One can grow wealth more quickly if income is allowed to compound. Likewise, businesses will grow more quickly when they are reinvesting most or all of their profits in the business. One could have one
pizza restaurant and take home the profits each night. If the business is successful, the profits may provide enough income for a family’s necessities for several years (the successful restaurant,
like shares of stock, is an asset). If instead of taking home all of the profits, however, some of the money generated by the restaurant was used to expand the restaurant, add other touches that would
bring in more people, or purchase the land and building to open a second restaurant, the income generated by the restaurant would grow with time.
When a business is young and there is a lot of room to expand, the value
of the business can grow quickly if most of the profits are reinvested. This is why many young companies pay little or no dividend. Because there are a lot of opportunities to expand the
business, it is better for the company and the shareholders to use the cash flow for expansion and acquisition of competitors.
Young, rapidly expanding businesses can have a very high rate of return, but
are also more risky than larger, more established businesses. If they expand too rapidly, make a bad acquisition, or simply misread the market the effect on profits will be much more severe than it
would be for larger businesses. Larger businesses can have many product lines and are in many different regions, while smaller businesses typically just have a few product lines and only a few
Because of the their opportunity for rapid growth and expansion, small, young
companies that pay small of no dividends are great for growing wealth. Because they are more risky and the rate of growth in any given quarter or year is uncertain, they are not good for maintaining
wealth or generating income. For example, if one invested in Amazon in the late 1990’s, one would have seen the value of one’s shares grow several hundred percent over then next few years. A similar
investment in a bank CD would have only returned a few percent per year.
If one were relying on the investment and selling shares periodically for current income, however, one would have been in for a nasty shock. In the early 2000s, when the internet bubble burst, the value
of Amazon fell through the floor. One would have been lucky to even sell the shares for what one originally paid if they were bought on the way up.
For the investor who didn’t need the money right away and could actually buy more shares after the fall, this would not be any great tragedy. In fact, the value of the shares has recovered and even grown a bit
above their value in the late 1990s (since Amazon is now actually making a profit to justify their stock price). The income investor, however, who needed the money each year and could not wait for the
recovery, would have had to sell at low prices.
Stocks suitable for growing wealth have the following characteristics:
They tend to be young companies or companies that have undergone a
radical transformation (a large new business line or a huge
restructuring in which many assets and liabilities were shed).
They have a lot of room for expansion.
They are able to grow profits substantially each year.
They pay little of no dividend.
They have little or no debt. They have a lot of cash flow from
current operations that allows them to grow and make acquisitions.
They have the ability to perform research or test new product lines
using cash flow from current operations.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.