Cash Flow – The Ultimate Margin of Safety

Cash is King

The intrinsic value of a stock is considered to be the discounted value of future cash flows.  But, it is free cash flow (defined as cash from operations less capital expenditures) that is used for paying dividends, paying down debt, and buying back shares, actions that create value for shareholders.  The more robust and secure the cash flows, the safer the investment.  As an added bonus, the more free cash flow produced per dollar invested, the higher the expected return.   On the flip side, the more leveraged and fragile the cash flows, the more risky an investment becomes.  Even for fixed income, cash balances and cash flows determine whether or not timely interest and principle will be paid on an investment.  As such, an investor should constantly monitor the source and stability of cash resources.

Universal Truth

The same logic that applies to business applies to personal finances.  Income that comes from a salaried position at a quality company would typically be more consistent than a commission based job in a cyclical industry.  A person with inconsistent income and high personal debts would be in a more precarious financial position than someone with no debt and millions of dollars in liquid assets, especially in an economic downturn.

Extrapolating this thought process to the national level, it is clear that countries that have stable incomes and low levels of obligations have the ability to sustainably provide services to their people while keeping taxes low so that business and investment can flourish and grow.  Those that don’t have reliable revenue more often than not make up for it with increased debt loads and higher taxes.   If tax rates rise faster than business revenues and personal incomes, the system crumbles (as we are now witnessing in Europe).  The other approach to high debt is money printing.  This is often used as a politically less offensive way of paying for accumulated debt.  The resulting inflation can be blamed on greedy businesses or previous regimes.   Either way, the system is hit with hardship.

While the simple concepts outlined above seem obvious, the core lesson seems to be eternally lost upon the financial markets, politicians, and the voting public. George Bernard Shaw once said, “Hegel was right when he said that we learn from history that man can never learn anything from history.”

Quality of Earnings

In investment circles and the media, much of the focus is placed on earnings.  Each quarter’s earnings release is awaited with baited breath.  If the company “misses” the collective analysts’ expectations, then the stock sells off.  If the company “beats the street”, then the stock rallies.  Despite the fact that cash flow may be declining and debt rising, the markets are often happy if “earnings” go up.

The actual meaning of “earnings” is often missed, and often has no bearing on the amount of cash that a company generated or burned.  Remember, you can’t pay back debt or pay dividends with earnings.  It is the cash that counts.  While this article is too short for an elaborate explanation of earning vs. cash flow, suffice it to say that the difference is often large.  Further, executives that mismanage companies often spend a significant amount of time on spinning or even manipulating earnings (e.g. Enron, Madoff,…) .  Over the long term, it pays to understand the difference between earnings and cash flow, and to focus on the source and sustainability of the cash flow.

Quality of GDP

As stated above, the economic reality of a nation’s finances are not fundamentally different from that of an individual or a business.   Most pundits measure the financial strength of the economy by looking at Gross Domestic Product, or GDP.  (For a review of GDP, see my November 10, 2009 blog “Is the Recession Really Over?”)    Much like the earnings of a company, GDP can be of high or low quality.  For example, GDP is of low quality if consumption growth is currently funded by a massive run-up in debt.  Ditto for government spending.  The short term GDP gain will have to be paid for with principal and interest, potentially turning the short term gain into a long term drag.  Keeping up with the Joneses doesn’t work well for families, or governments, if long term stability is the goal.

Similar to earnings, GDP has little to do with cash flow.   The Government gets its revenues from taxes, and to a lesser extent, fees.  If there is a deficit, debt issuance and/or money printing is used to make up the shortfall.   If one wanted to assess a government’s ability to pay its obligations, it would be more instructive to compare that government’s debt to tax revenue with an eye towards stability of the tax source, than to GDP.  (With regard to the stability of the tax source, for example, the capital gains tax can generate a large amount of revenue in years where the stock  markets are booming, but usually contribute much less in most years.  1999’s tax revenue would have looked different without the taxes generated by stock options and day trading.)

Suffocating the Golden Goose

Contrary to the pronouncements of U.S. government officials, cash flow, not credit,  is the lifeblood of the economy.  If it is not nurtured, the entire system suffers.   In the U.S., Japan, and much of Europe, debt levels are ballooning in relation to cash flows.  Most of the recent U.S. GDP gains were created by the unprecedented use of credit, for both consumption and real estate development.  To fix the debt problem, governments have decided to run deficits.  The thought is that by deficit spending (adding debt), we can help debtors get out of debt.  This sounds ridiculous in theory, and it hasn’t worked in practice.  Nevertheless, our leaders continue to try to cure the economic hangover by administering more booze.

The current level of debt is having a negative impact on business cash flows and will have a bigger impact when interest rates rise from their historically low current levels.  And we are now finding out that state and local pension plans (and many business pension plans) are significantly underfunded.   The first political reaction to all of this is to raise taxes.  For example, in the U.S., a value added tax is being considered, not as a substitute for the byzantine income tax system, but in addition to it.  Taxes and fees are being raised at every level of government (e.g., public parking fees, licensing fees, transportation fees, bridge fees, sales taxes…).  Taken in the aggregate, higher taxes slow down business.  Lower business revenues mean lower cash flows.   Lower cash flows mean lower salaries, and fewer jobs.  People that make less money, and pay higher taxes, will have less to spend.  It is easy to see that this negative cycle makes debt burdens larger.  If business taxes rise, their cash flows will suffer.  As those cash flows suffer, so will their investors’ returns.

Hard Choices

What can we do about it?   Unfortunately, the only way out of this is to cut government budgets, reduce pension payments, and or print a large amount of money.  There is no easy solution, and few politicians are willing to be honest with their voters.  All of these solutions will have negative outcomes.  Budget cuts will bring reduced services and transfer payments country wide.  Reduced pension benefits will lower many people’s incomes, wreaking havoc on their lives and lowering consumption.  It may even lead to social unrest, as is currently the case in Greece.  Money printing, and the resulting inflation, has always been a painful process.   Many people’s life savings are impacted, and middle and lower class people are hit particularly hard.

Investment Implications

While the solutions are hard to swallow, there is no other way to solve these problems, problems borne of over promising entitlements and from habitual deficit spending.  Investors need to protect themselves against the probable outcomes of slower economic growth, lower investment values, and higher interest rates.  Stock investments should be of the highest quality.  Look for companies with strong balance sheets, hefty cash flows, and entrenched products.  Fixed income should be of the highest quality, with a bias towards the short end of the curve.  A gold hedge would be prudent for most investors.  A margin of safety is always smart when making an investment, but today, it may be more important than ever.

Matt Marcewicz

May 5, 2010