Cash matters, not accounting "profits"

Most investors are happily oblivious of accounting rules.  I envy them.

Accounting rules are supposed to standardize how companies report their financial condition.  Instead, the rules tend to muddy the waters.

Few realize that accounting rules are set by an accounting body called the Financial Accounting Standards Board (FASB).  Although this body is supposed to be independent, when majority rule or special interests don’t like its rules, the Congress or Executive branch pressure it to toe the line.  This is seldom in the interests of individuals or shareholders.

Accounting rules don’t stop shareholders from digging through the data and seeing things clearly.  In fact, I’d say such an effort is one of the keys that allows dedicated investors to get better returns than most. 

You see, what matters is not the accounting number a company reports, but how much money a business actually makes.  What matters is cash: how much cash did the company make after all expenses. 

Earnings per share and net income–the accounting fictions companies report–are not the same as cash.  Accounting fictions are based on assumptions that can distort or even mislead.  Cash doesn’t mislead.  It’s what’s left in the the bank account at the end of the day.

Most investors ignore cash because it takes effort to calculate and understand.  The accountants don’t make it easy to find.  But, it’s there for those who look.

A business spends cash to buy inventory, pay workers, build factories.  After it sells its end product, it receives cash from buyers.  Subtract cash received from cash spent, and you have cash earned. 

What matters it not accounting profits–which can’t pay dividends, repay debt, buy back stock, expand the business–but cash.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Cash matters, not accounting "profits"

Savings, not consumption, grows the economy

It’s hard to believe, but in a country where thrift was once a virtue, it’s become a vice in the view of many.

The blame lies clearly with economists and politicians who try to reverse cause and effect.  Their attempt fails when confronting the facts.

Imagine yourself on an island in the Pacific Ocean without any outside contact.  Do you think you could grow your standard of living by eating more, or by storing food?

The answer is obvious.  You can’t consume what you haven’t produced.  You can’t live in the shelter you haven’t built, you can’t eat the fish you haven’t caught, and you can’t escape on the boat you haven’t constructed.

To have the time to build the shelter and boat, you’d have to put enough fish aside so you could build instead of fishing.  You can’t both build and go fishing, and without fish you’d starve.  To grow your standard of living, you have to forgo consumption by eating less, which then becomes savings.  The savings then allows you to build shelter and a boat.  Savings is what leads to growth, not consumption.

And, so it is in the world economy.  To get to the point where we have shelter, transportation, clothes, etc., we need to first save up enough food to have the time and resources to devote to building the other things we need.

Here’s another example.  Assume you want to open a store that sells clothes.  To rent the store, purchase inventory and pay employees, you need money.  You can’t use the sales revenue you haven’t gotten yet.  You need to use someone else’s savings.  Once those savings are used to rent the store, buy the inventory and pay employees, you can pay back the person you borrowed from.  But, you can’t borrow what’s been consumed–it must be saved first.  The lender has to save instead of consuming in order for the store, the jobs or the clothes to ever exist.

Once again, so it is with the world economy.  To create growth, hire new employees, etc., you need savings first.  Savings that are invested create growth.  Consumption can’t do it.

If you spend more than you produce, your standard of living will go down.  That’s just a fact.  You can’t spend your way to prosperity.  You have to save first.  But, to save, you need to spend less than you make.

Sometimes, savings doesn’t produce growth.  As illustration, suppose you put enough fish aside to build some shelter, but a storm comes along and blows it away.  Now, you have to save enough fish up, again, so you have enough to get by as you rebuild a new shelter.  Consumption won’t fix the problem, only more saving. 

Using my second example from above, suppose the clothes store fails–suppose buyers are not interested enough in the clothes to pay as much as the rent, employees and inventory cost?  Then you won’t have enough to pay back the person you borrowed from.  To build back to the point the lender started from, more savings will be required–which means the lender will have to consume less and save more.

Once again, so it is with the world or national economy.  Bad loans are solved by more saving, not consumption.  Destruction by mother nature requires more saving, not more spending. 

More spending than production leads to lower standards of living.  The solution, once again, is savings, not consumption.

Don’t be fooled by those who say the U.S., or China, or Europe, or Japan, or anyone else can create prosperity or growth by borrowing to consume.  Growth comes from savings, not consumption.  And borrowing to consume requires even more savings to get back to break even.

Next time you hear someone prattle on about how we need more consumption to get growth “going” (I don’t care if they have a Nobel prize in economics–that just means they should know better!), think about an island in the Pacific and that consuming fish doesn’t create shelter or boats.

It’s time to go back to our country’s roots, it’s time to tear down the over-worship of consumption and spending and replace it with a reverence for savings and investment. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Savings, not consumption, grows the economy

Long term optimistic, short term pessimistic

Markets seem to be sitting on the edge of their seats, and for good reason. 

On the positive side, there are tremendous innovations in technology, growing and thriving emerging markets, and the possibility (I didn’t say likelihood) of real fiscal reform in developed markets.

On the other hand, there are very big fiscal problems in developed markets, increasingly burdensome regulation that’s slowing growth/innovation/employment, threats from bad growth and politics in emerging markets, and the ever-present danger of terrorism and natural disasters.

Markets are waiting to see what choices politicians make, because if they screw up–which is extremely likely–then things will get significantly worse before they get better.  If politicians straighten out the fiscal messes they’ve made, and reduce ineffective and burdensome regulations, then individuals and entrepreneurs will be free to innovate and grow everyone’s prosperity. 

If they don’t, then several crises will unfold and we’ll likely end up with the same reforms anyway.  Herb Stein once said that if something can’t go on forever, it won’t. 

The developed countries of the world have built up too much debt and entitlement programs which can’t possibly be paid for.  If/when politicians wait too long to deal with those mathematical problems, crises will result that will force change anyway.  We’ll get change, it just depends on which route we take.

One route will require much more pain and time and the other will require less difficulty and set us on the road to a big recovery.

Having studied history quite a bit, I think politicians and voters will put off the pain until it’s too late, but they can’t avoid logical consequences any more than the U.S. Congress can legislate gravity out of existence.

Canada in the mid-1990’s faced the music and have been booming ever since.  They saw that economic reality couldn’t be avoided and changed course.  They are very much the exception, not the rule.

If the U.S., Europe and Japan face the music, we can all get on with life.  If not, then tough days are ahead.

And, that’s why I’m long run optimistic and short term pessimistic.  I don’t think our politicians will face the music because voters don’t want to, either.  But, like a 3-year-old throwing a fit, that won’t change the facts.

If past market cycles are any guide, we’ll get down to 10x normalized earnings at some point, which would be 670 on the S&P 500 today, 890 five years from now, or 1200 ten years from now (versus a level of 1320 now, requiring drops of 50%, 33% and 10%, respectively).

It’s not inevitable, but it’s very likely.  Plan accordingly.

After that, we’ll probably have another long boom that will take the market back to euphoric peaks.  That will be a fun ride, and I’m very optimistic it will happen.  But, probably not as soon as I’d like.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Long term optimistic, short term pessimistic

In-depth research

I must admit, I love doing research.  I have an innate curiosity about almost everything, so when I get to dig into a company and its industry, I’m in hog heaven.

Recently, I’ve been digging into the technology field and it’s amazing how many nooks and crannies there are to understand. 

Just in computers, you have two major sides: hardware and software.  Both of those can be divided into customer sectors: consumer, small and medium business, public, and enterprise.

Just in the enterprise part, you have storage, servers, mainframe/virtualization/cloud software, networking equipment, database software, operating systems software, middleware, and applications.

Some businesses compete across all categories, like IBM, HP and Oracle.  Others pick niches that allow them to work with competitors in one market and against them in another.

The hardware side also has a long chain of providers.  If you buy a disk drive, the company you buy from probably out-sources assembly and buys parts from others instead of manufacturing itself.  In the case of enterprise storage companies like EMC and NetApp, they are more software than hardware companies!

And then there are services.  Some businesses are pure consulting with no products to sell, others provide services in one particular niche, like storage, and still others do everything from top to bottom, like HP.

Is it better to be a niche company, or cover the whole field?  Which companies have sticky products that are hard to dump, and whose products or services are easy to quit?  How is the landscape changing?

Technology seems to be more rapidly changing now than five years ago, and a lot of that is a culmination of widely available and cheap high speed broadband, both wireline and wireless. 

Will old businesses that were once dominant be toppled, or can they adapt to the new landscape?  Or, will customers be the ones to benefit because stiff competition reduces profitability?

To truly understand all these nuts and bolts, and to be honest enough with yourself to know what you don’t know, you need to do a lot of homework.  Sometimes that homework pays off in insights that generate better than average returns.  Sometimes it’s just a dead end.

Either way, in-depth research is the best way to go when it comes to investing.  I believe that is one of the reasons it’s so hard for part-time investors to generate above average results–they are competing with people who are digging deep in areas and ways that no part-timer can match.

But, it’s not enough just to understand the companies, the technologies and the competitive landscape.  You also need to understand the financials and be able to value individual securities. 

In many ways, I think I’m one lucky duck, because I get to do what I love, what interests me, what I’m good at, and what the market needs all at once. 

For me, in-depth research isn’t just a means to other ends, it’s a very enjoyable end in itself.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

In-depth research