Smash, dough, fiddlies, coin, tin, silver, hay, oot, shekels, ice, mazooma, bread, sponduliks, silver—cash has been known by many names over the years. No matter what you call it, cash is the second important concept to think about when you’re investing: cash flow, not just earnings.

The essential reason every investor ought to think about cash flows and not earnings is that the two can diverge significantly. And cash flow is by the far the more important of the two. A company simply cannot survive without cash flow over the long haul.

One simple reason we follow cash flow rather than earnings is for defensive purposes. A company may be reporting nice earnings even though it is not translating those earnings into real cash. That’s a very important reason why following the cash will keep you out of some impending disasters.

Doing that, however, is not as simple as just investing in companies that are generating lots of cash flow. Rapidly growing companies may show nice earnings and poor cash flows for years. And they may still be worth investing in. Nevertheless, the approach in this book emphasizes cash flows. So, typically, a company that consumes a lot of cash is not likely to be a candidate for investment in our approach.

There is another reason to follow cash flows other than just playing defense and avoiding losers. Cash flows can alert you to some real gems that the market is entirely overlooking.

So what is cash flow specifically?
One basic proxy for cash flow is to add non cash charges like depreciation to earnings, then take out capital expenditures. That’s one decent and rough measure of cash flow—though it does not include working capital changes.

Working capital changes include things like changes in inventory and accounts receivable. Such factors can have an impact on cash flow, and it pays to consider them when looking at a company.

When inventory rises, that logically reflects a use of cash. A company with increasing amounts of inventory is tying up money in that inventory. The same with accounts receivable. Accounts receivable is simply money owed to the company for services rendered or product delivered. Higher amounts of accounts receivable tie up cash.

Now, companies don’t have to use only their own cash to fund these things. They have vendors that give them terms. Let’ s say your inventory is lumber, and you’ve gotten 30 – day terms from Lumber Supply. You don’t absorb the whole cost of all the lumber in your inventory: you finance pieces of it. This financing show on financial statements as accounts payable.

When we take accounts receivable and inventory and subtract accounts payable, we get a number called working capital.

Working capital changes are important and real, and as mentioned earlier, they have an impact on cash flow. Rising working capital requirements absorb cash. You can find all of these numbers on the balance sheet.

Expect these numbers to grow over time with sales and earnings. Inventory and accounts receivable rising faster than sales could be a warning sign. Old inventory may be piling up, or the company may have sloppy inventory controls. Accounts receivable may be rising because the company is booking sales by giving easy terms but finding it more difficult to convert those sales to cash.

These are issues to think about. There are no easy ways to sort them out, and no pat numbers to use. You have to make comparisons to other companies in the same industry and try to understand what is going on in the business. There may be perfectly legitimate reasons for the patterns in a company’s cash flow; you just have to find them out.

Are you disappointed by this conclusion? Perhaps you’re reading this and saying, “Well, this is all well and good, but I can’t use this. I don’t know what to do or how to start. . . .”

Unfortunately, there are no easy answers. You’ll just have to get used to looking at financial statements—income statements, balance sheets, and cash flows. And maybe more importantly, you’ll have to get used to asking and thinking about these questions.

As an investor, you hold all the cards. If a company’s finances are too hard to understand and you’re not sure what to do to understand them better, then you can pass and look for another company. I tell my readers often: Never feel rushed to invest. The stock market will be here tomorrow and the day after, and for a long time after that.

Anyway, you can use the basic proxy of net income plus non cash items (depreciation and amortization) less capital expenditures with the previous comments in mind. What are capital expenditures? They are investments the company makes in its own business. Capital expenditures are often disclosed in press releases. In financial statements, you’ll find the number in the statement of cash flows, under investing activities, usually called something like “capital expenditures” or “addition to fixed investments.”

This number has two components; neither is usually disclosed, but both are worth considering. The first component is ongoing maintenance. Every company has to plow a certain amount of money back into the business. The second component is funding for growth or expansion. The considerable amount of money that some companies spend on expansion efforts can make their cash flow numbers look worse than they are. That’s because money invested for expansion is obviously discretionary. That is, management didn’t have to spend it, but they chose to, perhaps for very good reasons.

Some investors have a bias against companies or businesses that require high levels of capital expenditures and don’t want to own “capital-intensive” businesses. I think this bias is not wise. What is more important is whether the business is making—or is reasonably likely to make—a good return on its investments.

Plus, the overlooked aspect of a capital-intensive business is that the high level of capital expenditures required can be adeterrent against new competition, which has to invest so much to get started.

A frequent modification made to the cash flow calculation is to also add back interest expense and taxes. Then you get the infamous EBITDA: earnings before interest, taxes, depreciation, and amortization. I say “infamous” because during the bubble years of the late nineties many companies and analysts abused this ratio and started to focus on it to the exclusion of the other real factors that I’ve already mentioned—things like capital expenditures and working capital.

So EBITDA got a bad name. But as long as you understand its limitations, it is useful in comparing companies and looking for bargains.

Why, you may wonder, do you add back interest expense when calculating EBIDTA? Well, you add back interest expense because you are going to use it to compare firms based on enterprise value. Remember, in the EV calculation you’ve included net debt. Some firms have debt and some don’t. If you don’t also add back interest expense to get EBITDA, you’ll get a distorted view. You have to add back interest expense to earnings so that you are comparing apples to apples. For the same reason, you add back taxes, primarily because debt levels have an impact on taxes, since interest is tax-deductible. By adding these two things back, you can reasonably compare different businesses in the same industry without allowing financing decisions—such as how much debt to carry—to colour the basic profitability comparison.

The best way to know how a portfolio is performing is to calculate the return on a regular basis. While this exercise may seem easy, the math can get tricky. Mistakes are common and sometimes they compound into very large errors. I find there are two common mistakes people make when computing return of investment calculation. Both errors are explained below.

Counting Deposit and Withdrawal as Investment Gains and Losses

A common error when doing return of investment calculation is to treat deposits as investment gains, and withdrawals as investment losses, rather than treating them as additions or subtractions to an account. Here is one embarrassing real life example of a group that counted deposits as investment gain:

The Beardstown Ladies are members of a famous investment club formed in the early 1980s. The ladies rose to prominence in the mid-1990s after the club proclaimed fantastic investment results. For 10-years ending 1993, the club reported a compounded return of 23.4% in their stock portfolio versus 14.9% for the S&P 500. The ladies bought stocks of companies they knew, like McDonald’s and Coke. The investment success propelled the ladies into stardom. They appeared on TV shows and in commercials, spoke on radio programs, and not to miss a moneymaking opportunity, published best selling books on the subject of personal finance and investing.

The world changed for the Beardstown ladies in late 1997. A reporter from the Chicago magazine noticed something peculiar about their published investment results. After calculating the numbers several times, he concluded that a gross error had been made. The error was so large, that the accounting firm of Price Waterhouse was called in to clear the air. In the final tally, the clubs worst fears were realized. The ladies’ actual return was only 9.1%, far below the 23.4% they reported, and well below the S&P 500. For years the ladies deposited monthly dues into their account and classified it as an investment gain, rather than additional capital. An embarrassed treasurer blamed the error on her misunderstanding of the computer software the club was using.

It is natural to make return calculation errors in a bull market. Investors expect their account to be performing well. An error may not be large enough to effect performance in the short run, but if not corrected, the distortion compounds over time. Deposit and withdrawal are never treated as investment gains and losses with one exception, withdrawals used to pay direct investment expenses such as manager fees and trading costs are treated as a loss.

Buying and Selling Can Cause Return of Investment Calculation Errors

Flip through the mutual fund section of your local newspaper and you can quickly tell how your funds are performing. Although the return of a fund is listed correctly in the paper, it may not tell you much about the performance you have personally experienced in the fund. Return of investment can become distorted if you make frequent transactions in your account, such as adding money to a 401(k) plan each month. The following example highlights this problem:

At the beginning of the year, you invest $1000 in a stock mutual fund. By the end of the year that mutual fund is up 15%, therefore, you made a $150 profit. Satisfied with this result, at the start of the second year you place another $1000 in the mutual fund bringing the total to $2150. Unfortunately, during the second year the market moves down and the fund falls 10%. Overall, your account lost $215, leaving you with a balance of $1935.

Here is an interesting question. During the two-year period, what was the return of the mutual funds and what was your actual return?

The mutual fund gained 15% the first year and lost 10% the second. A $100 investment grew to $115 after the first year and fell to $103.50 after the second. That’s a total gain of 3.5% for the period and an annualized return of 1.7%. Although the fund had a positive return, you did not make any money. You lost $65. Your annualized return was -2.2% based on average two-year investment of $1575 ($1000 the first year and $2150 the second). In affect, the return of the mutual funds was not the same as your return.

The return of investment to the investor is not determined by the performance of the markets, it is determined by the behavior of the investor. In the example above, the fund did not cause the $65 loss, a timing error by the investor caused the loss. Let’s look at this phenomenon in a larger picture. The stock market returned about 18% annually over the last 20 years, however, the average investor did not experience returns close to that number in their personal portfolios. The average stock investor earned significantly less than the stock market. The timing of cash flows into and out of various investments was a large cause for the difference.

Getting a reputable financial adviser can be hard; in reality, a lot of them are terrible, so you have to be very careful in selecting the most suitable one to work with.

Given that I used to be involved in portfolio management for a leading asset management firm, for a huge asset management company, I am going to give you an insider’s perspective on what you need to look for in access your the fee that you pay your financial adviser.

Financial advisers are most often paid in one of three specific ways. Older financial advisers (the ones that used to be pure stock brokers) get a commission based on any sales that they do in your account, which is paid to them whenever you purchase a stock, bond or mutual fund. This is a form of transactional payment, because the advisor is paid on the trades that they make for you rather than your bottom line account growth.

This fee is generally charged to the client right after the adviser buys an investment for them, which really doesn’t do anything to encourage the adviser to do anything more than sell you things that he thinks you will buy. This type of compensation is definitely the most dated, which means that you should definitely be cautious about working with this sort of financial adviser.

The second type is an adviser that charges a residual fee, which is usually a percentage of the capital that you have with them. In the last decade, the wealth management industry has been going through a transition to this sort of structure.

In my experience, clients generally like this type of fee the best, since they pay of their adviser is directly related to their account performance. If the clients account makes money, the adviser get a higher fee; if the account loses money, the adviser gets a lower fee

The main problem with this sort of arrangement is that it encourages the investment adviser to allocate all of your money, because the fee that they charge doesn’t usually include available cash position. If anything, the recent economic turmoil has shown that it isn’t always smart to be fully invested, with this sort of fee plan making it far more likely that your adviser will try to convince you to invest as much as possible into the market.

Lastly, there is a type of financial planner that only charge you for investment consultation, rather then on your account balance or transactions. In this type of circumstance, you will generally pay on a hourly basis – or per session – and may not even have your investments managed by the adviser. The main issue with this is that such advisers may not take a longer-term outlook with your portfolio – or even give it a considerable amount of thought – since they are simply paid by the hour/by appointment, while the other two type often meet with new prospects for free.

With everything considered, I think that the best option would be the fee based on assets under management. The main advantage of this over the other two is that it favors a longer term relationship, and aligns your interests with the adviser’s. Even so, you should fastidiously investigate any adviser, before you decide to give them your business.

The Sky Is Falling!
Everyone is wondering what to do. Everyone is fearful.

Actually that’s not true at all. The unschooled, untrained, unknowing Masses are indeed fearful. They are reading the newspaper headlines each day and getting more and more worried for their jobs, their businesses, their investments, their retirement. But, not everyone is fearful. Some people are happy. Gleeful. Self-assured. These are the Rich People. They know exactly what to do.

In this brief article, I will explain exactly what to do.
First, go right back to basics. What is the Number One rule for investing success? That rule is …

Buy Low Sell High

If it’s so short (four words) and so easy to understand, why isn’t everyone following it? There indeed is a reason why the Broke People do not follow it. Here is that reason.

Prices are low when there is a problem. Prices do not like chaos, problems, uncertainty. So, they fall. When there is a problem, prices are low. Rich People see the low prices, they remember the rule “Buy Low Sell High” and they buy. Broke People see the problem, get fearful reading the headlines of the newspapers, forget the rule of wise investing, and run. Yes, run away from investing — right when prices are low.

So, what are rich people doing right now?

Buy Low

Rich people are racing to buy US real estate. I personally just bought a duplex in a major city. It was listed at $530,000. The sellers were extremely eager to sell. In a very brief several-day negotiation, they lowered the price by a shocking $100,000 to only $430,000. So, I bought it. I see the problem; I see the low prices; I buy.

Now, let’s look at the other side of the coin.

Sell High

Just look at the newspapers and besides seeing that real estate prices are low, you will see that gold prices are high.

The previous all-time high gold price, on January 21 1980, was $850. The World waited for almost three decades for gold to get near that price. Then, on January 3rd, gold broke that high. Then, on March 13, gold broke through the $1,000 per ounce barrier for the first time ever!

Now that there is so much good news about Gold, The Masses are buying gold and dumping their real estate. Weird. What am I doing? What are rich people doing? We are selling all our gold and silver. I had hundreds of pounds of silver in my safe and hundreds of grams of gold and some platinum all locked away in my safe. I bought when prices were low. I’ve just sold it all over the last few days.

Your Turn

You may now be brooding that you have no gold to sell and have no cash to buy real estate. So, what should you do? First get into practice by selling anything you’ve got that you can part with that contains gold or silver – old jewelry, silver cutlery, etc. Second, do anything you can to get into an investment property right now, even if you have to joint venture with some friends to raise the down payment. Get started. Begin investing correctly.

Sell when prices are high, even if all your friends are buying.

Buy when prices are low, even if there are problems.

Do you want to have financial freedom? Many people do and I’m one of them. Financial freedom is great because you can have the freedom to do whatever you want with your life. You can work whatever job you want at whatever time you want. You can even stop working if you want to. You don’t work because you have to. Instead, you work because you choose to.
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To achieve financial freedom, one important thing you should do is learning how to invest. By knowing how to invest you can greatly increase your chance to achieve financial freedom. It can make the difference between living from paycheck to paycheck your entire life and having financial freedom. That’s because by investing you will make your money works for you. You won’t just let your money sits on the bank doing nothing. Instead, you make it work so that your wealth grows more and more. Eventually, your wealth will reach the point at which you achieve financial freedom.

But knowing how to invest is not enough, you should also start early. The earlier you start, the better you chance to achieve financial freedom. That’s because by starting early you will have the compounding effect works for your advantage. Since compounding effect has the potential to grow your wealth exponentially, the more time you have the more growth you can expect. That’s why starting early is so important.

You need to start now. Don’t wait until the situation is perfect for you to start investing. While waiting for the perfect time, you are actually wasting a lot of time to have the compounding effect works for you. People who start earlier will have been far ahead of you by the time you find the “perfect” time to start investing.

You don’t have to start big. Start investing with whatever amount of money you can. Obviously, the more you can invest the better. But the most important thing here is time. Don’t let anything get in your way of investing early.