In the spirit of big-picture thinking for the new year, I want to diverge from my usual columns on portfolio management and discuss what it takes to achieve wealth.
I work with nearly 100 private clients, and my job is to preserve, diversify and increase their assets by investing in the market. Where did these clients get investable assets in the first place? Achieving wealth is not necessarily a matter of superior intelligence, luck or inheritance, although those factors help. People who end up wealthy are levered in some fashion such that income is no longer tied to hours worked per week but to some other function.
Here's a simple example: Once upon a time, a young milkshake mixer salesman visited a California restaurant to learn why that customer bought many more mixers than the average account. He observed that the restaurant's simple menu and fast turnaround were very attractive to a new generation of car-mobile consumers. That salesman, Ray Kroc, bought the rights to franchise the concept. Soon McDonald's
(MCD)
restaurants spread across the country, and later across the world. Kroc's estate, despite philanthropic donations, is now worth about $2.2 billion (according to Forbes), all from the licensing fees that flow back from the franchises, not to mention a portion of each hamburger sale.
As a salesman, Kroc made a good although not spectacular living from commissions. By leveraging the capital and hard work of the franchisees, he became a billionaire.
How to Make a Lot of Money
Through the 19th century, most manufactured products were custom goods -- for example, a furniture maker's income was limited by how many hours a year he spent in the shop. Leveraging capital and production created the great fortunes of the 20th century. For example, the Mars family's wealth was derived from candy bars, the Rockefellers' from oil, the Carnegies' from railroads, the Phipps' from steel, the Gambles' (of Procter & Gamble) from soap, the Fords' from automobiles. From each unit sold, a tiny slice flowed back to the founding families. Multiplied by millions of units sold, vast fortunes accumulated.
Late-20th century examples include Bill Gates of Microsoft
(MSFT)
and Michael Dell of Dell Computers
(DELL)
. Tiny slices of each PC sold eventually led to multibillion-dollar fortunes.
The Many Ways of Achieving Leverage
You don't have to be a captain of industry to achieve wealth, though. Think about it: Why do lawyers and other professionals form partnerships and hire associates? Because a portion of the revenue stream associated with each associate flows to the firm's partners. Why do people in my industry, financial services, which includes asset management, venture capital, investment banking and corporate lending, make such good money? Because our fees are levered off the value of the assets we're managing.
Leverage can also be achieved through real estate. An entrepreneur owned a vacant lot on which he built a garage. The cash flow allowed him to borrow against the garage to buy another lot to build another garage, and then another. Eventually he diversified into office buildings and residential construction worth hundreds of millions of dollars.
Leverage can be achieved through employee stock options. If you have the good fortune to be an early employee of a successful corporation, your wealth is not just a factor of your own work but that of the entire corporation's. Unfortunately, this kind of wealth can be transient, so look at some of my previous articles including "Employee Stock Options: Protect your Paper Profits" and "Questions and Answers on Managing Employee Stock Options".
Leverage can be achieved through media. Through records, videos, movies, broadcasting and publication, a talented individual can command enormous revenue streams. Authors such as Suze Orman (Nine Steps to Financial Freedom) or John Gray (Men Are From Mars; Women Are From Venus) have leveraged a single book into a whole industry of follow-on books, videos, board games and calendars.
How about leverage by investing on margin or by trading options? These are not strategies that I employ for my clients, and I would caution you to be very careful in pursuing these strategies on your own. Even the smartest, most sophisticated traders get torpedoed with leverage of this kind (consider the fates of Enron
(ENE)
and Long Term Capital Management).
How to Get Started
What's your next step? If you want to move from comfortable to wealthy, here's where you start. Take inventory of all your assets, skills and relationships, and try to discover where your leverage can be found. Even so, it's a competitive world (I doubt the McDonald brothers would be quite so casual about giving up franchise rights today as they were when Ray Kroc first came around), so you'll also need skill, hard work and patience to run a business on your own.
If that's more of a risk than you're willing to take, make the most of your opportunities as an employee. For example, seek positions in profit centers (for example, sales) rather than cost centers (human resources). If you're paid on commission, get in the habit of sweeping 10% of each commission check into an investment account. If you receive an annual bonus, live on your base, bank your bonus (some of my Wall Street peers used to spend their salaries and borrow against their expected bonuses, leaving them with nothing saved).
Even if you receive a straight salary, pick a comfortable number ($100, $500 or $1,000 a month) and set up an automatic investment program into a mutual fund. If you have vested, in-the-money options, take steps to diversify and preserve your gains so you don't end up like those poor Enron retirees.
Lastly, treat windfalls (inheritances, lottery winnings, lawsuit payouts) with respect. A couple of years ago, a woman who had received a $1 million payout from an industrial accident came to speak with me about money management. Unfortunately, this appointment came after she gambled away half the funds in Las Vegas and made several "loans" to family members. There wasn't much I could do for her at that point.
David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. At the time of publication, his firm held no positions in any
securities mentioned in this column, although holdings can change at any
time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback and invites you to send it to David Edwards.
