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"

A little extra cash is not a bad thing

I must admit, I used the recent stock market rally to sell some of my clients’ and my holdings, and I didn’t re-invest the money into something else right away.

This may sound like a prudent thing to do, but many take issue with such an approach.

They believe not being fully invested means timing the market. But I disagree with the approach that always being fully invested is the smartest way to go. I also disagree that not being fully invested–holding cash–means timing the market.

In the history of free enterprise, the most successful businesses almost always operate more conservatively than they need to. By doing so, they have the ability to be aggressive in difficult times.

During the Great Depression, companies with extra cash were able to boost advertising at low rates, purchase competitors at cheap prices, expand into new markets, etc., while their competitors were simply attempting to survive the crisis. Having extra cash on hand during tough times allows great businesses to buy at super-cheap prices exactly when competitors are hamstrung.

The same is true for investing. By operating a bit more conservatively–holding extra cash in principle–an investor can purchase during those rare times when prices are once-in-a-lifetime cheap. Those who are fully invested cannot. Those with extra cash may under-perform during boom times, but they tend to out-perform over the long run.

Holding extra cash is not the same as timing the market, either.

Timing the market is the attempt to sell at the top and buy at the bottom. That’s not my approach, nor do I think timing the market is a successful strategy.

Instead, I assess the value of businesses. With such an assessment, I attempt to purchase businesses (that’s what buying stock is: purchasing part-ownership in businesses) when they are cheap and sell them when they’re dear. The buying and selling occurs because of the relationship of price to value, not because of my opinion about the market’s top or bottom.

Carrying extra cash can be a competitive advantage, both in business and investing. I’m happy to sit on a little extra cash and wait for stock prices to move to cheaper valuations. If it happens sooner, great. If later, that’ll work, too.

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.