0110 Secrets of the Capitalist Class
As you learned in Class in the United States and Household Income in the United States, the capitalist class represents the top 1% of income. Sometimes called the super-rich, in 2013 members of the capitalist class had a minimum income of $389,436. However, if you live in Connecticut, the minimum is $659,979, Washington DC is $554,719 and New Jersey is $547,737.
To make the top one percent of the one percent you needed a minimum income nationwide of $8.32 million in 2013. To be counted among the Forbes 400 you needed an adjusted gross income of $100,000,000 according to the IRS.
In this discussion, part of our How to Get Rich guide for new investors, we'll reveal the secrets of the capitalist class. You'll learn what they do differently that results in building wealth. You'll find out the philosophies that helped them reach a place where they are financially independent enough to spend time with family or travel the world.
A High Income Isn't Enough to Truly Join the Capitalist Class
Before we begin, let me reiterate the example I provided in Class in the United States to illustrate the difference between merely having a high income and truly being a member of the capitalist class.
Imagine two men, Greg, and John. Greg is a medical doctor and earns $300,000 per year. He has to show up to work regularly, using the rare skills he’s acquired through a very expensive medical school education and years of on-the-job training. If he dies, or goes into a coma, his family will receive little or no income because he’s unable to work. John, on the other hand, owns a $3,000,000 limited service hotel that generates $300,000 per year for him. He doesn’t have to run it or be involved in any way because he pays a management firm to set rates, staff the property, and maintain the standards required by his franchise agreement. If John suddenly passes away or is incapacitated, his property will continue to generate income.
Make Money Work for You
I've always said that the purpose of investing is to make your money work for you so that it generates cash regularly instead of (or in addition to) you having to sell your labor. In this case, John is truly a member of the capitalist class because he owns assets that generate cash for him as a result of providing needed services to the economy. In other words, John is not important or respected because he is rich; he is rich because what he has built fills a necessary need in society and the money is evidence of that. Greg, however, is very well off and experiences a standard of living among the highest in history. But he is not a true member of the capitalist class. To be, he would need to take his earnings from practicing medicine and build a collection of cash generating assets that could work alongside him, pumping out money as he focuses on healing people at the hospital.
02They Work on Projects that Pay Dividends for 25+ Years, Not a Single Paycheck
The Answer is Passive Income
The single biggest distinction between the capitalist class and the lower classes is that the members of the capitalist class focus their efforts on projects that will continue to generate dividends for years, if not decades. The lower classes do the same work, but exchange it for a paycheck that is gone once they've spent the money.
An Example of a Paycheck vs. Dividends
Take the Drury Inn. The highly acclaimed upscale limited service hotel in the Midwest was began by a family that owned a construction business. They realized that instead of building hotels for other people, they could construct their own property, earning money for decades on the guest revenues. To borrow a phrase from a very wise business consultant: In effect, the construction company got paid once for every nail that was pounded into the building. Now, the nails are more like an annuity stream. The same cost. The same effort. Far different consequences for the owners, who receive huge monthly cash flows from the properties, some of which are valued at $15 million or more.
03They Diversify Income Sources as Well as Assets
You often hear the financial media, as well as stock brokers and financial planners, talk about the importance of diversification. But they almost always focus on diversification of assets. The capitalist class realizes that the much bigger opportunity is focusing on diversification of income source. We discussed this powerful concept in How to Utilize the Berkshire Hathaway Model In Your Own Life.
You inherently know this, even if you don't follow it yourself. Who would you rather be: a highly paid executive earning $300,000 from a manufacturing company or a middle manager earning $100,000 at your job plus collecting another $200,000 in real estate rents, dividends on stock holdings, consulting fees, etc.? The latter is in a far safer place and much more likely to survive recessions or bear markets.
Lowering Risk, Increasing Income
In fact, diversification of income not only lowers your risk, it makes it easier to get rich because you can use earnings streams to buy undervalued assets when everything crashes. If you had been the executive earning $300,000 and been laid off, you probably wouldn't have been in a position to come up with money to invest when bank stocks such as Wells Fargo hit $10 per share. Yet, if you had been the middle manager, you could have used your profits outside of your salary to buy those cheap shares, even if you had lost your job, because you wouldn't have needed every penny to cover your bills.
04The Capitalist Class Prefers Passive Income Over Active Income
Members of the capitalist class value their time. That's why they want the biggest chunk (if not every penny) of their cash to be generated from passive income sources. As you learned in Introduction to Passive Income, passive income doesn't require you to actively be involved to earn a living, freeing you up to focus on more important things, such as your family and your leisure.
Passive income can come from sources as varied as:
- Rent from real estate properties
- Patent royalties for an invention
- Trademark licensing fees for characters or brands you’ve created
- Royalties from books, songs, publications, or other original works
- Profits from businesses in which you have little or no day-to-day role or responsibility
- Earnings from Internet advertisements on a blog or website you own
- Dividends from stocks, REITs, equity mutual funds, or other equity securities
- Interest from owning bonds, certificates of deposit, other other cash and cash equivalents
- Residual income for a sales person on accounts that are typically renewed automatically
An Example of Passive Income
A few weeks ago, one of the companies I founded approached a local manufacturing business and signed a contract to create a software platform that would let this firm's wholesale customers order through a password protected site, track the progress of their purchase orders, track packages in real time, send messages, pay invoices, and much more. In exchange, the company didn't pay us a penny, but rather allowed us to add a 5% surcharge on all orders that came through. We earn about $50,000 per year in profit because the system has no cost to us and there will be little or no maintenance going forward (perhaps a few hours each month). That money will go directly into expanding our other companies or buying shares of stock.
If we pay $18,000 in taxes on that profit, this leaves $32,000 for our shareholders. Assuming we can earn 15% on book value over the next 20 years, this stream of after-tax profit is worth nearly $3,278,200 to my shareholders. Every day we show up at the office, our goal is to find projects like that and have the money reinvested in cash generating assets.
How You Can Do It
It's extremely simple. There's no reason you can find opportunities in your own life to solve people's problems and make money doing it. The secret is you must focus on how you can achieve the objective without being actively involved.
05The Capitalist Class Understands the Nature of Money
The poor and working class see money as a finite commodity; there is only so much and then you spend it until there is none left. The rich members of the capitalist class know the truth: Money is like a seed. Each dollar that comes in to your hand has the potential to be planted, grow, and expand into far more money. It's no different than a farmer growing corn. You can either eat your seed, or plant your seed. One gives you satisfaction today; the other can feed your family for generations.
Focusing on Rate of Return Over Time
Everyone wants to be a Warren Buffett. Yet, when you consider that an 18 year old today has 67 years to compound to reach the same age as Buffett (currently 85), it becomes clear how easy it would be to grow rich. If our teenager were willing to save $10,000 per year - an easy task for those who start out with that goal and avoid credit card debt - at a 12% annual rate of return, they'd have over $85 million by the time they were Buffett's age! But it takes discipline and focus.
The capitalist class understands that time is the friend of money. Like a great oak tree from a tiny acorn, the longer capital can be left to grow, the larger the ultimate fortune will be. The capitalist class also understands that rate of return is extremely important.
06The Capitalist Class Makes Its Own Luck
Luck vs Focus
The lower and middle class foolishly assume that the capitalist class is merely lucky or cheats to get ahead. What they don't realize is that the capitalist class is constantly working, studying, and creating opportunities.
Think of it this way: The average person very rarely takes risks or chances. They often get up, go to work, and come home. With the capitalist class, they are researching investments, building shopping centers, finding investors, launching new products, or going after big clients every single day. When only one of these activities pays off big, it's enough to be set for life. To the outside world, it looks like mere luck.
Where Preparation Meets Opportunity
I encountered this in my own life. Several of my family members asked what I was going to do with myself after I had graduated from college. The fact that I had been obsessed with investing since I was ten years old, and had saved nearly every penny to build my investment portfolio, wasn't visible to them. Then, out of nowhere (to them), I bought my starter house, my first car, and new furniture. How? Years ago, I set aside a very large percentage of my assets in shares of AutoZone because of the repurchase program that had begun when ESL investments got control of the firm. Those shares continued to grow and I was able to use them to pay for the personal side of my life without hurting my companies and taking money out of them.
I read several thousand 10K reports each year for companies that most people don't even know exist. I spent years studying accounting. That's what led me to that investment.
Perhaps Oprah Winfrey summed it up best when she said, "What looks like luck to most people is when preparation meets opportunity." The capitalist class is constantly out there looking for, and creating, opportunity.
07The Capitalist Class Doesn't Care What the Market Does
What Matters is What You Do, Not What the Market Does
One of the favorite questions of the middle class is, "What is the stock market going to do?" or "Where do you think real estate prices are going?" You'll very rarely hear this asked by a member of the capitalist class. Instead, the questions will be more along the lines of, "What do you think the Burlington Northern Santa Fe deal will do to Berkshire Hathaway's earnings five years from now on a per share basis?" or "Do you think we could get tax credits by purchasing those properties and opening low-income housing rentals?"
The middle class is looking for someone to hold its hand and tell them whether to buy or sell. The capitalist class is trying to calculate the value of specific assets and then makes a decision to buy or sell based on that calculation. The former requires total guesswork, whereas the latter is entirely based on conservative mathematics and sound business.
That is one of the major reasons its rare to see capitalist class investors panicking when the market collapses. Through the credit crisis that started in 2007 and extended into 2009, as the Dow Jones Industrial Average plunged from 14,000 to nearly 6,000, the news was filled every day with stories of Warren Buffett, Goldman Sachs, or JP Morgan buying up everything it could afford.
The capitalist class credo could best be summed up as, "The market may go up, the market may go down, but there will always be intelligent things to do."
08The Capitalist Class Understands Taxes
Study Money, Finance, Accounting and Taxes
The average person doesn't bother to read the tax rules or pay to have good accountants. It is more than possible to save substantially on taxes by learning the regulations the IRS makes available in easy to download documents on the official website.
Imagine you know a member of the capitalist class who invested $10,000 in Walmart back in the 1970's. Today, those shares, with dividends reinvested, are worth more than $10,000,000 and pay out cash dividends of approximately $210,000 each year. If he wanted to come up with money without selling any shares, he'd likely know his options included:
- Depositing the stock into a brokerage account and borrowing small amounts on margin against the underlying shares. The debt could be withdrawn without triggering the capital gains taxes. As the dividends were received into the account, they would lower the margin balance.
- Using the shares to fund a limited liability company or a limited partnership and then gifting equity in this partnership below the gift tax levels to children and grandchildren. If he is married, between him and his spouse, he could give up to $26,000 per year to each person without triggering taxes. If he had 4 children and 16 grandchildren, this could result in a transfer of $520,000 annually. Over time, he'd be able to get a lot of wealth into the hands of his family without capital gains tax consequences.
- He can setup a charitable remainder trust funded with the shares. The trust document will call for a certain percentage, say, 5% annually, to be paid out to a beneficiary of his choice (a child or grandchild), with instructions that when that person passes away, the remaining money in the trust will go to a charity he has defined as the death beneficiary. He gets a tax write-off for donating the shares, his child or grandchild gets a regular "paycheck" to help them build their life or purchase a home, and later, the charity benefits from a large donation because it's possible the account has grown in value through compounding.
These are just a few examples of how the capitalist class is able to achieve its objectives, support charity, and still end up with more money in its pockets by knowing the tax rules.
09The Capitalist Class Thinks of Business as a Game
The Balance Sheet is Your Scorecard
The middle class often has an almost perverse relationship with money. From the time students leave college, they are told to get a good, "secure" job with benefits, fear stock market fluctuations, and spend their money on assets that depreciate such as cars and consumer electronics. For the capitalist class, business and money are merely tokens - tangible proof that they have succeeded. Some capitalist class members have described the balance sheet as the "score card" by which they can compare themselves to their competitors.
This approach to business, and life, makes it easier to take risks. It removes a lot of the fear because you know that if you lose money (which, of course, you always avoid at all costs), you're only one idea away from rebuilding the asset.
10The Capitalist Class Realizes Money is a Fungible Commodity
Money as a Fungible Commodity
A defining characteristic of the capitalist class is that they treat money as a fungible commodity. This manifests itself in several ways.
- Members of the capitalist class don't care if they earn their profits from non-sexy businesses such as trash hauling, storage units, or plumbing services.
- When raising capital to start or expand a business, members of the capitalist class don't care where the money comes from, only the terms and cost of the funds. They will often approach banks, private equity groups, or even insurance companies!
- The capitalist class sees every dollar as a dollar and puts it toward its greatest use.
11Profile of the Capitalist Class
So, now that you know some of the secrets of the capitalist class, it might be useful to see who the average member of the capitalist class. According to government and private research data, the capitalist class:
- More than 90% did not inherit their money - they are entirely self-made.
- Many own their own business and have lived in the same town for more than a decade. These businesses are unglamorous and include things such as HVAC, commercial plumbing, self-employed lawyers, accountants, and real estate investors.
- More than 90% own their own home and have lived in it for years. Fewer than 7% rent or lease.
- More than 90% graduated from college, but grades had no correlation with their financial success. In other words, students with a C- average were just as successful as those with an A average.
- Most newcomers work in the financial or securities industry.
Membership is Not Guaranteed
About 11% of Americans will join the 1% for at least one year , but only 5.8% will be in it for two years or more. Only 1.1% of Americans hold onto this status for at least 10 years.