The Six Different Asset Types for Successful Portfolio Management

How We Approach Capital Allocation at My Company and in My Family

Asset Allocation Asset Classes for Portfolio Management
One secret to successful portfolio management is to make sure your assets are divided among asset classes that meet your needs, resources, and risk profile. LEOcrafts / Digital Vision Vectors / Getty Images

All assets, whether a gold nugget or a working farm, can and should be compared to others when making purchasing or investing decisions.This is known as opportunity cost. In the past, I've used some of my own private company investments to illustrate basic concepts including profit margins, financial ratios, investment returns, and more. Today, I'm going to share one of the ways we think about capital allocation in-house when we determine whether we are going to make an investment, be it expanding one of our existing businesses, acquiring another firm, purchasing shares of stock, building cash reserves, or even adding tangible assets such as real estate or commodities to the balance sheet.

My hope in doing so is that it will help you put together your own portfolio and structure your financial life to achieve what you want out of your personal and business investments. Money, after all, is nothing more than a tool. By putting it to work for you in the most rational, fulfilling way, you can enjoy success earlier in life and with less risk.

Asset Type #1: Those That Generate High Returns On Capital, Throwing Off Substantial Cash On Very Little Capital Investment But That Can Be Grown But That Can Be Grown By Reinvesting Profits Into the Core Business for Expansion.

These are the second best investment because you can earn large returns on very little money. The downfall is that you have to pay out all of the profits as dividends or reinvest in lower returning assets because the core operation can't be expanded through organic capital additions.

Think of a patent to a device that generates hundreds of thousands of dollars per year.

There are little to no investment requirements once the cash starts coming in but you can't invest it in more patents at the same rate of return. Unlike the first asset type, you can't put that money to work at the same level (you get your patent royalty check and have to find something else attractive whereas Ray Kroc at McDonald's simply built another location, generating roughly the same return at the new McDonald's location as he did on the old one.)

At some point, all #1 type businesses will become #2 type businesses. This normally happens at saturation. When that moment is reached, management may begin returning a lot more money to shareholders either in the form of a higher dividend payout ratio and/or aggressive stock repurchase plans designed to reduce the total shares outstanding.

Asset Type #2: Those That Generate High Returns on Capital, Throwing Off Substantial Cash On Very Little Investment but That Cannot Be Expanded By Reinvesting In the Underlying Asset

These are the second best investment because you can earn large returns on very little money. The downfall is that you have to pay out all of the profits as dividends or reinvest in lower returning assets because the core operation can't be expanded through organic capital additions.

Think of a patent to a device that generates hundreds of thousands of dollars per year. There are little to no investment requirements once the cash starts coming in but you can't invest it in more patents at the same rate of return. Unlike the first asset type, you can't put that money to work at the same level (you get your patent royalty check and have to find something else attractive whereas Ray Kroc at McDonald's simply built another location, generating roughly the same return at the new McDonald's location as he did on the old one.)

At some point all #1 type businesses will become #2 type businesses. This normally happens at saturation. When that moment is reached, management may begin returning a lot more money to shareholders either in the form of a higher dividend payout ratio and/or aggressive stock repurchase plans designed to reduce the total shares outstanding.

Asset Type #3: Those That Appreciate Far Above the Rate of Inflation but Generate No Cash Flow

Think of a rare coin or fine art collection. If your great grandparents owned a Rembrandt or a Monet, it's going to be worth millions of dollars today versus a relatively small investment on their part.  Despite this, over the years your family owned it, you wouldn't have been able to use the appreciation in the asset to pay the rent or buy food unless you borrowed against it, suffering interest expense.

That is the reason these types of assets are often best left to those who can either A.) Afford to hold because they have substantial wealth and liquid assets elsewhere so that tying the money up in the investment is not a burden or hardship on the family and/or B.) Those who have an intense passion for the underlying collection market and derive considerable pleasure from the art of collecting whatever it is they enjoy collecting (oil paintings, wine, coins, baseball cards, vintage Barbie dolls – the list doesn’t end). These people are in a win-win because they experience personal utility and happiness from building the collection with the monetary benefits an added bonus.

I'd go so far as to say you should never collect anything about which you are not personally excited.  

Asset Type #4: Those That are "Stores of Value" and Will Keep Pace With Inflation

Have you ever watched an old movie and heard the matriarch of a family warn others to "hide the silverware" when a person of ill repute appears on the doorstep?  Certain assets are intrinsically valuable enough that they are able to keep pace with inflation, assuming you bought them intelligently at the lowest price you can.  While not true investments, they do provide a bulwark that can be used in dire emergencies such as a Great Depression.

A classic example of this sort of asset is high-quality furniture bought in the secondary market from antiques dealers or at auction; furniture from manufacturers such as Baker, Henkel Harris, or Bernhardt. It may seem absurd for a wealthy person to pay $18,000 for a 19th-century armoire at Sotheby's but, assuming it was shrewdly acquired, it very well may end up not only retaining its value but beating bond yields over the holding period!

Dr. Thomas J. Stanley at the University of Georgia did research on the wealthy in America. He found these balance sheet affluent men and women have a penchant for buying things that last a very, very long time.  They like to pay more upfront but get a lower cost per use in the long-run, analyzing everything down to their dining room table the same way a corporate CFO might analyze the capital expenditure budget of a new manufacturing plant.  In contrast, the poor and middle class buy throw-away furniture that lasts a few years, is often made of particle board, and ends up in a landfill.  It isn't long before they're back in a store, spending more money, shelling out money for a replacement.

You'd never want a lot of your money in these sorts of assets but if you live debt-free and things really do go south, you'll at least coast through the next global economic collapse in style, comfort, and with things you can sell for food or ammunition.

Asset Type #5: "Stores of Value" That Will Keep Pace With Inflation but Have Frictional Costs, Thus Turning Them Into Liabilities In That They Require Cash Out of Your Pocket

This is where gold, real estate, and Steinway grand pianos fall.

Looking back at charts for thousands of years, on a long-term basis, the best these assets can ever accomplish is to keep a person or family's purchasing power at parity, less the cost of storing and worrying about the assets for all those years.

In other words, these assets classes might keep you rich, but they won't make you rich unless you deploy large amounts of leverage to amplify the underlying return on equity. In practical terms, that means if we were going to experience extreme inflation, it would be best to utilize leverage by either borrowing to purchase real estate or acquiring gold futures (which has its own drawbacks - it's almost always better to take delivery of the underlying gold, even if you're just stocking up on gold bullion such American Eagle, Canadian Maple Leaf, Vienna Philharmonic, or Gold Krugerrand coins despite the transportation and storage costs if you really think the world is falling apart so you don't need to worry about counterparty risk).

This is why you see a lot of wealthy families engage in something known as "equity stripping" (there are some asset protection reasons for doing it but the economic returns are equally, if not far more, important, in my opinion).

Here's a quick overview of how it works:

Let's say you owned a house for $1,000,000 in Southern California. If you had no mortgage and the property appreciated at 5%, in 30 years, it would have a value of $4,320,000. Now, obviously, you've been out the frictional costs - homeowners insurance, heating, water, etc.

- for all of that time but you also had the utility of living in the property. Your returns with no mortgage would be unspectacular. You would have actually lost purchasing power after adjusting for the related costs on an inflation-adjusted basis despite having a "profit" of $3,320,000.  Why?  Because of one basic fact: Purchasing power is all that matters.  What counts to your family's pocketbook is the number of hamburgers, or pianos, or pens, or cups of coffee, or whatever it is you desire that you can acquire.  Wealth must be measured in relative purchase power, not merely dollars or asset levels.

If you learn nothing else from the millions of words that I've written over the years, I'll have done my job.  Purchasing power is your guide.  Purchasing power is what counts.

If, on the other hand, the family had put down $250,000 and borrowed $750,000 to buy the property that gain of $3,320,000 would be against an initial $250,000 equity investment. Their return on equity before mortgage costs would be 14.47%, beating stocks. They would obviously have enormous mortgage interest expenses, which should be offset in the calculation by the lower taxes they paid during that time period, so it's actually unlikely that the real estate would have beat the stock market.

For most families, it doesn't matter because the leveraged real estate lets them generate real wealth, built up in the form of home equity while having the utility of living in the property. Even if stocks or private businesses would have generated higher returns, you can't live in them.

The danger of using leverage like this is the damage it can do if prices fall, resulting in substantial, perhaps even bankruptcy-inducing, losses.

Additionally, there are often "special situations" in real estate that are not included here and can be highly attractive to an investor looking to build wealth at exponential rates of return over several years. Those that have the understanding and experience to purchase real estate options, for instance, and can turn around and sell the property are effectively managing a "business" with qualities more akin to Asset Type #1 or #2, depending upon their methods and circumstances.

The fact that the underlying asset consists of tangible land or buildings is inconsequential (as a corollary -- cattle is a low return business as is real estate but McDonald's combined the two into a system based on a franchising model that generated unbelievably high returns on equity for the shareholders over the course of decades).

The same is often true in regards to gold, only there is much higher risk utilizing leverage because the commodity markets are far more speculative than the equity and bond markets. A relatively small drop that wouldn't have hurt you in stocks could wipe you out due to the margin maintenance calls at most commodity brokers. This would be acceptable if gold had utility to the average person like a house does. It simply doesn't, unless you are an industrial manufacturer who happens to need the reserves for your core business and is willing to make bets on the direction of prices.

Thus, the man who wants to invest without worrying about losing everything is left to buy bullion, frequently in the form of gold coins, outright for cash. The implication is that unless he experiences one of the few, relatively rare booms in the gold prices (a la the 1980's), he can never grow his wealth higher than inflation on a long-term basis. (There is also another rare situation in which gold can be a highly attractive investment and that occurs when the price of above-ground inventories falls below the production costs of extracting it from the ground. At some point, the supply/demand relationship must reach equilibrium. For those who have the resources to take advantage of the situation, and the intelligence to know that it can be a few years before that happens so they avoid getting wiped out in subsequent price fluctuations, it can be -- if you'll pardon the expression -- a gold mine.)

That said, for long-term holding, gold doesn't budge in real terms.  The last time I checked the inflation-adjusted rate was $1.00 versus $1.01 - a 1% return in real terms for two hundred years. Again, real terms -- that is, inflation adjusted -- is all that matters. No matter how you measure it -- dollars, clam shells, shark teeth -- all that counts is how much purchasing power you gained relative to your investment. Say it over and over again to yourself.

Another concern for long-term holders of precious metals, as opposed to the short-term trading which, as I've pointed out, can be very lucrative for those who know what they are doing despite the extreme wipeout risk, is that there is often a mistaken belief that they provide doomsday protection. For those with any knowledge of financial history, it seems a bit absurd because the Government would simply do what it did in the 1930's -- order that safe deposit boxes could not be opened outside the presence of a bank regulator or officer to ensure that no precious metals were inside.

Those who violated these rules were subject to harsh criminal penalties.

To put it bluntly, if the world really did go to hell, the only way to enjoy gold use would be to store it in a vault in Switzerland where no one knew it resided or be willing to risk dealing in a domestic black market that would inevitably develop if the dollar went to German reconstruction hyperinflation levels. This could only be accomplished by refusing to report bullion holdings to the United States Government, committing a crime in the present for a potential future contingency. That always seemed idiotic to me in light of the better returns available in other asset classes.

I should point out that this section only applies to the bullion. Rare gold coins normally fall into asset category type #3. They have value for their own scarcity making them trade independent of the value of spot prices. It's an entirely different thing.

Asset Type #6: Consumer Goods or Other Assets that Depreciate Rapidly with Little or No Resale Value

Without a doubt, when you look at the data and research, this is how most people spend their paycheck. From video game consoles to cars that lose tens of thousands of dollars the moment you drive them off the lot, new clothes to some new must-have gadget you'll forget about in two years, this is what you find in the homes of most Americans.

Perhaps the quickest way to guarantee poverty, or at least a paycheck-to-paycheck lifestyle, is to purchase Type #6 assets with debt that has:

1. An incredibly high-interest cost on an after-tax basis (consider that a business loan at 10% for a company with a 35% effective tax rate costs less than a personal credit card balance at 7%).

2. A longer maturity/amortization timetable than the salvage value of the underlying asset (e.g., borrowing $3,000 for 5 years to buy a high-definition television that will be, for all intents and purposes, worthless by the time the debt is repaid).

This is the reason lottery winners go broke. This is the reason NFL and NBA stars end up back in the poorhouse following eight and nine-figure career earnings. This is the reason trust funds are exhausted. Be very careful with the percentage of your cash flow you put to work in this category as it's a sunk cost.