For some reason I got to thinking about the news last month of the sudden death of the Duke of Westminster. It’s not that I’m big on landed gentry and aristocracy or anything but the Duke had invested a significant sum in transforming the centre of my home city, not for charitable reasons of course as I imagine his estate will earn plenty from rents, but it was a much welcome regeneration job that has left the place markedly better off than it was before. Upon the Duke’s death his titles, lands, estates and so on will pass to his son who, at the age of 25, is now the 7th Duke of Westminster and will inherit a £9bn fortune that instantly makes him the world’s wealthiest person under the age of thirty if reports are to believed.
In a way it’s quite strange that the aristocracy has kept itself in business in the U.K. considering all that’s happened over the past several hundred years. Back in medieval England the idea of passive income would have been almost exclusively tied to the concept and economics of land. If you were born into the nobility you were essentially born into a stream of passive income. Depending on what kind of nobleman you were The Crown granted you the rights to certain lands in return for services and patronage. You in turn got to levy rents on the tenants who had the right to work and farm the land.
It wasn’t much of system if you were a tenant, as rents were often extortionate, but pretty fantastic if you were in the nobility. Owing to the rise of capitalism the young Duke will probably not be receiving rents from largely impoverished tenants in return for farming rights today, but instead from the kinds of ventures that transformed the centre of my home town. Stuff like shopping malls, cafe’s, restaurants, hotels and so on.
The other thing is that the development of the modern capitalist economy means we’re no longer tied to land as a source of a passive income. Check out the stories of people like Ronald Read, or Margaret Dickenson and Paul Navone. These were not people who were ever in a position to inherit vast sums of wealth in life, but through their own accumulation of productive assets were able to build significant passive income streams. By productive we are talking about assets with almost insane levels of cash generation.
Just like the Duke’s ownership of real estate such as hotels and retail developments regularly churns out cash, so did their ownership of highly productive enterprises like Johnson & Johnson, British American Tobacco and Exxon Mobil. The thing is that so many investors don’t view it in that light because the initial results don’t show you much. They want to be like those noblemen coming into the assets on day one instead of slowly becoming their own passive income baron.
Here’s the way I view it. In the vast majority of cases you’re going to be working for a living; that’s your labour time in exchange for cash needed to live. The road to significant passive income starts when you’re in a position where you can save some of that cash and become an asset owner. At that point you’re accumulating productive assets that start to work for you. Let’s say you can tuck $1,000 a month away in cash savings. In year one that starts you off in the core portfolio positions that span right across the economy. You get energy through Exxon Mobil or Royal Dutch Shell; you get beverages with Coca-Cola and Diageo; food with Nestlé; household goods with Unilever and Procter & Gamble, and so on.
Year one doesn’t look too inspiring because your passive income only comes in at a few hundred bucks. A 3% yield on your core holdings only gives you about $480 in passive income for example. By year two that would probably be over $500 on its own accord without you doing anything. But here’s the thing: when you reinvest those dividends that’s a few hundred dollars that is now working for you. It’s not anything significant yet – only enough to bring in an extra couple of dollars per year – but it’s a start. Once you get past years ten, fifteen and twenty then you’re reaping the rewards of super high quality cash flow that you can almost run on autopilot.
That’s the difference between owning something productive and not. It’s wealth creating more wealth. The sooner you start and the more savings you can allocate will speed up the process.
Building Passive Income: Kellogg Company Case Study
Let’s take a look at a real world example using Kellogg, which is pretty much your stereotypical boring blue chip defensive stock. Its organic growth prospects are pretty limited, but the underlying earnings are high quality due to its type of business and the brands they own. Imagine that rather than diversifying across several highly productive stocks we plug $12,000 into Kellogg stock at the start of every year instead. How would that have looked over the past decade?
Starting off in 2006 our year one purchase produces a total of $309 in passive income from an initial total of 271 shares in Kellogg. Every year you deposit an additional check for $12,000 with the transfer agent to purchase more stock and set the dividend option to automatically reinvest into more shares. By year five you’ve accumulated a total of 1,315 shares, 10% of which have come solely through reinvesting dividends. In total that was enough to throw off $2,050 a year in additional income, which just so happens to be around the average annual spend on gas for the typical American household. Essentially you bought yourself free gas for a lifetime if you quit at this point. That’s cash flow that you can then deploy elsewhere, hopefully in the pursuit of picking up more cash generative assets.
Let’s say you carry on reinvesting and putting in the $12,000 at the start of each year. By the end of year ten you’re looking at 2,740 shares in Kellogg delivering $5,400 this year in passive income. That’s easily a solid month’s worth of income for the average American household. The value of the reinvested dividends would be equivalent to about a quarter of the total starting value of invested capital (428 shares worth approximately $30,000). If you quit there then you’ve essentially bought your household a bonus month’s worth of income for the rest of your life.
Imagine being in a position to start that process off in your mid to late twenties. By your mid-thirties you’d have bought yourself a month’s worth of essentially free income. That’s just over a ten-year period. Had we started the same process just five years earlier at the start of 2001 then the passive income this year would be well over $10,000. Over a fifteen year period in a fairly stodgy defensive stock that’s pretty darn good. Even if you decided to stop at the point that’s an extra $10,000 every year to supplement your life; equivalent to a couple extra month’s extra income for the average American household.
What’s more is there’s a good chance that figure will grow over time. It might not be amazing growth depending on your chosen stocks, but it’s income growth you no longer have to work for. If you’re smart you allow the cash thrown off by your expanding empire of productive assets to accumulate even more productive assets. By years twenty-five and thirty the results will start to look spectacular.