How to Make Money in Stocks Using Cash Flows
There you are in front of your computer screen, and lo and behold you notice one of your top 10 positions is down -11% (let’s call it ticker: ABC). With sweaty palms and blood rushing from your head, you manage to click with trembling hands on the ticker symbol that will imminently deliver the dreadful news. A competitor (ticker: XYZ) just pre-announced negative quarterly earnings results, and an investment bank, Silverman Sax, has decided to downgrade ABC on fears of a negative spill-over effect. What do you do now? Sell immediately on the cockroach theory – seeing one piece of bad news may mean there are many more dreadful pieces of information lurking behind the scenes? Or, should you back up the truck to take advantage of a massive buying opportunity?
Thank goodness to our good friend, cash flow, which can help supply answers to these crucial questions. Without an ability to value the shares of stock, any decision to buy or sell will be purely based on gut-based emotions. Many Wall Street analysts follow this lemming based analysis when whipping around their ratings (see The Yuppie Bounce & the Lemming Leap). As I talk about in my book, How I Managed $20,000,000,000.00 by Age 32, I strongly believe successful investing requires a healthy balance between the art and the science. Using instinct to tap into critical experience acknowledges the importance of the artistic aspects of investing. Unfortunately, I know few (actually zero) investors that have successfully invested over the long-run by solely relying on their gut.
A winning investment strategy, I argue, includes a systematic, disciplined approach with objective quantitative measures to help guide decision making. For me, the science I depend on includes a substantial reliance on cash flow analysis (See Cash Flow Components Here). What I also like to call this tool is my cash register. Any business you look at will have cash coming into the register, and cash going out of it. Based on the capital needs, cash availability, and growth projects, money will furthermore be flowing in and out of the cash register. By studying these cash flow components, we gain a much clearer lens into the vitality of a business and can quickly identify the choke points.
The other financial statements definitely shed additional light on the fitness of a company as well, but the income statement, in particular, is subject to a lot more potential manipulation. Since the management teams have more discretion in how GAAP (Generally Accepted Accounting Principles) is applied to the income statement, multiple levers can be pulled by the executives to make results look shinier than reality. For example, simply extending the useful life of an asset (e.g., a factory, building, computer, etc.) will have no impact on a company’s cash flow, yet it will instantaneously and magically raise a companies’ earnings out of thin air…voila!
“Stuffing the channel” is another manipulation strategy that can accelerate revenue recognition for a company. For example, let’s assume Company X ships goods to a distributor, Company Y, for the exclusive purpose of recognizing sales. Company X wins because they just increased their sales, Company Y wins because they have more inventory on hand (even if there is no immediate plan for the distributor to pay for that inventory), and the investor gets “hoodwinked” because they are presented artificially inflated sales and income results.
These are but just a few examples of why it’s important to use the cash flow statement in conjunction with the income statement to get a truer picture of a company’s valuation and “quality of earnings.” If you don’t believe me, then check out the work done by reputable academics (Konan Chan, Narasimhan Jegadeesh, Louis Chan, and Josef Lakonishok) that show negative differentials between accounting earnings and cash flow are significantly predictive of future stock price performance (Read more).
So the next time a holding craters (or sky-rockets), take an accounting on the state of the company’s cash flows before making any rash decisions to buy or sell. By doing a thorough cash flow analysis, you’ll be well on your way to racking up gains into your cash register.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.