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An unprecedented number of Americans have received unprecedented incomes and accumulated unprecedented net worth in recent years. Sure, the gains are tempered by the reality that while the top tier is gaining, the income shares of the rest are falling.
Many Americans have seen no purchasing power gains in decades, and they've only recently advanced because of the big fall in energy prices.
But lack of income didn't deter spending. In aggregate terms, spending has risen a half percentage point per year faster than after-tax incomes for 25 years, pushing the saving rate from 12% in the early 1980s to -1% today.
Many financed their excess spending growth by tapping stock appreciation during the long 1982 to 2000 rally and, more recently, their house appreciation. Don't believe the Bull Market bull. Get your portfolio in shape to survive tumultuous times.
While Washington politicians and even Fed Chairman Ben Bernanke wring their hands over income polarization, we're more interested in how the rich get rich. There are many strategies. A number are far from new, but have been pursued much more vigorously and with much more spectacular results in an era when extraordinary liquidity is readily available due to low volatility and low perceived risks. We've identified 11 different strategies that have stood the test of time.
Before examining each, however, we must point out that luck is often paramount, regardless of how sound or flawed the game plan. Being in the right place at the right time has made fortunes for idiots. Think of the dot-com speculator who only sold out in late 1999 because he was buying a McMansion for his new wife, and that house then doubled in value over the next five years.
Conversely, "the best laid schemes o' Mice an' Men, Gang aft agley, An' lea'e us nought but grief an' pain, For promis'd joy!" as Robert Burns put it. Bad luck can turn a surefire strategy into a disaster. Elisha Gray had the misfortune to arrive at the U.S. Patent Office to patent the telephone a mere hour after Alexander Graham Bell.
Furthermore, none of these strategies are surefire. As we'll discuss, all of them have pitfalls, sometimes because they are so successful that they invite their own demise.
1. Government subsidies
Perhaps the most time-honored and surest way to make big money is the old fashioned way--skill, brains, luck, clairvoyance, hard work--and so much government support you can't miss. Benefiting directly from direct government spending is obvious. What's more subtle and therefore more interesting are the vast government subsidies.
Again, this is nothing new. The Homestead Act in 1862 gave free Western land to homesteaders both to relieve crowded Eastern cities and to populate the continent before European powers encroached on the U.S. The building of the transcontinental railroads in the late 1800s was subsidized by free land in one-square-mile pieces on alternate sides of the right of way in checkerboard fashion.
Ethanol is subsidized with a $0.51 per gallon tax credit, an import duty of $0.54 per gallon and the elimination of ethanol's main oxygenate competitor, methyl tertiary butyl ether (MTBE). Some want more. The new 25-by-25 Renewable Energy Alliance of farm groups, hunters and fishermen and environmentalists calls for $64.5 billion in new federal subsidies to achieve its goal of producing 25% of the nation's energy from farm, ranch and forest products by 2025. The Department of Energy plans to provide $385 million in subsidies to six companies to produce biofuel alternatives to ethanol that will cost $1 per gallon.
But despite the current zeal for ethanol, it cannot be shipped by pipeline due to its corrosiveness, and the needed trains, tracks, storage tanks and loading and unloading facilities will be expensive. Add in the current high price of ethanol's main feedstock, corn, at $4 per bushel, and the natural gas needed to convert corn into ethanol, and this fuel could not compete with gasoline profitably without huge government support.
Today, ethanol costs about $1.60 per gallon to produce. It normally sells at $0.51 per gallon more than gasoline, reflecting the subsidy, but now the spread is $0.45. And at $2.06 per gallon, ethanol ex the subsidies fetches $1.55, or $0.05 per gallon below costs.
2. Inheritance
You can always make big money by picking rich parents who die young, or wealthy and feeble uncles with no other heirs. For most, however, inheritance is not the route to riches. The fact is, parents are living longer and incurring more medical expenses before they die. A 65-year-old man can expect to reach 81 and a similarly aged woman is likely to live to 84. That's almost two decades beyond normal retirement, and in that time high and soaring health care costs may well dissipate wealth substantially.
About 40% of those 65 and older will probably spend some time in a nursing home, and costs there can run over $100,000 per year. So most Americans will need to look at strategies beyond inheritance to make big money.
3. Little equity, lots of debt
You can make lots of money by investing with little equity and huge borrowing--as long as you're right on the investment's price direction. Real estate is obviously in this arena. Earlier, 20% down payments on houses were the norm, but they've shrunk to zero or even negative numbers with "piggyback" loans, second mortgages on top of the usual 80% first mortgages, which can take the total loan to more than 100% of a house's value.
Example: If a house buyer puts down 20% and the price rises 10%, he makes 50% on his investment--excluding, of course, brokerage commissions and other closing costs, taxes, maintenance, utilities, mortgage interest, interest foregone on his down payment, etc. But with 3% down and the same 10% appreciation, the gain on his investment is 333%.
4. Leverage
Our third strategy, little equity with lots of debt, amounts to huge financial leverage. But leverage as a way to make big money extends well beyond the use of debt.
Example: Think about movies vs. stage productions. A play can only reach an audience of several hundred and must be repeated night after night by the same actors to generate much revenue. But movies are presented to unlimited audiences worldwide and, if they have legs, for decades to come. The same leverage and opportunity for big money exists for entertainment transmitted via CDs, DVDs, radio, TV and the Internet.
5. Great ideas, but not necessarily the first implementers
Ralph Waldo Emerson supposedly said, "If a man can write a better book, preach a better sermon, or make a better mousetrap than his neighbor, though he builds his house in the woods the world will make a beaten path to his door."
Example: Ever hear of Seattle Computer Works? That company developed a computer operating system in the 1970s that Bill Gates bought in 1980. IBM was late in realizing the potential of PCs after Apple led the way, and knew that its engineers were too tradition-bound to develop an operating system quickly. So Gates paid $50,000 for Seattle Computer Works and licensed MS-DOS to IBM for use in every one of its PCs.
6. Small slices of very big pies
Fortunes can be made by taking small slices of very big pies, especially if those ultimately granting the slices are making money. Fees of, say, 0.1% of the transaction's price don't sound big, but they add up to big numbers.
Example: The term "leveraged buyout" got a bad connotation with the discrediting of Michael Milken and the collapse of his company, Drexel Burnham, in 1990. So they're now called "private equity deals." Nevertheless, those involved still treat themselves to huge fees in dollar terms, but still minor percentages of the deal size. Equity Office Properties Trust, a Real Estate Investment Trust, was recently acquired by Blackstone Group after a takeover battle with Vornado Realty, which forced Blackstone to increase the price to $39 billion, including debt.
On a deal of that size, investment banking fees would normally run around $40 million, or 0.1%. But Blackstone, like other private equity firms, acted as both client and banker with no party on the other side to resist bigger fees. So Blackstone charged a net $100 million.
7. Cartels and monopolies
Cartels and oligarchies are great ways to make big money--as long as they last. Of course, a cartel only works when demand is so insensitive to price that higher prices will actually increase the seller's total revenue. The purpose of cartels is to exercise monopolistic control--to raise prices and revenues by limiting production, restricting exports, setting prices, dividing up markets among the cartel members, setting up standards of accounting and markups, etc.
Example: Until 1978, airlines were controlled by the Civil Aeronautics Board, which controlled airline routes, with specific airlines pretty much dominating specific geographic areas. Fares were also controlled by the CAB, which essentially rubber-stamped whatever airlines wanted.
Since passengers paid through the nose, the industry thrived even though costs were high. Airline personnel were well paid, and senior pilots made more than $200,000 per year--a king's ransom in the 1970s--for working less than 40 hours per month. This allowed many of them to live in, say, Montana, and commute at company expense to their flight bases in New York and other major cities.
8. Sell the sizzle, not the steak
An age-old route to riches is to promote hopes and dreams, regardless of how far they may be from reality. Of course, government regulation has curtailed the wild health claims for snake oil and many other patent medicines, hair restorers, potency formulas and fountains of youth, but opportunities still abound.
Example: Penny stocks of dubious, even nonexistent Canadian gold mining companies have long been the staple of the Vancouver Stock Exchange and appeal to sizzle lovers. So, too, do get-rich-quick schemes and the get-rich-quick and related self-help books. The purveyors can make good livings and then some selling their strategies as they prey on hopes and dreams.
9. Take advantage of addictions and vanity
Catering to addictions and vanity has always been a big moneymaker, even more so when they are outlawed. Think of sex and prostitution, the world's oldest profession.
Example: Caffeine addiction has created vast fortunes in coffee and tea. It had a lot to do with originally attracting the British to the Far East. And don't believe soft drink makers when they say they put caffeine in their products to improve the flavor and pep you up. It's mainly to make them habit-forming.
10. Picks and shovels
Supplying goods and services to a risky but potentially very profitable venture is a time-honored way to clean up. The old story is that few gold miners in the 1849 California gold rush got rich, but those selling them picks and shovels--and Levi pants--did. Fast forward to today, and businesses that prosper as suppliers to those who hope to make gigantic profits are legion.
Example: In stock bull markets and especially bubbles, investors have dreams of fabulous riches and will pay heavily to those who serve their needs, aspirations and whims. This includes stockbrokers, as shown by the close correlation between stock prices and brokerage commissions. Ditto for investment advisers and mutual fund advisers. Those that provide back office, custodian and other services to stockholders like State StreetBoston are also in the picks and shovels business.
11. Get paid with money that isn't the payer's, especially if they're desperate
Small pieces of big pies get bigger and easier to obtain when the buyer of the pie wants it badly and considers the service in question essential to get the deal done.
Example: CEOs are often quite free with corporate money in paying bonuses to consultants who may help save their companies, even when those outside experts tell them what they already know. A CEO friend talks about high-priced consultants he hired who took what he called "a walk down the hall." They interviewed all of his senior staff on the issue in question and then simply regurgitated that information to the CEO.
Excerpted from the March 2007 issue of A. Gary Shilling's Insight. For more ideas and analysis from A. Gary Shilling.