Businesses invest in facilities, equipment, and other types of assets to fulfill their strategic objectives. How and where a firm invests in these assets is known as capital allocation. When making investments, it's helpful to identify the major asset types and how they fit into in-house capital allocation strategies, be it expanding an existing business or even adding tangible assets like real estate or commodities to the balance sheet.
In doing so, you can put together your own portfolio and structure your financial life to achieve what you want out of your personal and business investments, with less risk.
Assets That Generate High Returns on Capital
These asset types are suitable for holding over the long term because the core operation can be expanded through organic capital additions, allowing the business and its investors to earn large, sustained returns over time.
Think of a franchised business like a fast-food chain. When the business owners want to grow the business, they can simply build a new branch at a different location and generate similar or better returns at the new location as they did on the old one. There may be more investment requirements as the business scales up, but the business can make those investments in the same asset.
Assets Yielding High Returns That Can't Easily Be Grown
These are a solid investment to include in the capital allocation because you can achieve large initial returns with little money, but the downfall is what is known as "reinvestment risk." That is, a business that invests in these high-growth assets eventually has to reinvest in other assets that yield lower returns (or pay out sizeable dividends from its profits) because they generally can't grow the returns by investing more into the underlying asset.
A patent is an example of this asset type. Imagine that you want to invest in a firm that holds a patent to a device that could generate hundreds of thousands of dollars per year. There would be little to no investment requirement once the cash starts coming in, but the firm can't necessarily invest in more patents at the same rate of return. The inventor might get their patent royalty check and move on to something else attractive. In other words, unlike the first asset type, this asset doesn't let you put your money to work at the same level through continued investment over time.
At some point, all assets are likely to transition into this asset type—normally at the point of saturation. When that moment is reached, a business 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.
Highly Appreciating Assets With No Cash Flow
This type of asset tends to produce returns above the rate of inflation—think of a fine art collection as an example. If your great-grandparents bought a Rembrandt or a Monet several decades ago, it could be worth millions of dollars today compared to the relatively small investment on their part. But over the years your family owned it, you wouldn't have been able to use the appreciation in the asset to pay rent or buy food unless you borrowed against it and incurred the interest expense.
For this reason, these assets are often best left to:
- Those who can afford to hold them: They should have substantial wealth and liquid assets elsewhere in their capital allocation, such that tying the money up in the investment is not a burden or hardship on the family.
- Those who have a knowledge of and passion for the collection market: These investors are more likely to have success and derive considerable pleasure from the art of collecting the asset (oil paintings, wine, coins, baseball cards, for example). Choosing this asset type is an investment win-win for them because they get personal utility and happiness from building the collection and monetary benefits as an added bonus.
Only invest in non-cash-generating assets about which you are personally excited.
"Stores of Value" That Keep Pace With Inflation
If you've ever watched an old movie and heard a character warn others to "hide the silverware" when a person of ill repute appears at the door, you already have a notion of this asset type. Certain assets are intrinsically valuable enough that they can keep pace with inflation, assuming you bought them intelligently at the lowest price you could get. While not investments in the traditional sense, these commodities provide a hedge against inflation when included in the capital allocation.
A classic example of this type of asset is high-quality furniture bought in the secondary market from antique dealers or at auction. It may seem absurd for a wealthy person to pay several thousands of dollars for a 19th-century armoire, but, assuming it was shrewdly acquired, it might end up not only retaining its value but also beating bond yields over the holding period.
You don't want a lot of your money in these sorts of assets, but if you live debt-free and things go south financially (an economic depression, for example), you'll at least have assets that you can sell for food or other necessities.
"Stores of Value" With Frictional Costs
Gold bullion, real estate, and Steinway grand pianos fall into this asset type. These assets tend to keep pace with inflation and have the potential to appreciate beyond that, but your gains will be offset by friction costs, which are indirect costs associated with the investment. For example, the price of gold has gone from $35 per ounce in 1934 to $1,702 in April 2020. Adjusted for inflation, this represents an increase of around 150% in 86 years. But the friction costs of storing and insuring gold would eat into those returns.
When you factor in friction costs and the risks of price volatility and extreme inflation, you might only achieve purchasing parity with these types of assets. In other words, these assets classes might keep you rich, but they're not a surefire way to gain wealth unless you deploy large amounts of leverage to amplify the underlying return on equity. In practical terms, investors could utilize leveraging by either borrowing to purchase real estate or acquiring gold futures.
Some wealthy investors engage in a form of leveraging known as "equity stripping." 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. This is a rounded figure based on the future value formula with 5% interest compounded annually. You'd be out of the frictional costs (homeowners insurance, heating, and water, for example), but would have had the utility of living in the property. Your returns with no mortgage would be unspectacular. You might have actually lost purchasing power after adjusting for the related costs on an inflation-adjusted basis despite having a "profit" of $3,320,000 because of one basic fact: Purchasing power is all that matters. What counts to your family's pocketbook is the number of hamburgers, pianos, cups of coffee, or whatever it is you desire that you can acquire.
If, on the other hand, you 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, resulting in a higher return on equity before mortgage costs. They would obviously have enormous mortgage interest expenses, but 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 potentially generated higher returns, you can't live in them.
The danger of using leverage is the damage it can do if prices fall, which can result in substantial, perhaps even bankruptcy-inducing, losses.
Rapidly Depreciating Assets With Poor Resale Value
From video game consoles to cars that lose tens of thousands of dollars the moment you drive them off the lot, these are assets that sharply lose value over time. These assets mainly come in two types:
- Those with a longer maturity/amortization timetable than the salvage value of the underlying asset: For example, you might borrow $3,000 for five years to buy a high-definition television that will be largely worthless by the time the debt is repaid.
- Those that come with high interest costs to purchase them: Exorbitant financing charges make it difficult to recoup the losses stemming from a low resale value on an asset.
These asset types can lead to a paycheck-to-paycheck lifestyle or serious debt and poverty, even for those in high-earning careers, so it's important to minimize the percentage of your capital allocation that you put to work in them to avoid the sunk costs.