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"

Appearance versus substance

One of the most frustrating parts of being a professional investor is being pleased with how an investment company is doing only to see Wall Street sell it off time after time.

It’s bad enough to invest other people’s money into investment companies that do poorly, but when the one’s that are doing well get crushed, it’s hard not to heave a big sigh.

I was reminded of this ever-present need for patience watching a couple portfolio companies report earnings this week.

In both cases, I was pleasantly surprised to see things were going better than expected only to find Wall Street selling the companies down to the tune of 5% and 10% one-day losses. Why, oh why?

The answer may be frustrating, but it is simple. 1) Wall Street doesn’t focus on the same metrics as rational owners. 2) Wall Street is focused on 6-9 month results because that’s its average holding period.

Wall Street is enamored with certain metrics that business owners care much less about. In retail, it’s same store sales. In computers, it’s market share. In telecommunications, it’s new customer additions.

I don’t mean to imply that such metrics would be unimportant to rational owners, but they wouldn’t necessarily be the all-consuming focus that it is to Wall Street.

What matters most to owners? Cash flow. How much money came in and how much money did was spend to get it. That’s it.

Warren Buffett calls it owners earnings–the earnings an owner could use to build the business, buy back stock, pay off debt or pay a fat dividend.

An easy way to think about this number is to look at a company’s cash flow statement: subtract maintenance capital expenditures (capex required to keep the same level of sales and profits) from cash flow from operations.

Perhaps a couple of other adjustments may be necessary, but in general that’s it.

Both of my portfolio companies reported strong free cash flows.

A retailer reported 12 month free cash flows that are a mere 5.6x current price, or a free cash flow yield of 17.9%. It’s price was down 5% that day.

A computer company reported quarterly free cash flows that are a mere 5.7x current price (minus cash on the balance sheet), or a 17.5% free cash flow yield. It’s price was down 10%.

Owners of such companies would be salivating to have such returns in a lousy economic environment like this. But, Wall Street is not full of stock owners. It’s full of renters.

Renters don’t care what will happen over the long term (even 3-5 years, it seems). They are just in it for the quick “kill.” Does anyone wash a rented car?

With a time horizon of 6-9 months, Wall Street doesn’t care about free cash flow yields. All they want is to beat “estimates.” Estimates of what? You may have guessed: market share, incremental revenues, same-store sales, new customer adds, average revenue per user, etc.

What matters to owners? Free cash flows to price. That’s the bottom line.

I know I’m whining, but I also know that patience is well-rewarded in the end. Eventually, Wall Street does wake up to free cash flow yields. Eventually they notice how much value resides in businesses that throw off a lot of cash relative to price.

It takes a lot of patience to wait for that fish to come in. But, when it does, my whining sighs turn into war-whoops of triumph.

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.