Asset Allocation & Myths About Liquidity

Asset allocation is something successful business owners, entrepreneurs, and investors are constantly thinking about. You have cash flow coming in, but what should you do with it? While there are plenty of opportunities, we want to explain why the all-too-common strategy of buying low-cost index funds (usually in equities) may be significantly overrated, especially for business owners with better options.

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Let's assume you're a younger business owner. You own a flooring business that's valued around $1.8M, and you do $600k in EBITDA and $350k in net income. You have 8 years of payments left on a remaining $1.2M 6% SBA loan, putting your equity in the business at $600k. If you generate $350k in cash, how should you invest it? Here are some options:

1. Reinvest in business growth (i.e., improving operations, finding more talent, or expanding)

2. Pay down the SBA loan, freeing up cash flow & your equity (ownership) in the business

3. Buy an S&P 500 index fund for future spending needs (i.e., retirement income)

A financial advisor may tell you it's wise to choose the latter option. Not only are you securing growth for retirement, but you're diversifying your net worth. In theory, that all sounds great. But, as a business owner, shouldn't we be focused on getting the most value out of each dollar?

Valuations & Growth

Let's start by thinking about equity valuations. If you're unfamiliar, investors generally look at P/E (price-to-earnings) ratios, which gives them a sense of how "cheap" or "expensive" an investment is. For instance, if the aggregate S&P 500 is trading at 20x earnings, it generally means that, with no growth, it will take 20 years for those companies to generate enough profit equal to your initial investment. All else being equal, and it's better to invest at lower valuations.

For context, JPMorgan recently published an article, which looked back through history to plot 10-year future returns based on current earnings multiples. What they found was that when the market was trading at high multiples, future returns were poor. While the market has pulled back a little bit, JPMorgan showed that from similar valuations as what we had just about a month ago, historical 10-year returns were effectively flat.

This happens for a couple of reasons. First, it's important to note that this figure isn't based on CURRENT earnings, but next year's expected earnings. Therefore, if growth expectations decline, multiples may contract. Investors are willing to pay more for each dollar in earnings if they expect those earnings to continue growing each year. Additionally, there's no reason why earnings can't simply decline if the economy slows.

When we consider the impact of tariffs, a decreasing supply of cheap foreign labor, the potential for less government spending that benefits corporations, and tax changes that decreasingly favor the ultra-wealthy, we could be entering an economy that begins to favor small business owners and place less emphasis on the stock market. You have a two-fold effect where earnings, and expectations of future earnings, decline, in which we may begin to see capital flowing abroad, threatening the "standard" 10% market return assumption everyone clings to.

Liquidity & Control

Your advisor may then explain that the high valuations are justified because stocks are liquid as opposed to small businesses. As a former trader, I can attest that on any given day, it's super easy to sell a substantial amount of MSFT stock. You can't do that with a small business.

However, this contradicts traditional advice. Call your advisor when your portfolio is down 20% and you need capital (because of a recession), and see if they give you pushback when you want to sell your "liquid" index funds. Most likely, they're just going to tell you it's just a pullback, and the investment should be held for the long term (which benefits them from maintaining the fees on the assets they "manage" for you). The buy-and-hold strategy isn't so "liquid," now is it? And if you do defy your advisor, you're now breaking the "buy low, sell high" rule of investing.

Another aspect of liquidity that's overlooked is the earnings. Some investors focus on high-paying dividend stocks, fixed income securities, or loans, which throw off capital that can use on an annual basis. However, the S&P 500 dividend yield is only 1.27%. For every dollar that you invest, you'll receive about a penny in dividends. Additional corporate earnings may be used to reinvest in the business, buy back stock (which is a poor investment if multiples are high), reward executives, or make additional investments that may or may not pan out. You have zero control as an individual shareholder.

Lastly, as a business owner, when you buy index funds in a brokerage account, you're pulling after-tax capital out of your business and investing it in someone else's business. While your investment alone probably won't impact a corporation's outcome, serious thought should be given as to why that's a sound financial strategy, especially when you consider the true illiquidity and lack of control with owning public equities.

Business Reinvestment

Now, let's talk about your business. If you're doing $350k in net income on a business valued at $1.8M, that translates to just over 5x earnings. If earnings are constant, it would take about 5 years to generate enough income to equal the value of your business. But, even more importantly, YOU have control of that capital. If you want to take distributions, you have that option. If you want to reinvest in attractive business opportunities, it's your choice. You have the control.

Additionally, if you look at the average small business, value is tied up in depreciating assets or the owner-operator's management abilities, relationships, and knowledge of the industry. By successfully reinvesting in your business, YOU can largely control the multiple your company can sell for without any revenue growth at all. Building out SOPs (standard operating procedures), delegating responsibilities, retaining key employees for new management, reducing debt (for potential buyers using leverage), cleaning up your books, and creating a succession plan are all ways to increase the MULTIPLE your business sells for.

Lastly, let's talk about the return on each dollar. If your business is currently worth just over 5x earnings, and each dollar you invest can maintain revenue growth, then you're getting much more bang for your buck than buying public equities trading at 25-35x earnings, depending on which multiple you use. Remember, price and value both matter with asset allocation.

Control

We aren't against investing in the stock market. However, we believe business owners generally have a MUCH better opportunity to increase and free up liquid value in their businesses. If you truly value autonomy, think twice before allocating your dollars toward companies that neither you nor your advisor know anything about. However, the liquidity concerns are incredibly overblown and misunderstood.

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