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It's Future Cash Flows, Stupid!

From The Financial Times newspaper:

Link to original Letter at FT.com

It’s future cash flows, stupid!*

Published: November 24 2007 02:00 | Last updated: November 24 2007 02:00

From Mr Logan Flatt.

Sir, It is no surprise that an academic study overlaying fundamental company data with equity market data (Long View, John Authers, “Number-crunchers are socially desirable again”, November 17) would conclude that reported earnings or earnings forecasts are the “best predictor” of the market’s valuation of a publicly traded company. After all, the market’s “valuation” represents the market pricing the company’s shares based on supply and demand.

Holding supply constant, market price is determined at the margin by speculative demand for the shares. Most speculators probably formulate their demand for the company’s shares based on a mixture of its most recent quarterly earnings report, analysts’ forecasts of future earnings, unofficial Wall Street whisper earnings, and random online chatter. In the spirit of “group think”, it is entirely possible that most speculators give more weight to earnings measures simply because more people in the market talk about earnings measures than cash-flow measures.

Ah, but there’s the rub: the objective and reasonable valuation of a company has little to do with the supply of and demand for the company’s shares and everything to do with the company’s ability to generate future cash flows. Many successful investors have proven records of using cash-flow-based valuation approaches to uncover and then take advantage of compelling investment opportunities that have exceeded historical market index returns.

They gained their advantage by using estimated future cash flows to assess a company’s intrinsic value – the economic benefit today of holding onto the company’s shares over the long term for the sole purpose of collecting future cash flows from the company – and then asking themselves: “What price am I willing to pay for the company’s shares today given the economic benefit the company’s shares offer me today?”

A quick look at the ticker tape told them whether or not it was prudent to pay the prevailing market price for the company’s shares. If the company’s prevailing market price exceeded the company’s intrinsic value, these successful investors likely took no action. If the company’s prevailing market price fell well below the company's intrinsic value, they probably committed significant capital to the investment opportunity and never looked back.

I submit that speculators’ focus on the company’s near-term earnings measures probably created the short-term market inefficiency that led to the mispricing of the company’s shares vis-a-vis their intrinsic value. Furthermore, I submit that long-term market efficiency probably ensured the successful investors' market-beating returns since, to paraphrase Benjamin Graham, the market is a voting machine in the short term, but a weighing machine in the long term.

Logan Flatt,
PowerWealth.com,
Dallas, TX 75230, US

Copyright The Financial Times Limited 2007

*NOTE: Title chosen by The Financial Times, not Logan Flatt.

Copyright 2007 PowerWealth.com. All rights reserved.

How to Get Ahead In America (5th of a 12-Part Series)

By Logan Flatt, CFA

NOTE: This article is Part 5 of a 12-part series detailing the “12 Refusals That Helped Me Pull Ahead in America.” To start at the beginning of the series, click here.

5. Refuse to let America's media and entertainment industry own your reality.

   If you live in the United States of America, one reason you may feel challenged to pull ahead financially is that America’s culture is heavily focused on the consumption of goods and services by individuals and families. While consumption may help grow America's mammoth $13.1 trillion economy, it can also hurt the long-term wealth of the average American family. Why doesn't America's culture focus on more fiscally responsible behavior like saving and investing? Because America's powerful media and entertainment industry keeps American culture centered on the consumption of products and services by offering and providing advertising and other marketing solutions to America's best and brightest marketers. It is the combined power of the industry and the marketers that keeps you and your family focused on spending your money on goods and services in the here and now instead of doing what is best for you and your family in the long run – building wealth by saving and investing.

Don't Fool Yourself – Your Home Is Not An Investment.

By Logan Flatt, CFA

   Recently, a respected blogger on the Web misquoted me on their blog in an entry referencing my essay, "You Don't Own Real Estate. Real Estate Owns You." The blogger made a couple of critical errors in quoting me but the errors have, for the most part, now been corrected based on three points I made privately to the blogger by email. Below, I present the text of my email (with some small edits) for all PowerWealth.com readers who have an interest in real estate investing to review and consider.

******

   First, I never said on my PowerWealth.com site that a "home mortgage is not an investment." What I said was, "…your home is not an investment…" That's a huge difference! I think your confusion arises out of your merging of two separate and distinct financial considerations from the homeowner/borrower perspective:

1.   The Asset, which is the real estate property we would call "home"; it is an asset because it has marketable value to you and others in the real estate marketplace;

AND

2.   The Liability, that loan or mortgage serving as a lien on the real estate property only because the buyer of the home did not have enough cash on hand to pay for the property outright and had to borrow the money from a bank or mortgage lender to complete the purchase of the real estate property.

   From the borrower's perspective, a "home mortgage" could never be viewed as an investment. It is a legal contract obligating the borrower to pay back the money borrowed, plus interest charges and other fees. In effect, the home mortgage slowly drains the borrower of cash through those interest charges and fees paid out over time. Being legally obligated to pay someone else cash over time is a liability. One "invests" in assets, not liabilities. A freedom loving person seeks to rid themselves of a liability – having no meaningful financial obligations such as liabilities is what "financial freedom" means. Consequently, an investment in a liability is a non sequitur.

   It is important to note here that only the lender would view the "home mortgage" as an investment because that home mortgage is indeed an asset to the lender – in exchange for lending the money to the borrower, the lender gets the mortgage documents signed by the borrower agreeing to pay the money back plus interest charges and other fees. So, what is a liability to the borrower – the mortgage – is an asset to the lender. If you were writing about lenders, then your implication that a home mortgage is an investment would make more sense. Unfortunately, you were writing about borrowers in your post. So, contrary to what you posted, no, I do not agree with you.

   Second, my quoted statement on your site [Editor's note: the quote used from my article was, "To make it your home, you must take cash out of your pocket each month to finance it, insure it, maintain it, fix it, furnish it, and pay property taxes on it. Unlike investment real estate, your home generates no income to offset these out-of-pocket expenses. So, while you likely derive much pleasure from owning your home, you lose money on it every month. Don’t fool yourself – your home is not an investment. It is simply a purchase."] would be true for a home that had no mortgage on it if only we were to delete two words: "finance it." So, the home need not have a mortgage on it to fail my "investment test" – even if the homeowner owns the home free and clear, there are a litany of expenses associated with home ownership that make it difficult to call a home an investment (because the home generates no income itself to offset those expenses). This was the full point of the "Personal Real Estate is Simply a Purchase, Not an Investment" section in my article on PowerWealth.com.

   Third, both you and [a financial services professional who made, in my view, an erroneous comment to the blogger's post] appear confused on the notion that the use of "leverage" to buy a home somehow instantly transforms the purchase of a home into an investment. No, it does not. While "leverage" is a sexy term used by professionals in the trade to romanticize real estate investing and make it sound exciting conceptually, it is a red herring. It masks the truth: to use "leverage" is to legally obligate yourself to a lender. In other words, what you are doing when you "lever a deal" is voluntarily take on a liability and the risk of losing your home to the lender due to your failure to pay back that liability according to the lender's terms. The addition of a liability to your home purchase does not – poof! – make your home an investment.

   To clarify, when you use "leverage" to buy your home, you are essentially completing two separate and distinct transactions at the same time:

1.   purchasing a piece of real estate that will generate no income for you to help you offset all the expense associated with owning said real estate,

AND

2.   entering into a legal agreement to borrow money from a lender whereby you agree to repay the money borrowed plus interest charges and fees according to the lender's terms specified in the agreement.

   Note that the addition of "leverage" to the deal did nothing to change your home's ability to generate income for you one bit. In fact, by borrowing the money to buy your home, you simply increase your home ownership expenses by adding interest charges and fees. Clearly, "leverage" is sexy in concept only; in the harsh light of reality, it is anything but sexy.

   [Blogger], I hope that you and your readers will consider reading again my article, "You Don't Own Real Estate. Real Estate Owns You." at PowerWealth.com to recall and reinforce its key takeaways:

1.   to invest in real estate means to own and operate income-producing real estate;

2.   to speculate in real estate means to buy real estate at the prevailing market price and hope to sell later at a higher market price;

3.   your home is neither an investment nor a speculation – it is simply a purchase of a piece of real estate to enjoy and call "home", not to make money from it;

4.   you really don't own real estate if a government can swoop in and take it away from you because that government thinks your real estate stands between it and a just cause – a cause apparently less important than your personal property rights.

   Thank you,

   Logan Flatt, CFA
   PowerWealth.com

******

Copyright 2007 PowerWealth.com. All rights reserved.

"Growth Investing" Nothing More Than Rank Speculation

By Logan Flatt, CFA

   Recently, Financial Times columnist, John Authers, made a “Long View” case for growth investing over value investing (Market News & Comment – Long View, “Now may be the time to go for growth stocks”, October 6/7, 2007). Unfortunately, Mr. Authers’ case for growth investing is actually a case for rank speculation.

   Thanks to decades of promulgation by the financial services industry, it is now common for many people not unlike Mr. Authers to mistakenly use the terms “value” and “growth” to describe two contrasting styles of investing. However, there are not two styles of investing. Instead, there is investing and there is speculation. What is known as “value investing” is bona fide investing where fundamental analysis, reason, long-term ownership, and patience lead most investors to wealth.  What is known as “growth investing” is rank speculation where fear, greed, short-term trading, and the desire for immediate gratification lead most speculators to treat Wall Street like a casino, placing emotional bets on what seem like ever-increasing market prices. That is, until reason prevails, the tables turn, and the madding crowd rushes for the exits, losses in tow.

   Mr. Authers further errs in his contrasting definitions of growth investing and value investing: “Growth takes advantage of the market’s undervaluation of future earnings while value profits from undervaluations when a company gets into trouble.”  Unfortunately, neither definition is correct. Value investing takes advantage of the market’s mispricing of a company’s shares relative to their intrinsic worth (i.e., the present value of the company’s likely future dividends or after-tax free cash flows expressed on a per-share basis) regardless if the company is in trouble or is as healthy as it can be. For example, it’s the buying of a company reasonably worth $25 a share when the market has it emotionally priced at only $15 a share. In contrast, growth investing takes advantage of the “greater fool theory” – the belief that regardless of what price you pay for a high-flying stock, some other speculator will be there to pay you a higher price when you are itching to sell it.

   Another Financial Times columnist, Arne Alsin, had it correct months ago (Columnists – Inside Curve, “Two simple questions that protect against the siren’s song”, March 9, 2007) when he stated, “All great investors, from Warren Buffett to Peter Lynch to Michael Price, understand a single, fundamental premise. That is, in order to be a successful investor you have to be able to answer two simple questions: ‘What does it cost?’ and ‘What is it worth?’” As Mr. Alsin went on to point out, if an investor does not answer the second question, the answer to the first question is meaningless. We can surmise then that the speculator, in contrast, finds ignorance of the answer to the second question to be perilous bliss.

   That “growth investing” is rank speculation is made clear by Mr. Authers’ concluding statement, “…stick to stocks whose fundamentals are really growing and then be ready to sell at the first sign of trouble.” Only a speculator would think this way. Warren Buffett – investor par excellence – has suggested that selling the shares of a company with sound fundamentals may very well be the last thing an investor should do when “trouble” arises. Instead, Mr. Buffett suggests we take a harder look and determine whether the trouble at hand is short-term operating trouble or long-term strategic trouble. If the company has hit a rough patch operationally but nothing about the company’s winning strategy has changed, a reasonable investor would stand pat or even buy more of the company’s stock. After all, if the company was good enough for you to buy its shares in the first place, why not consider buying more of it when speculators overreact to “trouble” and post their shares up for sale at significantly lower prices?

   Ultimately, if Mr. Authers is correct and growth investing is “due for a period of outperformance,” we are entering – or, more likely, have already entered – a period of widespread speculation in stocks. Caveat emptor.

Copyright 2007 PowerWealth.com. All rights reserved.