In today’s essay, we take on what’s probably the single most important factor for many investors: income.

Most investors aren’t trying to become Gordon Gekko. What they really want is a safe way to earn a reasonable return – say 8%-10%. With this cash income, they can pay their living expenses, or if they’re still working, simply compound the money over time. Today, I’ll give you my best secrets for compounding wealth safely or using your assets to generate income for current living expenses.

The Federal Reserve has made it nearly impossible to live off your savings (or compound them safely). Thanks to the Fed’s manipulation of interest rates, anyone who chooses to simply save money is going to lose a lot of value.

[ad#Google Adsense 336×280-IA]The Bureau of Labor Statistics announced the latest Producer Price Index numbers earlier this month. They showed prices have risen 6.8% over the last year. Savings accounts are paying less than 1%. So if you had $1 million in the bank, you lost roughly $50,000 in value last year. You’ll go broke fast if you can’t earn at least as much as inflation on your savings.

We will never understand why so many mainstream economists believe stealing from savers this way to reward people who borrow makes for a better society. I don’t believe a word of it. It’s just a sophisticated form of socialism.

In any case, if you’re interested in safely compounding your wealth or living off your savings, you must adopt a few slightly more sophisticated strategies, which I’ll detail below.

First though, a word about the importance of saving. If you can teach your children one thing about money, it should be how to save and why it’s so important to do so. Share this example with them… and ask, who will end up with the most money at retirement?

Saver No. 1 is a hard worker who understands the value of time and the importance of saving. He gets a job at age 16. Each year, he saves $2,000 – roughly 250 hours of work at minimum wage. That’s roughly six weeks of full-time work in the summer, or 25 weeks of part-time work (10 hours per week) during the school year. Either way, it’s not an unrealistic amount of money for an enterprising 16-year-old to earn, while still having plenty of money for current spending.

Saving $2,000 per year becomes a habit, and Saver No. 1 does it every year. Even after he begins his career in his mid-20s, he simply continues to set aside $2,000 per year. He invests these savings in a conservative way. He opens an IRA account so his investments won’t be taxed. He puts 40% of his savings into short-term, highly rated corporate bonds. He puts 40% of his savings into high-quality “dividend growing” stocks. And he puts 20% into gold. Simple.

His portfolio only produces modest returns. Over time, he earns about 8% a year – mostly by reinvesting his dividends and interest payments. He’s not worried about getting “rich.” He’s just saving his money. And it’s easy because he never saves more than $2,000 a year. He has plenty of money to spend on things he needs and wants – but he always remembers to save first.

By the time he’s 40 years old, he’s contributed $48,000 in savings to his portfolio. At that point, he calculates that if he continues to earn 8% a year on this portfolio and reinvest all his dividends and interest, he’ll have plenty of money for retirement at 65 years old. So at age 40, saver No. 1 stops saving money. He’s now free to spend all the money he makes for the rest of his life.

Saver No. 2 doesn’t learn to save as a child and doesn’t even get a job until after college. By that time, he’s so busy buying things – cars, vacations, dinners at nice restaurants, clothes, houses, etc., he can never “afford” to save a dime.

He wakes up at age 40 and realizes he doesn’t have anything in the way of a retirement fund or really any liquid savings at all. So he begins to save, and he does a great job. He’s putting away $10,000 per year, every year. He knows he’s got to play “catch-up.” Like Saver No. 1, he invests conservatively and earns 8% a year. He reinvests everything, like Saver No. 1. By the time he turns 65 years old, Saver No. 2 has contributed $250,000 toward his retirement.

Guess who has a bigger portfolio at age 65? Is it Saver No. 1 who never contributed more than $2,000 per year and whose savings totaled $48,000 in his lifetime… or is it Saver No. 2, who saved more than five times as much money initially?

At age 65, Saver No. 1’s portfolio is worth a bit more than $1 million. Saver No. 2’s portfolio is worth $800,000.

The point is, if you’re planning to take the safe and sure route to wealth – which is saving and compounding your wealth – it pays to start early. If you don’t, you’ll have to contribute large sums of capital to your plan. Or… you’ve got to discover ways of getting high rates of income…

If I could do one thing for every one of our subscribers, it would be to give them the confidence and the knowledge to buy high-yield corporate bonds – bonds trading at a discount from par. Yes, you have to know what you’re doing to buy these bonds, but once you understand the secret to making these investments in the right way, you can easily and safely earn annual income in excess of 10% a year, every year.

In fact, once you’ve made money like this, you’ll probably never go back to buying stocks again. I’ve written about the idea of buying discounted corporate bonds many times over the years… so I won’t use today’s space to talk about them. I’ll simply say: Please… develop the confidence and knowledge required to buy discounted corporate bonds. It will change your life. It changed mine. You can read my thorough write-ups on this idea here and here.

Now… despite my pleading… Many readers aren’t interested in acquiring this skill. They prefer to stick with income investments they can buy with one click of the mouse. And that’s fine… You can still earn terrific yields on your money with my second, third, and fourth ideas.

My second best income idea is to learn the secret of “positive carry.” As I noted in my September 2009 issue of Stansberry’s Investment Advisory, “The Seven Real Secrets of the World’s Best Investors,” most individual investors use margin (borrowing) in the wrong way. The most common way individual investors use margin is through buying put or call options. They want a big leveraged position, and they buy their leverage in the options market. They would get better odds in Vegas. Buying leverage in the options market is extremely expensive and unlikely to lead to success over the long term. Most of the great investors I know never buy options. They only sell them.

Why? Positive carry.

“Carry” refers to the cost of borrowing money. With interest rates this low, most institutional traders can get margin loans for 3%-4% annually. To make money with these loans, they don’t have to earn very much. Using conservative strategies – like selling puts on stocks they want to buy anyway (which Dr. David Eifrig does in Retirement Trader) – they can earn 15%-30% per year. These kinds of highly leveraged positions involve some risk. But if you’re good at it, you can make incredible profits. You’re borrowing money at 4% and earning 20% with it. This is “positive carry.”

You can earn positive carry in lots of ways. You can invest in higher-yielding debt obligations, like junk bonds. You can lend money to payday-loan vendors. You can invest in high-yielding stocks, like energy infrastructure master limited partnerships (MLPs). The point is, most of the great investors I know are always involved in carry trades of some kind. They keep 25%-50% of their capital tied up in these kinds of trades, which will earn them around 20% a year. They only take their money out of these trades when they have a unique and profitable opportunity.

Don’t use margin to buy speculative positions. Don’t use margin because you’re not disciplined enough to keep a cash reserve. Only use margin when you can calculate that it will enable you to produce a substantial amount of positive carry.

My third best income secret is what not to do. Don’t take on risk in a desperate attempt to capture a higher yield via an investment in a highly leveraged corporation. When most investors enter the supermarket of income investment opportunities, they head straight for the dirtiest, riskiest aisle. They focus exclusively on companies that sport high yields… like stocks paying a dividend yield greater than 10%.

In this aisle, you’ll find conventional income investment ideas your broker probably loves… like highly leveraged real estate companies and oil-shipping companies. These companies generally sport low profit margins and require large and ongoing capital expenditures. Yes, there’s a time to buy them – after they’ve gotten wiped out and fallen by 90%. But that’s exactly when none of our subscribers will buy them, which is why my best advice is simply to avoid them. They’re too risky and volatile.

Let me be a bit clearer about what kinds of income stocks I’d strictly avoid. I’m talking about low-margin businesses that take on enormous amounts of debt so they can pay shareholders substantial dividends. You’ll know these companies because they require constant injections of debt financing to operate. This “high debt, low margin, high payout” business model works well until it doesn’t work at all.

A good example of what always ends up happening to these companies is the commercial real estate collapse of 2008. REITs are collections of real estate assets bundled together and securitized. Boston Properties is one of the largest owners of office space in the U.S. Host Hotels & Resorts is giant owner of U.S. hotel properties. Like most real estate concerns, REITs carry large amounts of debt on their books.

REITs enjoyed a steady bull market from 2003 to 2006. As America went wild for real estate, this bull run accelerated into 2007. Prices soared. Large real estate firms took on increasing amounts of debt to leverage themselves to the “boom times.”

I knew the boom couldn’t last. The most obvious signal the boom was ready to bust came when legendary real estate investor Sam Zell sold his company Equity Office Properties Trust to buy out firm Blackstone in the largest ever takeover of a real estate company (a $36 billion deal). It was a classic case of the “smart money” selling out to “dumb money.”

We published this piece from Steve Sjuggerud about how dangerous commercial real estate stocks were. We knew investors were “reaching for yield” and in a dangerous spot.

The bust I knew would happen came in 2008. All the years of real estate investors collecting high yields were dashed in months. The Dow Jones REIT index plummeted 65%. As I predicted, the giant shopping mall operator General Growth Properties went bankrupt in one of the biggest bankruptcies in U.S. history. It was crushed by a mountain of debt.

The following five-year chart of the Dow Jones REIT index tells the story…

You might be thinking… “But Porter… that was just an unusual one-time event.”

Trust me… these “boom and bust” cycles happen all the time in highly leveraged industries. They wipe out years of income payments earned by investors… and huge chunks of capital. They reinforce the saying, “More money has been lost reaching for yield than at the point of a gun.”

Let me be clear: I’m not saying you can’t make money in real estate stocks… and I’m not saying all REITs are bad… You can make great money in real estate stocks. But most folks are only interested in buying them at the wrong time and the wrong price. That’s why most folks should simply avoid them all together. Don’t chase yields with dangerous, highly leveraged businesses.

My fourth best income idea is learning how to invest in businesses that constantly raise their dividends. Even though this idea will seem simple and obvious… it’s amazing how few investors use this strategy, which in my mind is guaranteed to build wealth. Dan Ferris, editor of Extreme Value and The 12% Letter, has done more to promote this idea than any other analyst I know. He has identified a small group of elite, dominant businesses that have long histories of paying out large and growing dividends… companies like Intel (current yield 3.2%) and Johnson & Johnson (current yield 3.5%). He calls this group “World Dominating Dividend Growers.”

Regular readers should be familiar with this idea. World Dominating Dividend Growers are the biggest and best companies on the planet. They hold dominant positions in their industries. They have the best brand names. They have fat profit margins. They have pricing power. They have stable cash flows. These attributes allow World Dominating Dividend Growers to finance themselves.

These companies have little or no debt, so a credit crisis isn’t a serious concern for them. This makes them the safest of long-term investment vehicles. Remember the REIT crash from the chart from above? See how shares of World Dominating Dividend Grower Wal-Mart performed during the credit crisis…

Most income investors ignore these stocks because their current yields aren’t high enough to warrant any attention. If you want to use these stocks to get rich on income, you have to be willing to buy and wait three to five years. That’s when you’ll see how they really work…

As Dan Ferris noted in a recent issue of The 12% Letter:

Intel’s current yield isn’t big. But it has raised its dividend every year for the last seven years in a row. Since 1993, Intel’s dividend has grown at a rate of 25.93% per year. At that rate of dividend growth, you can hold the stock five years, and you’ll find yourself collecting dividends totaling 11% per year over today’s cost. Then hold it another five years, and with that kind of dividend growth – this is not a typo – you’ll get 40% per year over today’s share price.

Or consider the incredible income payments Warren Buffett is earning by owning shares of dividend grower Coca-Cola, one of the truly exceptional businesses in America. From his most recent shareholder letter…

Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.

[ad#article-bottom]Reread that excerpt… Buffett finished building his Coca-Cola position in 1995. By 2021 (26 years later), he expects to make more than his initial investment every year. That’s the power of compounding with a great business.

The hidden benefit with these kinds of stocks is that you stop worrying about the stock market. You stop caring what the Dow Industrials did this day or that. You even stop caring what it did this year or that. When you’re earning a dividend of 10%-100% on your purchase price, you don’t care if the stock market is up or down 10% in a given year. You just keep cashing dividend checks. You keep compounding your wealth.

We try to teach our readers to be better investors. Focusing on value and income are the two greatest traits of all good investors. That’s why I’m so proud to publish The 12% Letter. It’s become one of our most popular advisories because it covers investments that pay high current rates of income (between 6% and 12%)… And it features Dan’s proprietary list of “World Dominating Dividend Growers.”

I personally know several sophisticated, wealthy investors who use Dan’s list (and buy signals) exclusively to manage their stock investments. Like Buffett, these investors know the value of buying an elite business at a great price… and they know the incredible power of compounding. Rather than focus on the day-to-day movements of the market, they simply collect constantly rising dividends from the world’s greatest companies.

As I mentioned, when you’re earning a huge, 10%-plus yield on the original purchase price of your shares, you stop caring about what’s going on with S&P 500 index. You can learn more about Dan’s 12% Letter and several other income “loopholes” he has uncovered by clicking here.


— Porter Stansberry

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Source:  The Growth Stock Wire