Q: How do I improve my timing in order to buy shares at basement prices? A: For situations where share prices are low due to a weaker economic cycle it is best to invest over a six to 12 month period. The initial investment should be 50% of capital, with 10% each subsequently over the intended period for the last 50%. The timing of the initial investment of 50% is crucial.
Based on my experience it is best to buy on the day following the national government’s admission that the economy is in a recession and gives a negative GDP forecast for the rest of the year. When this announcement is one that makes the front page of the national daily, then almost all the bad news has been discounted by the market.
For a market crash due to a special event it is normally right to commit 50% of capital on the same day of the event and the rest of the 50% within a week. Special event crash tends to be immediate and furious as institutional and retail investors all unload holdings aggressively yet simultaneously, thereby prices reach bottom very quickly.
In the case of a banking crisis, the time to buy is when the government’s plan to use public money to re-capitalize the banks, whether directly or indirectly through tax incentives aimed at the disposal of bad loans, is at the final stage.
Q: What type of shares should one buy? A: Buy the top two of the best-managed institutions from each of the key sectors of banking, media, telecommunications, healthcare and computer software. These sectors tend to be essential and also have inherent oligopoly power.
Q: Is the investing going to be smooth sailing? A: Absolutely not, especially at the initial phase of your buying spree. All your good friends including your dear spouse will think that you are crazy. They will say, “The market is getting lower, this is too dangerous, you can wait”. And likely, in the next few days or weeks after buying, the market may indeed go lower, and you will look like a fool.
But to want to buy at the absolute bottom is not possible. But to buy near the bottom is possible and can be made highly probable by this approach. Be prepared for some short-term psychological torture. But you need to buy. If not, you will watch and miss the opportunity altogether. Somehow in most cases, you will later look like the wisest man in town for having the courage to buy those shares. View it as short term pain, long term gain.
Q: When then should one take profits? A: For shares bought resulting from a market crash due to special events (ie it is a one-off situation), one can take profits when profits are between 50% to 100% within a six months period.
However, for shares bought as a result of an economic crisis or economic downturn one should keep them for years. Liquidation should only begin when the bull market is so obvious and in such a great rage that it sucks in all kinds of new retail players. The greater fool theory, unfortunately, always comes into play near the end of a new bull market cycle. Shares should be disposed gradually over a 24-month period as bull markets normally last much longer than expected.
Q: After taking profits, what should the investor do with the money? A: Stay in cash until shares are at basement prices again. This strategy implies that when not invested one must hold cash and be patient even if the waiting period is long. In fact, one of the unprofitable “myths” that is frequently encouraged and practiced is that of continued deployment of capital to enhance returns.
This approach usually means that when the opportunity comes for acquiring bargain basement shares you will not have the money. Instead you will be among those hurt by lower share prices. Rather, you should build up liquidity for deployment when market liquidity is tightest in order to make big money.
Q: How often can a retail investor reasonably be expected to participate in such an investment strategy?A: Assuming a 35-year investment life, one can expect to participate in three to four complete economic cycles, with each cycle of about eight to 10 years, yielding returns of at least 200% over capital. With this approach, transaction costs will be at the barest minimum and any disruption to one’s job will be almost non-existent, as the investor will be doing nothing most of the time.
During this period of 35 years, one who is patient and courageous will in addition be rewarded with about five event market crashes, which should yield at least 50% for each event. Therefore this strategy though on a day to day basis does not seem to bear anything, can be very profitable and consistent over the 35 years horizon.
Be patient and be prepared, and you will come out tops in the investment arena.
If cash is king and cash is the bloodline of a company, then one ought to know how to read a cash flow statement. There is a saying that goes “Revenue is vanity, Profit is sanity and Cash is reality.”
This is the last series of the Beginners’ guide to getting started in investing. We have thus far talked about the income statement and the balance sheet. The final set is none other than the cash flow statement.
1. What is Cash Flow Statement?
A cash flow statement measures how much cash is coming in and how much cash is going out. It is directly connected to the income statement and balance sheet.
Then you might ask, doesn’t the income statement tells us how much cash is coming in and going out? Nope, it doesn’t. Only the cash flow statement does.
That means the net income you see every year doesn’t mean it is cash. It does not mean that in 2019, company XYZ collected $5,021 in cash profits. Now, why is that so?
This is because of accrual accounting, a concept that has been discussed in the previous post. Accrual accounting records revenue and expenses as and when it is incurred, regardless of whether there is any cash inflow or outflow.
For example, revenue is typically recorded when the company has transferred the risk and delivered the goods over to the customers. At this point of time, no cash has been collected as they might have given the customer up to 45 days for payment. BUT, the income statement would show that the company has earned say $20,000 even though cash has not been collected.
This is why the cash flow statement is important. Because it shows the actual cash that is coming in and going out. It removes the veil of accounting gimmicks and reveals the reality of the business.
2. Cash Flow Statement Example
A cash flow statement has 3 main categories:
Operating Activities
Investing Activities
Financing Activities
Operating activities are things that concern the daily business operations of a company. For example, paying suppliers, buying inventories, selling goods and etc.
Investing activities is as the term implies, investing. These are activities that deal with long-term assets such as purchasing land, buying some machinery or selling assets.
Lastly, financing activities are activities like borrowing money from the bank, paying off loans, refinancing and etc.
This is an example of how a cash flow statement would look like. I have decided to recreate a new set of financial statements to illustrate how everything connects.
The first line item of a cash flow statement will always start with the net income figure. This net income is the bottom-line figure that is taken from our income statement.
However, if net income does not mean cash, then how much cash did we collect in 2019? The answer is in the highlighted yellow text under the “net change in cash inflow/(outflow)”.
We collected $22k in 2019. So even though net income in 2019 is $35,550, cash collected in 2019 is $22,000.
How did that happen and why?
3. How to Prepare a Cash Flow Statement
A cash flow statement can be created from scratch just by looking at the income statement and balance sheet. You will see later how all the figures are connected and interlinked. I will use the above company ABC to illustrate a step-by-step process of preparing a simple cash flow statement.
This will get a little complicated. Hence, it is important that you have a fundamental understanding of the income statement and balance sheet before proceeding.
Cash Flow from Operating Activities
We will start with the “Cash Flow from Operating Activities” first.
First thing first, it always starts with the net income. So our top-line figure is $35,550 which is taken from the income statement. Just follow the arrows and observe where the figures in the cash flow statement come from.
Next, we will add back all the non-cash items in the income statement. In this case, only depreciation is a non-cash item. This is because it does not represent a cash outflow. It is just an accounting or accrual concept.
Finally, we will add or deduct all the changes in working capital. For this, we have to calculate the change in the balance sheet figures. Hence, we will need the 2018 and 2019 balance sheet figures. Then calculate what is the difference between both years.
For example, if accounts receivables decrease from 2018 to 2019, what does that tell you? It simply means the customers have paid up and you have collected cash. So that represents a cash inflow. Remember the journal entry transaction that shows how $10k moves from receivables to cash?
If inventories increase, what does that tell you? Well, the company has purchased inventories and that represents cash outflow.
If accounts payable increases, what does it mean? It means that the company has delayed cash payment. It has not paid anything and that should represent an increase in cash.
Hence, you see that the changes in the balance sheet figures flow directly to the cash flow statement. Just think about each line item logically and ask yourself whether it represents a cash inflow or cash outflow.
After which, just sum up all the line items and you will get the net cash generated from operations. Some investors prefer to use this figure rather than the net income as it represents the amount of cash that the company made.
Cash Flow from Investing Activities
In this category, we are trying to find out the cash inflow and outflow from investing activities. In the above example, you see a cash outflow of minus $10k. Why is that so?
Well, because we bought a machine that costs us $10k. That is also the reason why you see PPE has increased from $90k to $100k in 2019’s balance sheet.
On the other hand, if PPE decreases from 2018 to 2019, then what does it mean? It would probably be the reverse. That means we have sold some machines and that should represent a positive cash inflow. Under the cash flow statement, it would probably be “Sale of PPE” instead of “Purchase PPE”.
In the real world, there is probably a mix of sales and purchase. The next step is to sum up all the cash inflows and outflows from investing activities. That would give us the net cash generated from investing activities.
Cash Flow from Financing Activities
Finally, cash flow from financing activities is all the loans, debts, capital raising and dividends.
Again, if short-term debt increases from 2018 to 2019 in the balance sheet, what does that tell us? The company has borrowed some money so that should be a positive cash inflow.
In the above example, short-term debt has decreased from 20k to 15k. It means the company has paid down $5k and that is the same reason why you see a red negative -$5,000 in the cash flow statement. Because it is a cash outflow.
The same logic applies to long-term debt. Since long-term debt has increased $5k from 2018 to 2019, the company would record an increase in cash of $5k in the cash flow statement.
Retained Earnings in Balance Sheet
Lastly, what if the company pays out dividends to shareholders? Then that obviously represents a cash outflow since cash is given out to shareholders. Company ABC paid $5,550 of dividends in 2019, so we have another line item that records this cash outflow under financing activities.
If you have read the previous post on “How to read a balance sheet?“, you will be familiar with the term “Retained Earnings”. If not, here is a quick recap.
If you look at the retained earnings in 2019, it is showing a balance of $33k. How did we get that?
2019’s net income figure is $35,550. The dividends paid to shareholders is $5,550. So the retained earnings are $30,000. That is the money the company keep for itself in 2019. Since the balance sheet is a cumulative measure of what we have, we need to add in the previous year’s retained earnings. That is how I got $33k.
Matching the Cash Flow Statement & Balance Sheet
The final step in the preparation of a cash flow statement is to add up all the net cash generated from the 3 categories (Operating, Investing & Financing). This would give us the net change in cash for the year which is $22k.
You would realise that if you add the net change in cash with the cash balance in 2018, it should give us the cash balance in 2019. That is how everything links up.
4. How to Read & Analyse a Cash Flow Statement?
The last section is to see what ratios or metrics can be used to analyse the cash position of a company. There are quite a few variations but I realised I have not introduced the concept of Free Cash Flow (FCF). How could I? This is probably the most popular figure that everyone uses, including myself.
Free cash flow is calculated by taking cash flow from operations minus capital expenditures. Warren Buffet referred to it as “Owner Earnings“. The reason why FCF is important because it is the amount of disposable cash earnings they have after spending on all the business needs.
Net income isn’t really a cash figure, there are accounting concepts in it. So people use cash flow from operations. For example, Adam Khoo uses operational cash flow to do his DCF analysis and determine the fair value of companies.
However, cash flow from operations excludes the thought that business needs to invest in CAPEX every year to grow and expand. That is the reason why FCF is a more appropriate measure in my opinion.
Apart from FCF or Operation cash flow, there are other measures such as Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE). Now you start to see how those DCF models are highly subjective? Depending on which cash flow figure you choose, the valuation results would return an entirely different ballpark figure.
4.1 Sustainability of Dividend Payouts
This is perhaps the easiest and common way people measure whether a company’s dividend policy is sustainable. How do we do it?
Simply compare the FCF against the total dividends paid. The wider the gap, the higher the buffer or margin the company has. Let’s use one example.
Source: Retrieved from S&P Capital IQ
This is a real cash flow statement. The company is Singtel. At least now you are more familiar with the line items in the cash flow statement after reading this post. We only need 3 things. The cash flow from operations, CAPEX and total dividends paid. From there, we can calculate the FCF and plot the graph.
There you have it. Free cash flow is above total dividends paid, except for 2016. The gap between FCF and dividends is also fairly wide. There is an approximate $1 billion buffer in between. From this chart, we can tell that the dividends payout are sustainable and healthy.
4.2 Operating Cash Flow Ratio
Doesn’t this formula look familiar? Yeap, it is found under our balance sheet ratios. Current Ratio, quick ratio and cash ratio. That’s why I brought up the point that there are no hard rules in finance. Understanding the concepts and logic behind is more important.
In this case, we are trying to test the liquidity of the company. Since the payment is made in cash, comparing operating cash flow would be a better measure of liquidity rather than the current asset items. That is one way of looking at it. What else can you think of that can be replaced with operating cash flow?
Another popular metric is to modify the interest coverage ratio. This was covered in the first series of “How to read an income statement?” Well, simply replace the numerator from EBIT to Operating cash flow. That’s all. It would be a better measure because operating cash flow is a more accurate representation of the cash earnings rather than EBIT.
4.3 Operating Cash Flow to Net Income Ratio
A more interesting ratio would be the operating cash flow to net income ratio. Remember I started out emphasising that net income is not cash flow?
The net income is just an accounting concept for reporting purpose. That also means that it can be easily manipulated through creative accounting methods.
For example, management can overestimate an asset’s useful life. This would decrease depreciation expenses thereby increasing net profits. Secondly, underestimating bad debts to reduce expenses. Thirdly, accelerating the recognition of revenue. Fourthly, capitalising costs under the balance sheet rather than an expense in the income statement.
All these are accounting manipulations and management assumptions. These are just some of the many examples to “cook the books.” That’s why you need auditors to validate the reasonableness & judgement of management.
So how do we determine the “quality” of the net income that was reported? Quality is meant by how much of the net income is actually real cash earnings.
There is one way and that is to compare the operating cash flow against the net income. The operating cash flow to net income ratio is calculated by taking operating cash flow divided by net income.
Cash Flow to Net Income Ratio Interpretation
A ratio of 1 means whatever net income the company earned is exactly the same as the amount of cash collected. In normal situations, the operating cash flow should be higher than net income as you have to add back depreciation expenses.
The higher the ratio the better the “quality” of net income that is being reported. This is because the company is generating real cash profits from its operating activities. A low ratio means the “quality” of the net income is poor. Most of it could be accounting profits rather than cash earnings.
Let’s try it out on Singtel. We just need 2 things: Net income & Cash flow from operations.
Source: Retrieved from S&P Capital IQ
There you have it. Simple & easy. It is above 1 throughout the years. That is one quick and simple way to check a company’s earnings quality.
5. Summary on How to Read a Cash Flow Statement
These are the basic building blocks of a cash flow statement. It always starts with the net income that is taken from the income statement.
The cash flow statement is categorised into 3 parts: Operations, Investing and Financing. Summing all of them up would give us the net change in cash flow for the year.
The net change in cash flow for the year, when added with the previous year cash balance, should always be equal to the current year cash balance in the balance sheet.
Most people use the cash flow statement to evaluate the sustainability of dividend payouts. This can be done by comparing the free cash flow against the total dividends paid.
Other cash flow metrics are often a variant of the common financial ratios. Simply replace the numerator with cash flow from operations. Some examples of it include current ratio and interest coverage ratio.
Lastly, and this is less commonly discussed, is to evaluate the “quality” of a company’s net profits. This can be done by comparing the ratio of the operating cash flow to the net income.
The cash flow statement is the final set of financial statements. This Beginners’ guide to getting started in investing covers only the basics. But it should help you move towards intermediate as you read more financial statements along the way. It is my earnest hope that you have gained a better understanding of how to read a company’s financial statement after reading these articles.
Then, at age 29, you survive the global economic crisis that began with the collapse of the New York Stock Exchange, causing inflation, unemployment and hunger.
At 33, the Nazis came to power.
You are 39 when WWII begins and ends at 45. During the Holocaust (Shoah), 6 million Jews died. There will be more than 60 million deaths in total.
When you are 52, the Korean War begins.
At 64, the Vietnam War begins and ends at 75.
A boy born in 1985 thinks his grandparents have no idea how difficult life is, but they have survived several wars and disasters.
Boy born in 1995 and now 25 thinks it's the end of the world when his Amazon package takes more than three days to arrive or when he doesn't get more than 15 likes for his photo posted on Facebook or Instagram.
In 2020, many of us are living comfortably, we have access to different sources of home entertainment, and we often have more than we need.
But people are complaining about everything.
However, they have electricity, telephones, food, hot water and a roof over their heads.
None of this existed before.
But humanity has survived much more dire circumstances and has never lost the joy of living.
Maybe it's time to be less selfish, to stop complaining and crying.”
The ever positive and optimistic Warren Buffett investment guru sounds cautious during Berkshire Hathaway (BH) Annual shareholder meeting recently.
NOBODY KNOWS WHAT THE MARKET IS GOING TO DO TOMORROW.
QUOTED WB
“I don’t know, and perhaps with a bias, I don’t believe anybody knows what the market is going to do tomorrow, next week, next month, next year. I know America is going to move forward over time, but I don’t know for sure, and we learned this on September 10th, 2001, and we learned it a few months ago in terms of the virus. Anything can happen in terms of markets, and you can bet on America, but you got to have to be careful about how you bet, simply because markets can do anything.”
UNQUOTE
Comments Rolf:
I agree entirely that nobody knows what the market is going to do tomorrow or next year or the year after next. If you are having the mindset that wow… stock market is cheap and I am going to throw everything in, think again! Or if you think stock market is expensive now because it has risen 20% since late March low and you miss the boat, and are waiting for stock to retest March low, before you throw every cash you have in, also please think again. If you are trading, and in the last few months whether long or short and you managed to win $ and think highly about yourself, that you are going to win loads and loads of $ during this downturn, think again too! Your pride can just be your biggest misery, because nobody knows what the market is going to do going forward.
WB RECOUNTING GREAT DEPRESSION
It is almost first time I recall (correct me if I am wrong) that WB talks a great length about Great Depression during his annual meeting. An event that he himself having almost 80 years of investing experience did not experience the greatest collapse of the stock market in the last centure. Perhaps that is why he rarely talks about the Great Depression because WB loves to relate his experiences when he is giving a speech or answering during interviews. But this time, he sounds different and cautious!
To recap,
WB highlighted on September 3rd, 1929, the Dow average closed at 381.17, and people were very happy and buying stocks on margin that worked wonderfully. His dad, who was 26 years of age back then, was an employee in the bank who sold stocks to people.
Few months later 13 Nov 1929, Dow drop 48% to 198.69. His dad was too ashamed to face those people he sold stocks to, and stay at home and 9 months later WB was born.
The last trading day before WB was born on 30 Aug 1930, Dow was up 20% to 240.42 from 1929 low.
QUOTE WB:
People did not think in the fall of 1930, they did not think they were in a great depression, they thought it was a recession very much like had occurred at least a dozen times, although not always when stock markets were important, but we’d have many recessions in the United States over that time, and this did not look like it was something dramatically out of the ordinary. For a while, actually for about 10 days after my birth, that’d be …and the stock market actually managed to go up all of 1-2% there in those 10 days, but that’s the last day. UNQUOTE.
Almost 2 years later 7 Aug 1932, Dow was at low point of 41.22.
QUOTE WB:
if somebody had given me $1,000 on the day I was born, and I’d bought stocks with it, and bought the Dow Average, my $1,000 would have become $170 in less than two years, and that is something that none of us here have ever experienced that we may have had it with one stock occasionally, but in terms of having a broad range of America mark down 83% in two years, and mark down 89% of the peak, that was in September 3rd, 1929, was extraordinary.
UNQUOTE
1 Apr 1951 Dow 240.85, after more than 20 years, a buyer on WB’s day of birth finally gets even (though dividends had been received).
Comments Rolf:
Rolf: If you buy a stock in 1930 believing the crash in late 1929 is the worst and has bottom, it will take you 20 years in 1951 for your stock to recover to breakeven price. Likewise if you are buying a stock in late March 2020 and think that in the next 2-3, or even 3-5 years the recession will be over and you will earn a lot of money, think again. There can be a chance that you may end up in the mindset or situation with those who invested in 1930 and have to wait for over 20 years to breakeven your stock price.
I never say for sure it will happen, but what I am saying is there is a chance it can happened because nobody knows. Of course, I also think there is an equal chance the market will recover and hit high again.
Therefore when it comes to investment, when it is uncertain, you have to weigh RISK and REWARD carefully and cannot just bet for sure that market will improve within next few years. And if you do not throw all your eggs into the market and only thinking about recovery, then you are betting and not investing. Better to be safe than sorry! It is better to win less money with backup for worst of the worst, than having to wait for 20 years like what happened during 1930-1950s.
CONCLUSION
If you think that you know what is going to happen in the market next month, or next year, or next few years, YOU DON’T!
If you think that you are very smart because you utilize significantly large percentage of net cash buying into the market at its lows in March, YOU ARE NOT!
If you think that you are smarter than the rest because currently you are making money now in the market, YOU ARE NOT!
You are just fooled by randomness, and using betting mentality rather than weighing risk and rewards.
Always be humble and have the prepare for the worst mindset, while staying cautiously optimistic about the future.
Always seek the truth and be realistic and use data, risk and reward metrics to justify your actions.
Last but not least, do not overspend time looking at the market or news, as life encompass more things other than your desire to make money from the market.
Aside from work (if you still have it now),
Spend time enjoying with your family.
Spend time calling your good friends.
Spend time doing some exercise.
Spend time in your hobbies.
Spend time helping others if you are called to.
And of course spend time to relax enjoying nature....
