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Internal Rate of Return and the Cultural Divide of Cash Flows


Plus how John D. Rockefeller Jr. continues to exemplify success.


Editor's Note: To read more of Reid's content, visit the RLH Volatility Model.

When somebody asks me, "Hey, Reid, is 'X' a good investment?" I have but one invariable reply: "Compared to what?" Not because I'm a smart-ass (which I am), but because that's the only answer there can ever be. That's just the way life is. There are no absolute answers in finance, only relative ones.

If you like spreadsheets (I love them), the wide variety of financial calculations built into Excel for conducting "compared to what?" analyses is way beyond adequate for slicing and dicing the questions and comparisons to almost anyone's satisfaction. Yet so is the H-P pocket calculator I've carried around in my pocket since the late 1970s, and that's because the basic question encompassing a dollar parted with today weighed against an expected dollar coming back tomorrow hasn't changed. That is, how much am I putting up (cash flow out, investment), how much am I going to get back (cash flow in, expected return), when am I going to get it (time frame), and how likely is all that to happen without an untoward hitch in the road (risk, volatility, and probabilities)?

First, get your head in the right place for thumb-nailing and ball-parking -- the orientation you should always establish prior to booting up the computer -- and understand Present Value (PV), Future Value (FV), cash-flow sign convention ("-" for "out" and "+" for "in"), time (t), and Internal Rate of Return (IRR).

What are we trying to get our arms around when we size up an investment? That, of course, depends on the kind of investor (e.g., passive or active, net worth, risk type, and tolerance), the general category of the investment (e.g., real estate, stocks, bonds, direct), and the time horizon and what you're trying to accomplish (e.g., income, capital appreciation, liquidity concerns). There's as much art as science in identifying and putting measuring sticks to work on these criteria, and then, naturally, there's also a need for some kind of universal benchmark against which to compare and contrast the resulting evaluation.

This is what Internal Rate of Return calculations are intended to facilitate.

The Cultural Divide

The greatest psychological difficulty most passive investors bring to the table is not having experienced what it is to start, and run, a business. As with being a parent and raising kids, there's no way anybody knows what it is to make payroll until they've done it. The knowledge only comes with experience. Most investors are passive. They look at buying a stock or bond as a kind of "deferred-gratification ATM," a mindset that says, "I've worked hard, I've kept my spending under control, I have something to put away, and I'm doing that with the expectation that I'll be rewarded for my good behavior down the road when I draw it out for retirement, a kid's college tuition, or some other long-term goal." Play it straight now, live it up later -- the bedrock of good middle-class values.

A lot of very wise folks will tell you that those values have carried the day for this country and the greater part of Western civilization and elsewhere for a long, long time -- having more to do with securing for us peace and prosperity than great leaders or strong militaries or just about anything else. People keeping regular hours and good habits, getting up in the morning, going to work, doing their jobs, saving, and investing a portion of their earnings on a regular timetable; being good citizens.

Problem is, the business of capitalism isn't like that at all. For the most part, the great capitalists of history -- the people who have come up with the great, world-beating ideas, fought off the doubts of the naysayers ("Are you kidding? That'll never work!"), hung in there when nobody was on their side, then realized their vision and capitalized on it all the way to the point of great riches -- have been anything but normal good citizens abiding by the virtues of moderation and consistency in their daily lives. Indeed, I'd even go so far to say it's amazing most of them didn't wind up in the mental wards in straitjackets, and some of them have even done that. I sometimes wonder if among today's lunatic-asylum residents there aren't cures for cancer, solutions to the Gulf oil spill, and myriad other miracles trapped in the addled brains of the dispossessed and misfits society's conventions can't and won't tolerate as members of the mainstream.

And that's whom you're betting on when you contemplate an investment.

About the only concept in finance that's ever come close to capturing the essence of this insane lifestyle inherent in the people who create wealth and the enterprises they've built in which we contemplate investing is "uneven cash flows." This is a prosaic way of saying that most successful enterprises come about because the people behind them are so fanatically driven -- so unswervingly committed to going up against the grain of values held out to us as the foundations of successful existence according to those who impart the examples of what is "normal" -- their vision can't be defeated by everything around them telling them they're crazy. Indeed, being perceived that way almost seems to be their badge of honor, spurring them on all the more to rage against the machine.

Investing Is Really About Putting a Nutcase's Insanity and Rebellion to Work for You

Unconventional people often appear to be quite conventional, especially dressed in suits and ties, and mingle with conventional people without upsetting the social apple cart all the time. You might say they hide in plain sight. Their lives behold some of the great wonders of business -- nay, human -- history.

Consider the case of John D. Rockefeller Jr., and try hard to imagine what it was like to be that man. If you're reading this piece in some obscure cubicle that happens to be in an ordinary office building on that island known as Manhattan, cast off your current bad attitude -- you: "Ah, crap, it's another boring day at the office doing a job I'm not thrilled with" -- grab a nice greasy falafel from your favorite pushcart vendor, and take a lunchtime stroll with me over to Rockefeller Plaza. Unless you're a hardened shell of epoxy, an unmistakable yet indescribable feeling will come over you.

What you're feeling when you visit Rockefeller Center is exactly what John Jr. wants you to feel -- yes, I'm saying that in the present tense, even though he's dead. He was one amazing guy, and his dazzling spirit is still with us, I fervently believe. Always helpful to start with a visual, so get a good gander of the following:

Check out that rounded collar. Just reeks of success, doesn't it? I wonder why they didn't snug their tie knots up the way we usually do today, but it's a nice look, isn't it? Something that says, I'm richer than all get-out but there's a hint of a rascal in me, even in an expensive suit. But those folded hands, framed by French cuffs fastened by no-doubt expensive yet not-at-all-ostentatious cufflinks -- not to mention those impossibly long fingers! -- bespeak at once something genetically unusual as well as piety.

That leaves the face. That face says it all. This was one serious man. That is the face of a man shaped by serious experience.

The rest of the photo: darkness. It's lonely at the top.

But let's flash back first, because that portrait above, taken in 1915 when he was 41 years old, came along later on. John Jr. was born in 1874 and died in 1960. He was the fifth and last child of John Senior (1839-1937), who, as you can tell by these numbers, lived to the ripe old age of 98, an amazing feat in 1937. I guess it takes that long to build something as big as Standard Oil, but it also means the old man was 35 upon Jr.'s arrival. So by just shy of the turn of the 20th century, when Jr. was graduating from Brown (having resisted heavy pressure to go to Yale) -- where, of all things, the greatest capitalist scion ever earned honors for, among other things, studying Karl Marx's Das Kapital -- young John was now a man of just 23 years and his father was approaching dotage.

In some ways, he wasn't any different from most of us. Imagine yourself coming out of college, a degree highlighted by revolutionary Marxist philosophy under your belt, and your dad isn't only the richest man alive, but the richest man ever, and single-handedly has the world's energy supplies by the short hairs in the midst of the Industrial Revolution, with Karl Marx in the philosophical avant-garde background, inciting revolt against the Robber Barons, and you're a bit of an expert on that subject. Not surprisingly, young John didn't have much of an interest in the family business (except indirectly and academically, maybe also as a sense of family obligation), as hard as that may be to believe now. Quite a bit to have on a young man's plate but, still, just like us. Would you want to be you, or just a piece of the brick and mortar -- and incredibly earth-encircling tentacles -- of Standard Oil?

Talk to Me, John Jr.!

Hey! I'm talking to you, capitalist spirit, falafel in hand, sitting among your greatest real-estate legacies crowned by 30 Rock, a gem among gems, a true mother in the Mother of the Arts: architecture! Who are you?! What did you think about?!

Well, young John, after all, was only a man like the rest of us so, yes, he did join the family business after graduating from Brown. But after 13 years of it -- consumed by an ever-growing feeling of immense responsibility he began to develop even as a child, that his calling was an undeniable moral obligation to put the family fortune to use for the greater good -- passion eventually took command of his destiny, and he walked away from those Standard Oil offices in 1910 solely for the purpose of distancing himself from that fortune. He called it purification. He felt deeply that the pure calling of philanthropy was otherwise sullied in the context of pure capitalism. Heavy stuff. The Industrial Revolution's secular moral equivalent of St. John the Divine, so to speak.

Then what? You might say the attempt to contemplate his moral and philosophical navel didn't last very long, and another seminal event took control. Historians dispute one another what John Jr. actually knew regarding the events that led up to the Ludlow Massacre of 1914, the culmination of labor unrest in a Colorado mining operation owned by the Rockefellers.

Twenty men, women, and children died in the violence of that incident. For John Jr., it was the transformational moment for which he believed God put him on Earth, and it defined the man he would be the rest of his life.

The atmosphere at Ludlow was anything but calm; it was incendiary. But that didn't mean a thing to this dedicated and morally determined philanthropist. He was going out there to deal with these ordinary people who worked the mines, people unlike anyone he'd ever known or associated with in his family's rarefied ranks. Against all advice. The family lawyers and other advisers told him he'd get shot if he went there. He went anyway. He went right down into the mine, all by himself, and he talked to them. What happened after that, the accord that was reached, is still looked to by modern management and union leaders alike as the gold standard of labor relations.

I can only surmise, but I think that's when John D. Rockefeller, Jr., first felt like he was his own man worthy of examination by the Creator without worrying he hadn't done enough to justify his life. I bet he felt pretty good, just like I do right now sitting among the buildings he left us, munching on my falafel, and watching busy New Yorkers and foreigners from distant lands stream by on this overcast day in early summer 2010.

On a concluding note, regarding my observations of Rockefeller, while he was a deeply religious man, and that was the centerpiece of his philanthropic interest, that didn't mean he considered making money to be an evil thing. I'll leave you, the reader, to investigate on your own how this is a part of the moral framework of Protestant beliefs of that time that live on to this day.

So What the Heck Does This Have to Do With Investing?

The point is that great enterprises aren't built by people who live the far more conventional lives of most investors. Great enterprises are built by people who hang in there during extended lean years and crises that test your soul; who sacrifice everything, who go bust -- often more than once -- because they're immovably dedicated beyond rational explanation. No, John D. Rockefeller Jr., never went hungry and never went bust, but I'm confident he would have had he not happened to be Senior's son. How do I know that? I just do. Right now I'm reading his greatest piece of writing, and it's right here on a tablet in Rockefeller Center so you can read it too, etched into a polished granite tablet far more grandiose than those handed to Moses.

These are the ideals that drove John Rockefeller Jr., and if you ever attend an analyst meeting on Wall Street for ExxonMobil (XOM), there isn't an ice cube's chance in hell anybody will mention it:

I Believe

  • I believe in the supreme worth of the individual and in his right to life, liberty, and the pursuit of happiness.

  • I believe that every right implies a responsibility; every opportunity, an obligation; every possession, a duty.

  • I believe that the law was made for man and not man for the law; that government is the servant of the people and not their master.

  • I believe in the dignity of labor, whether with head or hand; that the world owes no man a living but that it owes every man an opportunity to make a living.

  • I believe that thrift is essential to well-ordered living and that economy is a prime requisite of a sound financial structure, whether in government, business, or personal affairs.

  • I believe that truth and justice are fundamental to an enduring social order.

  • I believe in the sacredness of a promise, that a man's word should be as good as his bond; that character -- not wealth or power or position -- is of supreme worth.

  • I believe that the rendering of useful service is the common duty of mankind and that only in the purifying fire of sacrifice is the dross of selfishness consumed and the greatness of the human soul set free.

  • I believe in an all-wise and all-loving God, named by whatever name, and that the individual's highest fulfillment, greatest happiness, and widest usefulness are to be found in living in harmony with His will.

  • I believe that love is the greatest thing in the world; that it alone can overcome hate; that right can and will triumph over might.

Am I attempting to say these are the driving beliefs of all capitalists shaping the great enterprises you need to look for when investing? Hardly. I'm saying they were the deepest beliefs of just one such man who did some of the most amazing things free enterprise, and philanthropy made possible through enormous wealth created by free enterprise, have ever produced, and that the organization(s) he built made a lot of ordinary people who led ordinary lives and saved and invested in ordinary ways a lot more comfortable in their post-career lives than they otherwise might have been.

Great capitalists -- and some lesser noticed ones, I'm also quite sure -- are nutcases who shun ordinary lives, and that's why we need to know how to analyze uneven cash flows, what happens while young entrepreneurs are hanging in there through thick and thin before they're out of the woods: the reality of yet-to-be-great enterprises when they're in their formative years.

At Last, Here's an Example of an Analysis of Uneven Cash Flows

Here's an analysis I developed to help a young couple considering the purchase of their first residence. The working assumptions were as follows:

Remember, agreeing or disagreeing with the assumptions has nothing to do with the validity of the math, but it has everything to do with the validity of the analysis. That's why I always gather the assumptions first, and make them variable. You'll also notice that there are two tiers of assumptions in this analysis; the second tier derives from calculations based on the first tier.

Here's what the analysis yielded:

Click to enlarge

What did the IRR analysis conclude?

Click to enlarge

Bottom line, without the "use value" (the assumed rental value of the house), this investment yielded a compound annual IRR of 3.07% over the 10-year life of the ownership including the net cash gain in sale year 10. With the "use value" folded in (stated with quotation marks, since they intended to occupy, sometimes known as an "imputed [or implied] value"), the IRR rose to 11.50%. These calculations could be compared and contrasted with conventional even-cash-flow annuities in the context of comparative risk.

In a riskier investment, such as an apartment house with varying expenses and income, including the inevitable prospect of vacancies, seesawing energy costs, and volatile market conditions for rent, the comparisons to annuities become increasingly esoteric. With a start-up business in a cutting-edge market, such as technology, almost anything can happen -- "sure-thing" markets disappear, proprietary technologies suddenly become obsolete, key people croak -- which is why venture capitalists rely so heavily on adequate capitalization and largely nonfigurative appraisals such as "management quality."
No positions in stocks mentioned.

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