Monday, May 21, 2012

The more they pay, the more it's worth

The longer I invest, the more I realize the importance of cash flow from my investments. It really doesn’t matter what I am investing in, stocks; bonds; real estate. Each investment has two profit centers: cash flow and appreciation. Appreciation is realized by markets that set the value of your investment which may have increased or decreased.  But really, we have no control over appreciation, it happens when it happens. You may have companies such as Microsoft or Wal-Mart whose earnings have increased for the last ten years at a steady and often impressive rate; yet a share now is not much more worth than it was 10 years ago.
So appreciation is beyond our control and therefor it is the truly speculative part of any investment. As Don Mclean sings: “The more they pay; the more it is worth”. How much is paid depends not on facts but on market psychology. Oil prices are governed by a combination of supply and demand (something that most of us cannot accurately gauge) and market fears such as the expectations of economic growth; actual production costs; political instability; social trends concerning the desirability fossil fuels  and whatever other objection a buyer can invent and thinks is valid.  In the end it is a question of ‘What THEY want to pay”.
Did you ever put an ad in Kijiji say for a piece of used furniture that you don’t want to throw out on the dump? You get those buyers at the door saying:  “I want your sofa for free and if not, there are many that give away their sofa so why should I pay 25 bucks for yours?”  Or “Eh, that Billy bookcase is damaged, look at the big scratch on its base!  I won’t pay more than $10!” You may say: “eh duuh, it has been used for 20 years! But nobody sees a scratch on the bottom. Look if you buy it new it cost you $100 at Ikea.”

The potential buyer turns around and says: “I pay $10 and not a penny more. Take it or leave it! There are 10 other suckers from which I can buy a used Billy!”  The buyer is probably right, and if you have to haul it to the dump it costs you time and a dump fee of $10. So… you take it. How unfair! But that is the market for you and it is really the same on the stock market and in real estate, art, gold, etc.
Really, if you buy for appreciation, you speculate! You buy with the expectation (no matter how reasonable) that there will be someone around now or five years from now that thinks your ‘investment’ is worth a lot more mula than you paid for it.
The second component of an investment is cash flow – net cash flow. In real estate it is nothing more than rental revenue minus operating costs minus financing costs.  In manufacturing companies it is revenue minus the costs of making and selling products or services minus financing costs. Of course when you invest in the stock market you give up control of how the net cash flow is used. Management decides and you SPECULATE that this translates in future higher earnings and a good market value.

The bottom line is the stocks dividend i.e. what ends up in your pocket! For you, the investor, net cash flow is  your real estate net cash flow or dividends or the interest payment from your bond. So from now on, let’s invest for net cash flow, dividend yield or interest and admit that the rest, in our purist form of reasoning is speculation – valuation of our investment that is really beyond our control. Is there something wrong with speculation? Not really, but let’s call a spade a spade. It will help you make better investment decisions.
So, when planning your portfolio, especially your retirement portfolio it is the cash flow that you count on. The rest will come or… not. This was also the idea that was behind the earlier ‘COI’ (cash on investment) and ‘ROI’ (return on investment) portfolios. It is really a tool for investor survival, because if you can do with just the cash income from your portfolio without having to sell, then you are in control and you will never be forced to sell, especially not during a bear market. You will have the financial strength to sit out the financial storm and even use it when a true buying opportunity comes along.
With this in mind, let’s examine ‘valuing’ an investment in more detail in a later post.

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