random stuff, is not that you need to sacrifice and cut back, but rather, that you change your perspective and view many of these things as time sinks that get in the way of doing more interesting things.

In most of our minds, productive things produce money, and unproductive things do not.

However, the definition I personally use for “productive” is that it is something that as an old man, I’ll look back as being happy I did. So getting enough healthy sleep, getting enough exercise, spending time with people, investing in myself through books, watching my favorite movies, working a good job, using free time for enriching or relaxing activities, and producing value for other people to generate extra income, are all productive.

Things that are generally not productive are excessive television, excessive video games, random web surfing, and unproductive maintenance time.

So if you want to achieve financial freedom earlier, while enjoying everything in your week to a more thorough degree, consider building a side income stream that you enjoy and that allows you to boost your savings amount by 50%, 100%, or more.

photo credit: esther

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The Fiscal Cliff and its Impact to your Portfolio

Top Dividend StocksNow that the U.S. election is over, the “Fiscal Cliff” dominates American news.

This article provides a quantitative overview of the American economy as it relates to this event, a bearish (but constructive) outlook for your portfolio, and an example of some potentially good stocks to buy and personal finance decisions to take.

What is the Fiscal Cliff?

The ‘Fiscal Cliff’ refers to an upcoming simultaneous set of events at the start of 2013 where taxes will go up on just about everyone and large and disorganized across-the-board federal spending cuts will kick in. Lawmakers from both the Republican and Democratic parties publicly wish to avert this, but are locked in gridlock on how to address it and stop it from occurring. If Congress does nothing, the Fiscal Cliff happens, because the various laws are already in place to expire. To avoid it, Congress and the President would have to agree on a delay or a real solution.

Here’s a breakdown of the main events that would occur:

Bush Tax Cuts Expire
The tax cuts enacted during Bush’s presidency will expire, which means income tax rates across all brackets will go back up to where they were a decade ago, and capital gains and dividend taxes will go back up to where they were a decade ago. This affects everyone, but it has a larger impact on wealthier citizens, because capital gains taxes would revert back to 20% from the current position of 15%, and dividend taxes would revert back to your ordinary income tax rate (up to around 40% in the highest tax bracket) from the current low point of 15%. The estate tax exemption would shrink as well. The expiration of the Bush tax cuts is the single largest part of the Fiscal Cliff, accounting for over a third of the total changes.

Obama Tax Cuts Expire
There were tax cuts enacted during Obama’s first term that reduced payroll taxes for the middle class. These would expire at the same time. This is another large part of the Fiscal Cliff.

Back in 2011, the United States Congress imposed a crisis on itself by potentially refusing to increase the debt ceiling unless actions were taken to reduce the deficit. Ultimately, no real compromise was agreed on by the Republicans and Democrats, and so their last-moment decision was to give themselves more time. The debt ceiling was allowed to go up to avoid a government shutdown, but $110 billion per year in across-the-board cuts to discretionary spending were agreed upon to occur unless the deficit could be reduced in the meantime, split evenly between defense and non-defense spending.

Neither party actually wanted these cuts to occur: they picked cuts that neither party wants to occur in order to make compromise desirable to avoid them. Republicans as a group don’t want defense cuts, and Democrats as a group don’t want these non-defense cuts. Even those that do want to cut both of those things generally agree that these particular cuts are undesirable due to how sloppy they are. Rather than targeted elimination of wasteful spending, they’re across-the-board cuts that were determined in the final hours of an agreement. The discretionary defense spending consists of various projects, but the specific projects to cut are not known. The discretionary non-defense spending consists of various cuts to organizations such as the Department of Transportation or Department of Agriculture. Disorganized sequestration cuts of $110 billion are the other one of the top three big parts of the Fiscal Cliff.

There also a variety of other things that would change that each make up a smaller component of the Cliff, including an end to federal emergency unemployment insurance and a reduction in Medicare payment rates for physicians.

The federal deficit is currently over $1.2 trillion. The Congressional Budget Office estimates that if the Fiscal Cliff does not occur, the deficit will remain high and the economy will grow by 1.3% in 2013. If the Fiscal Cliff does occur, the deficit would be reduced by around $500 billion, but the economy would shrink by 0.5% into a recession and would cause unemployment to increase to over 9%.

Why Can’t Congress Agree?

In general, most Democrats want a mix of tax increases and spending cuts to fix the deficit, while most Republicans are in favor only of spending cuts to fix the deficit.

From the Democrats perspective, the president wants what has been coined as a ‘Grand Bargain’. Back in 2011, in an attempt to avert the debt ceiling crisis, President Obama proposed the $4.7 trillion ten-year package to reduce the deficit, which consisted of a combination of spending cuts and expirations of tax cuts. Since it had more than 2x as much spending cuts as tax cut expirations, some Democrats were not in favor of the idea but overall it had Democratic party support. The Republicans rejected it due to its inclusion of tax increases. Now in late 2012, the president and many Democrats are again in favor of a mix of revenue increases and spending cuts, with Obama insisting this time that he will veto a bill that does not include some expirations of tax cuts for the wealthy. The primary position for the Democratic party is that they’d prefer the tax cuts for wealthier citizens to expire while preserving some of the tax cuts for the middle class.

From the Republicans perspective, many want to reduce taxation as a percentage of GDP, and therefore reduce government spending. Over 90% of the Republican members of Congress have signed a pledge that says they will not under any circumstances increase taxes. This means they cannot increase tax rates, and cannot cut loopholes unless they balance those loopholes dollar for dollar with reductions in tax rates, unless they’re willing to go back on their pledge. In the post-election environment, Republican majority leader John Beohner has suggested that while they will not agree to tax rate increases, they are now open to some revenue increases from reducing loopholes.

If the parties cannot agree by early 2013, tax rates and government revenue go up and spending cuts occur. The magnitude of these tax increases is larger than the magnitude of the spending cuts. Overall tax rates would be similar to a decade ago, because it’s mostly due to an expiration of tax cuts enacted under presidents Bush and Obama.

The Bearish Argument: A Very Long Negative Trend

Over the last three decades, the National Debt as a percentage of the Gross Domestic Product (GDP) has been growing. In contrast, for the three decades prior to that going back to the end of World War II, absolute national debt was fairly static while the economy grew, meaning that debt as a percentage of the GDP was shrinking. But starting in the early 1980’s and continuing through most years until today, debt has been increasing wildly:

An Increase in National Debt
National Debt Chart
Image Source

The debt levels are getting to a concerning level. Fortunately, Treasury interest rates remain particularly low, the U.S. has control over its own currency (unlike the Eurozone countries in default risk), and debt as a percentage of the GDP is not yet within range of an inherently problematic level. But it’s a trend that has to reverse itself at some point.

Essentially, a government deficit is a stimulus, especially if it’s from foreign money. A stimulus (like the one under President Reagan or the one under President Obama) is basically a euphemism for a deficit, except that deficits are unfortunately a common annual thing these days and a ‘stimulus’ is a larger, intentional deficit to provide a bigger economic boost. But just about any deficit is a stimulus.

When the federal government spends more than it taxes for, it is generally providing a boost to the economy for that year. (Exactly what it is spent on determines the efficiency of it.) All of this spending on defense, health care, roads, and social security goes to millions of worker salaries: federal workers, soldiers, government contractors, employees of companies that make products consumed by this process, etc. If this spending is much larger than the amount of taxes extracted from the economy due to borrowing from foreign sources, then it’s an insertion of capital into the economy (and one that has to be paid back). The deficit spending, especially if it comes from foreign money, is a boost to the baseline natural economic conditions, since money is basically being taken from outside of the economy and put into the economy. Of course, red ink accumulates on the balance sheet when this is done; there’s no free lunch.

The Shrinking Net International Investment Position (NIIP)
This is a lesser-known figure, and it’s about foreign capital. The NIIP for the United States is a comparison of how much foreign assets are owned by Americans compared to how much American assets are owned by foreign sources. For example, if you’re an American that currently owns some Novartis stock (a Swiss company), then you currently own a chunk of Swiss assets. But if you sell your Novartis stock and buy U.S. treasuries or Coca Cola stock, then your total amount of assets have remained unchanged but America’s NIIP has been reduced slightly. This can happen with millions of individuals, and it can happen with institutions or organizations like banks or foreign governments.

Until the mid 1980’s, the NIIP was a positive figure, meaning that Americans owned a larger chunk of the rest of the world than the rest of the world owned of America. Over the last 25+ years, however, the situation has deteriorated, and as of 2011, the U.S. has a NIIP of around negative $4 trillion. This represents approximately 25% of our GDP in that year.

In some ways, the trend is worse than it appears due to the types of assets owned. Americans own more equities of other countries than foreign sources own of American equities. But U.S. treasuries are popular in other countries, which account for a significant chunk of the foreign-owned assets. In other words, the types of assets that Americans own of other countries are riskier than those owned by foreign sources and provide better long-term returns. The rate of return of American holdings of other countries has been superior to foreign-owned American assets over the last two and a half decades, and yet the overall NIIP has deteriorated. What this means is that the actual cash flows have been the driving force of the deterioration. Foreign sources are buying more and more U.S. assets while Americans are not doing the same magnitude of purchases externally.

The summary of the NIIP here is that not only is the U.S. national debt increasing, but that it’s increasingly foreign-owned. Over the past generation, deficit spending has partially come from foreign borrowers or from reductions in the amount of foreign-owned assets that Americans would have otherwise bought.

The Modern Economy: Natural, then Artificial
If we define the ‘Modern Economy’ in the United States as being the period from after the second world war in 1946 until 2012 and counting, then we can divide it into two almost even periods. (Use the previous National Debt chart as a visual for this.)

The first period is the 35 years from 1946 through 1980, spanning presidents Truman, Eisenhower, Kennedy, Johnson, Nixon, Ford, and Carter, where federal debt was held relatively constant and where the economy grew, which resulted in a decrease in debt as a percentage of the GDP. Trade was fairly balanced, and the NIIP was positive.

Overall, this first period was a time of building a foundation of wealth. Economic expansion was largely natural.

The second period is the 32 years from 1981 through 2012, spanning presidents Reagan, Bush I, Clinton, Bush II, and Obama, where federal debt began increasing rather significantly, which resulted in an increase in debt as a percentage of the GDP. The only time during this period when there was not a significant deficit was in Democratic President Clinton’s second term with a Republican Congress, where the country had rather balanced taxation and spending, and where the internet boom provided strong economic activity.

Overall, this second period was a time of withdrawing from the previously established foundation of wealth and propping up our economy with it a little bit each year. The GDP growth each year was a natural baseline combined with an addition of an annual stimulus (federal deficits, including foreign capital infusions). But of course all of those deficits resulted in accumulation of national debt and reducing our NIIP. The debt got bigger, foreigners owned larger portions of that debt, and the ratio of American ownership of foreign assets shrank compared to foreign ownership of American assets.

The reason the Fiscal Cliff is projected to result in a double-dip recession by the CBO and so many economists if it occurs is that when we remove our deficits, we take away this artificial part of our economy. Our current economy is being propped up by deficit spending that equals about 8% of our GDP. Those deficits have to be fixed sooner or later to avoid ruin, and therefore this removal of artificial economic boost has to occur sooner or later. The Fiscal Cliff only cures about 40% of it, and does so in a disorganized, abrupt, and inefficient manner.

A precise estimate of how significant the overall long-term problem from this second period is would be difficult to determine even by a room full of experts on the subject. One way to begin an estimate of it is to extrapolate the CBO’s estimate for this Fiscal Cliff. The CBO estimated that avoiding the Fiscal Cliff and keeping the deficit high would lead to 1.3% GDP growth in 2013. They estimated that if the Fiscal Cliff occurs and the deficit is reduced by around $500 billion, then -0.5% GDP growth would occur in 2013. If reducing the deficit by 40% results in a 1.8% swing in the GDP, then extrapolating it to the full deficit results in an estimated loss of 4.5% of GDP. This doesn’t sound like much, but it’s slightly larger than the magnitude of the 2008-2009 recession.

In other words, although the exact numbers would be difficult to determine, the “artificial” portion of the U.S. economy that is fueled by unsustainable foreign capital infusions into federal deficits is at least a few percentage points of America’s cumulative GDP. There’s no telling when this would reveal itself and retract to the baseline “real” GDP, or whether it would be abrupt or gradual, because lawmakers get to decide those things based on their spending and revenue agreements, but it’s worth being aware of. The party has to end at some point in order to have a sustainable national balance sheet again, which means a time when debt as a percentage of GDP is no longer increasing.

A Corporate Example
Macroeconomics is a hugely complex subject.

To illustrate and simplify this macroeconomic phenomenon over the modern economy, we can use a corporate example to represent what America has done. This would be familiar for people who follow along with the dividend stock reports on this site.

Suppose, as an example, we have a company that sells hamburgers in 1946. It has a leveraged balance sheet but strong business operations. So from 1946 through 1980, the board of directors and CEOs work together to grow and strengthen the company. Over time, they grow revenue and earnings substantially, and they pay off as much debt as they issue, so the overall debt remains static. Since the company is growing and debt is static, their overall debt metrics such as the debt/equity ratio or debt/income ratio improve substantially. The company accumulates cash and investments on its balance sheet, pushes debt to very low levels, and grows very large.

Then from 1981 to 2012, the company is under different management. (The late seventies and early eighties were a time of recession, so they change course.) The company starts leveraging itself. They reduce assets on their balance sheet relative to the size of the company, and they accumulate debt on the balance sheet. The company is growing naturally, but they’re also boosting this growth through debt. Debt is being used to make acquisitions, perform internal capital spending to accelerate organic growth, or buy back stock. The problem is, in 2012, the company now has a very leveraged position. They keep having good growth rates, but a lot of the growth isn’t natural and sustainable; part of it is from taking money from outside of the system in the form of debt, and using it as a stimulus to their growth. But most of the employees and managers enjoy this growth obviously, and don’t want it to stop.

Eventually there’s a reckoning, and the company has to stop boosting its performance by increasing leverage, and instead focus on holding leverage stable or reducing it. They’ve tapped out their balance sheet. This would reduce the company’s growth, and maybe even set it back a few years. But it’s not because these corrective actions harmed the company; it’s because these corrective actions put a stop to the unsustainable portions of growth. Without those unsustainable injections of capital from increasing debt, genuine growth was a bit lower than it appeared to have been.

This is basically the course the United States has taken, quantitatively. During this second stage of withdrawing from our assets and increasing national leverage from foreign sources, part of our growth was unsustainable. Removal of most of the deficit, which has to happen at some point to avert ruin whether in the form of changes in taxation or spending or both, appears to harm the economy, but only because it eliminates the unsustainable and artificial part of the growth, leaving only the baseline state.

How to Prepare

I don’t know whether Congress and the President are going to smooth out and rationalize this fiscal cliff or not. We could go on deficit spending for years unfortunately accumulating more debt, or it could be addressed sooner. Regardless of when deficit reduction occurs, the two main ways to prepare for this are to invest conservatively, and invest often. While this article is somewhat bearish because it describes how fixing the deficit can provide a much-needed road bump to eventual genuine growth and stability, the upcoming issue of the dividend newsletter this weekend is going to point out some bullish aspects of the baseline natural economy.

Invest Conservatively
Any valuation of a company should take into account the observation that the current U.S. economy is being propped up by deficit spending equal to about 8% of GDP, with a part of it being directly or indirectly from foreign investments.

An increase in taxation, especially to the middle class, means that there’s less spending money to buy things (houses, furnishings, cars, candy bars, premium laundry detergent, shoes, electronics, etc.), which impacts consumer companies and then trickles to companies that do business with those companies.

A decrease in federal spending means fewer people receiving salaries directly or indirectly from deficits (fewer federal workers, fewer contractors, fewer purchases of products from any company that ever sells to the government or a government contractor, etc.), which again means less spending on things.

A lack of tax increases combined with a lack of federal spending cuts means continued accumulation of red ink on the federal balance sheet, which means interest takes up a larger and larger portion of the national budget. One, or the other, or both have to occur.

So, use the Dividend Discount Model or another valuation method to buy stocks at conservative prices. If the valuation requires too many positive assumptions to justify the price, then consider letting it go. Right now I’m interested in:

International Consumer Giants:
McDonald’s (MCD)
Yum Brands (YUM)

Index funds for International Exposure:
Vanguard FTSE All-World Ex-US ETF (VEU)

Blue-Chip Technology and Engineering Companies:
International Business Machines (IBM)
Emerson Electric (EMR)
Illinois Tool Works (ITW)
Dover Corporation (DOV)

Energy and Infrastructure:
Exxon Mobil (XOM)
Chevron (CVX)
Brookfield Asset Management (BAM)
Kinder Morgan Inc. (KMI)

Companies with High Shareholder Yields:
Chubb Corporation (CB)
Becton Dickinson (BDX)

Free analyses reports can be found on most of these businesses and others in the reports section:
Reports of the Best Dividend Stocks

(Full disclosure: Long NVS, KO, MCD, IBM, EMR, XOM, CVX, CB, BDX, VEU)

Whenever an investor is unable to find stocks at attractive valuations, several alternative investments exist:
1) Increase cash and bond positions to wait for opportunities that meet your long-term entry criteria.
2) Reduce any existing debt (student debt, mortgage, etc.)
3) Invest in rental property if real estate valuations are reasonable and if this fits your goals.
4) Sell cash secured puts to get paid to wait for better stock prices.

Save and Invest Often
Specifics of portfolio maintenance are only one aspect of wise long-term wealth accumulation. The much larger role is to ensure that you have outstanding personal finance habits. It doesn’t matter if a portfolio A beats portolio B by one percentage point per year, if the person behind portfolio B is flooding their investment account with 3x as much fresh capital every year.

The main thing here, if you haven’t done so already, is to shift the career mindset towards a wealth accumulation mindset. In a globally connected world where automation and outsourcing compete with increasing numbers of jobs, the goal of working from age 18 to age 65 and then retiring comfortably just isn’t a safe bet anymore for a lot of people. Rather than letting expenditures nearly equal your income with only minor retirement savings, it’s wise to drastically accelerate this process. Aim for financial independence in your 30’s or 40’s, or within 10 years from wherever your current age is, so that work becomes optional after that point.

It’s great to have a job and career your enjoy, and it’s even better for that job to be optional due to wise saving and investing habits that lead to substantial growing passive income.

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Are Dividend Stocks Overvalued? Four Reasonable Blue-Chips to Consider

An observation from various articles I’ve been seeing in increasing frequency this past year, including on sites such as Morningstar or Seeking Alpha, has been that dividend stocks, in general, may be overvalued. The articles of course have a range of quality, with some of them going so far as to call dividend stocks a bubble, with others using more reserved and nuanced observations.

It’s certainly an observation worth considering. After all, the Shiller P/E of the S&P 500 remains above the historical average, and I wouldn’t call the market in general undervalued by any stretch.

Dividend stocks may be a particular target of capital, as they are often (but not always) defensive, blue-chip investments with reduced volatility. Plus, a key issue is that interest rates have been so low that even stocks with mediocre yields rival bonds in terms of income while simultaneously offering historically superior total returns.

There are a few ways to examine the question of overvalued dividend-payers.

A) How have dividend payers performed relative to the market as a whole?

B) How are dividend payers valued now compared to historically?

C) How are dividend payers valued based on more objective valuation models, such as the Dividend Discount Model?

A) Dividend Stocks vs. the Market

Comparing the Vanguard High Dividend Yield ETF (VYM), the Vanguard Dividend Appreciation ETF (VIG), and the Vanguard Total Stock Market ETF (VTI), shows that over a five year period, VIG mildly outperformed, VTI was in the middle, and VYM underperformed. Over the most recent year, VYM outperformed mildly, VTI was in the middle again, and VIG underperformed.

Over both a one-year and five-year period, the differences were mild. Over the longer scale of five years, companies that focus on dividend growth outpaced high-yielders and the stock market as a whole, whereas over the shorter term of the past year only, the trend reversed itself and high-yielders outperformed the market and the dividend growers.

The comparison doesn’t exactly lend itself to the thesis of dividend stocks being substantially overvalued.

B) Current Valuations vs. Historical Valuations

The second way is to compare several dividend stocks to how they were years ago. One article I read, from Barron’s, literally said dividend stocks were at “nosebleed valuations”. (But then later went on to indirectly define that as “20 to 25% overvalued”, and the article was reasonable). I’ve also seen some articles throw the word “bubble” around.

So where do dividend stocks stand today in terms of valuation?

Johnson and Johnson (JNJ) trades for over 21x earnings, which I think is on the high side, but much of this was due to recent decreases in EPS rather than large stock price expansion. Ten years ago, JNJ was trading at over 25x earnings.

Walmart (WMT) trades for a bit over 15x earnings after a large recent spike in price. Ten years ago, the valuation was approximately double, at around 30x earnings.

Procter and Gamble (PG) trades for over 21x earnings, which again I think is on the pricey side. Ten years ago, the valuation was a bit higher, at over 23x.

Southern Company (SO), listed by the Barron’s article as a poster child for the overvaluation of dividend stocks, is over 18x earnings, and in my recent analysis, I said it was moderately overvalued. Ten years ago, it was over 16x earnings. So it has gone up… a bit.

Coca Cola (KO) is rather expensive as well, at over 20x earnings. Ten years ago, the valuation was double that, at over 40x earnings.

I can only go through a limited number here, although I’ve purposely selected stocks that I’m not exactly buying at current prices. I think we can safely cross words like “bubble” or “nosebleed valuations” off of the list, and stick to the more nuanced questions like, “are dividend stocks moderately overvalued?” and “is the stock market in general a bit expensive at these prices?”

C) Objective Valuation Approaches to Dividend Stocks

My preferred method of stock valuation rests not on relative comparisons, but instead on absolute metrics. Discounted cash flow analysis relies not on any external comparisons, but instead determines the fair price of a stock based on the amount of cash flow it can produce.

The Dividend Discount Model (DDM) uses this method and is tailored specifically for dividend stocks.

Using it, we can find several companies that pay good dividends that are reasonably valued.

McDonald’s (MCD) currently trades for under 17x earnings, and is a robust and defensive name with three and a half decades of consecutive annual dividend increases. Earnings have grown by an average of 16% annually over the past seven years, while the dividend has grown by over 24% annually over the same period, although this must slow down. Based on the DDM, McDonald’s only needs to grow the dividend at 7% per year going forward (or alternatively, 11% per year for 10 years and 5% per year after that) in order to justify the current stock price of around $90/share with an expectation of 10% annual returns.

Aflac (AFL) is potentially a deep value pick at well under 9x earnings, with almost three decades of consecutive annual dividend growth. This insurance company’s core business remains incredibly strong, but they do have 5-6% of their portfolio in risky European debt. Over the past several years, they have realized losses on their balance sheet due to European debt exposure and have worked to contain and eliminate those risks. The dividend has grown by an average of 18% annually over the past seven years, as the payout ratio has increased but remained low. At the current rate of EPS growth, if Aflac grows the dividend by 15% per year over the next ten years, they’ll only have a 50% payout ratio. If after that point, they grow dividends by 6% per year, then the DDM reveals the current price of around $46 to offer potentially 12% long-term returns. There’s certainly risk here, but if you’re looking for stocks on the other end of the valuation spectrum, a quality company like Aflac is one of the better places to start.

Emerson Electric (EMR) sits near the top of the list of consecutive dividend-payers, with comfortably over 50 years of consecutive annual dividend increases. The company is a leading provider of automation, process management, network power (focusing on data centers and telecommunications providers, two areas I’m bullish on), and climate technologies. At under 16x earnings, the stock trades for a reasonable price. The dividend has grown by an average of over 9% over the past seven years, although it was a bit low during the recession. According to the DDM, Emerson only needs to grow the dividend by 7% going forward in order to produce 10% annual returns.

Republic Services (RSG) is the second largest trash collector in the United States. With a decent economic moat from its large ownership of landfills, and annuity-like cash flows, RSG barely has to grow at all in order to provide decent returns through dividends and stock buybacks. The company only has to grow the dividend at 6% or better for the long term to provide 9% long-term returns, based on discounted cash flow analysis via the Dividend Discount Model.


Although I do think the market as a whole is modestly expensive (via the Shiller P/E for an overview as well as inspection of individual securities), dividend stocks in general do not appear to be at dangerous valuations. Some areas do seem to be heated (conservative utilities, certain telecoms, some consumer products companies, in particular), but to balance those out, there are other areas of reasonable valuation (cyclical industrials, insurance, blue-chip tech, and even a few defensive names like McDonald’s).

There are some slightly more advanced tools to work with, such as selling cash-secured put options to get good returns while waiting for better prices, but overall, sticking to sound valuation principles still reveals some reasonable stock choices out there.

Full Disclosure: As of this writing, I am long JNJ, PG, KO, MCD, and EMR.
You can see my portfolio here.

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