My 'Cash Flow Investing' Strategy

My wealth has come from a combination of living in America, some lucky genes, and compound interest.

– Warren Buffett

“Cash Flow Investing” is a strategy of my own design. It can either be a stand-alone tactic or used in combination with stock and bond picking. The basic concept is to receive money, each and every month, with a few quarterly additions if the yield is high enough, that can be used for living expenses or used to increase the size of your portfolio and your wealth.

The underlying fundamental is the compounding of interest which, if you receive money monthly, adds approximately 1.10% or 110 basis points to the yields that you are receiving. It also has a further advantage, made clear in our recent correction, of having the readily available cash to buy assets at lower prices and higher yields minus any change in dividends.

When I began to employ this methodology, some years ago, I quickly discovered that closed-end funds offered the best opportunity for its use, to employ my strategy. ETFs are the more touted protocol because, in my estimation, the manager receives more money as the assets increase, which is not the case in closed-end funds. Given this dynamic, closed-end funds are the ignored step-child, which is fine with me, as I load up on the monthly, with a few quarterly, dividend pay-outs.

After more than four decades on Wall Street, I also know that “stuff happens.” Consequently, I use investment-grade Corporate bonds, with maturities of 5-10 years, all bought at par or less, as the anchor of my program. Minus a credit event, you should receive all of your principal back, at one hundred cents on the dollar, upon maturity, regardless of the machinations in the markets. The Corporate bonds generally pay semi-annually, and they represent one-half of the portfolio.

Now I have spent countless hours choosing the closed-end funds that I prefer. Currently, my favored closed-end funds are composed of eight, mostly bond funds, with a few equities scattered about in some portfolios, and six MLP closed-end funds and one REIT closed-end fund. My favored MLP funds hold mostly pipeline companies which can be thought of as toll roads, collecting fees, for the transmission of oil and natural gas. Prices of the commodities up or prices down, the oil and natural gas still have to be transported. Choosing these funds is no easy task and the complexity of the choices is based upon any number of moving parts.

There is the NAV, the fund’s liquidity, the leverage used, the quality of the assets, the expertise of the manager, the yield, and the track record of the fund, just to name a few criteria. You have to know what you are doing because, if you don’t, you will make some very poor choices.

One of the components, of virtually all of the closed-end funds, is leverage. This is troubling to some investors mostly because of a lack of knowledge, and understanding, in my opinion.

First, the leverage is the funds and not yours. You are borrowing nothing, and it is the funds’ obligations. Second, closed-end funds are limited to a maximum of 50% leverage by statute. Closed-end funds do not have the 200% or 300% leverage of some ETFs, most of which I consider to be toxic investments that are in the gambling category.

Let’s examine the leverage in context. John Mauldin, in Forbes, cites an $8.6 trillion U.S. corporate debt level. He further states that the average ratio of U.S. corporate debt to GDP is 45.3%.

In the case of the MLP closed-end funds that I like, the average leverage is 27.83%. The one REIT fund that I favor is levered at 27.40%. Then the average for the closed-end bonds funds that I prefer is 30.62%. This puts the average leverage of all of my closed-end fund choices at 28.62%.

Now, let’s look at the yields. Most, as I said, are monthly payers which, by compounding the interest, adds about 110 basis points to the yield. For reference, I use Bloomberg’s “Indicated Yield” as the basis for my computations. In the case of the MLP closed-end funds, the average yield is 12.15%. The REIT closed-end fund yields 11.56%. For the bond closed-end funds the average yield is 11.17%. This then gives you an average yield of 11.63% for the funds that I find attractive. To put this in perspective, the ten-year Treasury closed Friday at 2.88%.

Therefore, at this point in time, if one-half of the money is in investment-grade corporates, yielding approximately 4.25% and one-half of the money is in the closed-end funds then the average total yield is about 7.94%. This is a quite conservative strategy, in my opinion, and one which allows for a peaceful night’s sleep when turmoil is jumping about you during our recent correction.

I also point out that appreciation can be a factor. The concept is to “make money on the money.” Therefore, if there is any meaningful appreciation, I generally suggest taking the profit and rolling out of one fund, or one bond, into another bond or another fund to keep making all the money possible on the cash that has been committed to the strategy. Adjustments can be made at the end of the year for tax planning, if necessary.

There you have it, “Cash Flow Investing” explained. Compounding interest leading to compounding assets which provide monthly cash to adjust to market conditions.

Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.

– Charlie Munger

Carol Humphreys