How To Build A Compounding Machine





Before I dive deep into the subject of how to build a compounding machine, let me explain exactly what my 7 year old son did after I gave him this advice.

As Einstein said: If you can’t explain it to a 7 year old, you don’t understand it.

einstein quote for 6 year old

 

My son Everest has a scrap metal business.  To be more precise, he dives into dumpsters in my neighborhood looking for aluminum cans and copper wiring.  He then takes it to a metal scrap yard and get’s cash.  This business costs nothing and he has been doing it around a year.

Without revealing too much about my amazing one and only son, suffice it to say he has more money in his account than the bottom 20% percentile of Americans do in their checking account.  According to the last survey of consumer finances by the Federal Reserve.

Obviously an amazing feat considering he is 7!

So Everest has this account and obviously he is trying to grow it more than the 0.25% interest he is earning.

So he said he wanted to buy a company with his scrap metal money.

I pitch him buying CMC stock. Thank you RobinHood for free stock trading!

building a compounding machine

 

I don’t necessarily think CMC stock is a screaming buy.  The goal is for my son just to learn about this company.  I know from personal experience than he will care a lot more about how this company makes money after he buys 1 share and invests his hard earned $20!  He will also get a nice 2.37% dividend yield.

So now my 7 year old has 5 levers of growth:

  1. Equity in his own business
  2. Cash flow from his own business
  3. Equity in CMC stock
  4. Dividend income from CMC stock
  5. Interest in his bank account

 

When you add all these up – this is his compounding machine.

Most of us have this but it’s too small.  Too small of machine.

This missing factor hear is leverage.

Even though my son has 5 compounding gears he basically only has 1 significant income driver – his scrap metal business.

For the vast majority of us – this is our W-2 job.

So how do we fix this?

There are a couple of things to do.

Obviously the end goal is for your compounding mahcine to be throwing off more income than your main income input (your w-2 income).

David Osborne wrote an entire book about this in Wealth Can’t Wait.

He describes this as moving from income based living to asset based living.

 

This principle is a little confusing – hence – he wrote an entire book about it.

 

I love the book and all his principles.  However, I think a simpler framework would be to build a compounding machine.  This way you aren’t stressed about your assets and you aren’t necessarily trying to limit your w-2 income.

With my framework, you are just focused on building your compounding machine.  The bigger your machine (assuming limited debt) the safer the machine.  Why do I say safer?  Well the bigger your machine and more levers, you have, you can afford to lose one – like the w-2 lever, or maybe stocks take a hit, regardless you can lose a lever, the bigger the machine.

 

Contents

So Let’s Build Your Compounding Investing Machine

It’s important that just like building a custom house, you are building a custom compounding investing machine.  It’s yours!  So build it like you want to.  If you are more comfortable with stock investing you might want to invest more into that, than investing in your own company.  Nothing wrong with that!

Sure, you might not make as much money, but you will have more time!

 

Foundation – W-2

Most people go about this process entirely wrong.  They want to increase their side hustle to more than their job income and completely abandon their job.

If you evaluate this agnostocially this doesn’t make any sense.  You are abandoning your major source of income.  Why not focus on growing this income base.  This is your foundation and usually your quickest win.

 

How to increase your income at your job:

Get a raise

Get a promotion

Learn a new skill-set for your employer

Start bringing in new customers

Get a certification

Be a rockstar and do all 5!

 

A lot of people falsely think this is just taking away time from your “side-hustle” when in reality you are becoming more valuable to your employer AND the marketplace!

For follow-up reading on becoming a triple-threat I highly recommend you read this amazing blog post by one of my favorite bloggers, Nev!

 https://kopywritingkourse.com/how-to-be-more-valuable-at-work/

 

Increase Equity In Your Business

The next stage is building equity in your business.  I highly recommend the two books below.

As John Warrillow beautifully articulates, most small businesses are worthless.  They are reliant on the owner/operator to function and they are usually reliant on 1 or 2 customers.  Built to Sell is not just a business how to book, but a story in how a guy transitions his business from a typical small business to a sellable asset.

Automatic customer is another great book and each chapter is basically a case study on different recurring revenue business models.  I actually just did this in my gutter cleaning business.  Instead of 1-off gutter cleaning, I now have an annual plan.  Customers love it so they don’t have to worry about finding another contractor every year.

 

Don’t worry about creating artificial equity and the value of your business, focus on creating value for your customers.  Solve a pain point where people are getting out their credit cards while you are talking.

Most people like to dream up “fun” business ideas.

Instead, talk to business owners and ask open ended questions about their pain points, and what they have not been able to figure out by themselves.

 

Increase Cash-Flow From Business

My first job out of college I worked for an investment bank that did mezzanine lending.  This is finance speak for high-interest loans to companies.  The only reason these companies were even thinking about getting a mezzanine loan were they were out of cash.

Cash is oxygen to a business, the more you have, the faster you can grow. <== click to tweet

Do not confuse this with debt.  Debt is the investors/lenders cash – not your own.  When companies confuse this fact, they typically are returning all their cash-flow to their investors/lenders and not the owners of the business.

This is why leverage should always be manageable under multiple scenarios.

The great news is your w-2 job is already a unleverage cash-flow lever for your machine.

Now, you simply need another unleveraged cash-flow machine.

Examples of unleveraged and high-cash flow levers for your machine:

Start a blog

Start a lawn-mowing business

Start a handyman business

Examples of a lot more side-hustles here

The great news is by increasing the cash-flow of your business, you are by nature increasing the equity value of the business.

All of this cash leads to our next lever: interest

 

Increase The Interest You Earn In Your Bank Account

warren buffett compound interest

For real estate investors this is a very sensitive subject.  Why?  Because I see investors mess this up on a very consistent basis.  They have their savings account at one bank, offering a high-yield, but they get loans at another bank with a lower rate.

Obviously, this makes a ton of sense.  However, it makes sense until it doesn’t.  What do I mean by that?  Well, eventually the bank loaning the money is going to get tired of having loaned you all this money with no deposits.

There is never a convenient time to move deposits.

However, whenever you find this amazing real estate deal or deal to buy a business and you need your lender to rush it.  It’s not going to happen, because you haven’t fully committed to the relationship.

This is probably a non-traditional way to start a conversation about earning more interest, but I fully understand, you shouldn’t just piece-meal your banking just to earn interest.  You are building an investment compounding machine!

Don’t sacrifice one lever for another.

With all that said, there are some simple things you can do to earn more interest that most people don’t do.

 

Increase float time on your cash

This strategy can easily work against you if you are unorganized.  However, it will have a dramatic impact on your finances if utilized correctly.

By the way, if you aren’t organized to manage your invoice cycle you should do that first before you worry about growing your business.

At the most basic level, you can increase your cash balances (or float) by paying your bills 30-days out, when most likely they are due, instead of when you receive them.

However, you can increase even this by paying them with a business credit card.

Again, let me pause and reiterate that I only recommend credit cards if you pay off your balance or you utilize the 0% introductory offers.

However, while I don’t fully endorse this strategy, some of my friends have bought houses on credit cards!  This is how powerful utilizing credit cards can be.

Then you will effectively earn 60-days of float.

Quote on float by Warren Buffet

Great article on Warren Buffet utilizing float to grow Berkshire Hathaway: https://www.businessinsider.com/warren-buffett-insurance-float-2017-4

einstein quote on compounding interest

Utilize CD based lines of credit

Many moons ago I once had a customer who owned a consortium of different businesses.  Importantly, one of the businesses he owned was a bank!  What was atypical was his personal financial statement.  He had a ton of CDs and a ton of lines of credit.  Always curious to learn I asked why he structured his personal financials this way.

His response has always stuck with me.

He responded with you are never going to get a lower interest loan, than a loan secured with cash.  TRUTH

He also responded with his line of credit useage typically goes up and down – as lines of credit should!  Therefore, when he isn’t utilizing the line of credit he wants his cash compounding as much as possible.

I highly recommend this strategy because it also protects your machine having this liquidity for yourself.

In summary, this strategy will increase your interest income because you are utilizing CDs and lower your interest costs because you are using a cash-secured line of credit.

 

Investing in Stocks

I have a bias towards stocks, simply because I won a stock market competition when I was 12 and loved reading-up on the markets since then.  I’ve had some success and some failures, but the best part about stocks is they just keep compounding for you AND it doesn’t require any work.

For the vast majority of people low-cost index funds just makes too much sense.

I’ll be totally honest though, I don’t own hardly any index funds just because I like to research stocks and invest in them.

 

Investing for Dividend Income

Many moons ago when I worked as an analyst for a hedge fund I met a guy who told me he would gladly invest with me if my returns were better than his.  I gladly accepted this offer because my returns beat the benchmarks and most everybody I talked with.

However, I was sadly disappointed when this guy had only invested in 3 companies: Philip Morris (now Altria) Reynolds and Lorilard (bought out).  All 3 are cigarette manufacturers and while you might have ethical problems with this, the stocks of cigarette companies have been amazing.

The principle reason for this is dividends.  You see, cigarette consumption has been going down in developed economies for the bast 25 years.  These companies can’t legally advertise in most mediums like magazines and TV ads, so they have nothing left to do with their cash but give it back to shareholders!

 

dividend returns of S&P 500

 

The reason dividend investing and compounding is so powerful is cash-flow.  These stocks are giving you cash-back.    If you are reinvesting that into stocks or your own company you are exponentially compounding your wealth, because hopefully the value of both of those entities are going-up as well!

This is the whole point of this article, to have multiple compounding levers for your machine (aka net worth).

power of dividend investing

 

Using the above percentages, here’s what $10,000 invested in a theoretical average stock within each dividend-related category would be worth at the end of a 30-year period, assuming dividends are reinvested:

  • Dividend growers and initiators: $179,316.
  • All dividend payers: $144,080.
  • Dividend payers with no change in dividend: $87,550.
  • All nonpayers: $22,898.
  • Dividend cutters and eliminators: $9,060.

power of dividends

Source: Visual Capitalist

 

 

Summary of Building A Compounding Machine

Hopefully, this article has inspired you and not left you feeling overwhelmed with a to-do list.

There is a Chinese Proverb that states: A journey of a 1,000 miles begins with a single step.

There is a high provability if you are reading this you already have a job and are probably already investing in a 401k and maybe a rental property.  For a simple next step, why not open up a non-retirement investing account?

If you already have rental property, why not just list your own house on AirBnB for an insane rate?  If somebody books it, awesome, if they don’t – know big deal.

These are just simple next steps that don’t require hardly any time or money.

For the more aggressive person wanting to compound their net worth significantly and retire early.  Follow these steps:

Start an Investing Account – invest in some fun stocks you believe in and also some good dividend value stocks.

AirBnB  list your house on AirBnB for an insanely high rate.  I have been pleasantly surprised at the number of families that just want a house to stay in.

Buy a rental property – don’t get overwhelmed with crazy formulas and rules.  Just try to buy under $100 a sq. ft and if you are just starting out I would highly suggest buying a single family house versus a multifamily house.

Start a side-hustle – this will have a dramatic increase on your cash-flow.  The trick is to reinvest this cash into another investment like real estate, dividend stocks or another business.  It’s very tempting to just blow it on vacation.  Which I am guilty of! YOLO!

Get a raise – Obviously this has an immediate effect.  I highly recommend thinking about what kind of value you bring to your employer and think about way’s to increase the value.

Start a Blog – document this journey you are on

Obviously this post has been entirely about growing your income and net worth and building a compounding machine.  It goes without saying that if you are doing this with credit card debt, you are literally trying to swim upriver.  It’s not that it can’t be done, it’s that it’s exponentially easier without credit card debt.

If you don’t have debt, I highly recommend you take advantage of the cash-back offers.  This is free money you are missing out on.  Credit cards can also  help you increase your personal liquidity with the extra time your cash is in your bank account.

 

I put a lot of time into this post on building a compounding machine to grow your net income and net worth.  If you would share it with your friends I would highly appreciate it.

Building an Investment Compounding Machine