Wednesday, April 12, 2006

"Dr. Flowlove" or "How I learned to stop caring about EPS and love the cash"

Ask most journalists, and they will tell you that what they like most about their jobs is that they get paid to talk to interesting people all day long. On that front, I'm certainly no exception. I didn't get into journalism with any woolly-headed notions of being a "writer" — my dream job was basically having somebody pay me to read different newspapers all day long, and I figured working for one of them would be the closest thing to that.

Mirroring my own interests, my journalism jobs thus far have run the gamut of diversity — I've done everything from news and editorial to sports and business. It's my work in the business press, however, that makes me privy to some truly fascinating people who can not only help me professionally, but give me some insights into the world of investing also.

Case in point? Jay Taparia. I recently had the privilege to attend a CFA Institute sponsored seminar led by Mr. Taparia. The lecture's aim was to be a sort of crash course in financial accounting for journalists, walking us through some of the more common accounting malapropisms that unscrupulous companies try to put in their quarterly reports, so that we can catch them in the act and unearth the next Enron before it happens.

I'd guess that a good 80% of the general population is woefully uneducated about finance, and I'm loath to admit it, but I doubt that members of the financial press fare too much better. Crappy companies depend on the fact that most deadlined-frenzied reporters couldn't define amortization if their lives depend on it, and the herd mentality dictates that all too often we get caught up in blindly reporting whatever the company's press release deems the "most important" number to be.

It shouldn't be that way, and according to Mr. Taparia, it doesn't have to be. While his seminar is already paying off in my day-to-day work of sussing out corporate bullshit, from a personal investing standpoint Mr. Taparia proved similarly invaluable.

I won't bore you with the details, but the Taparia mantra, in a nutshell, goes as follows: Cash flow is king.

Net income is the easiest trap to fall into, Taparia says, and small investors' obsession with charting earnings-per-share is foolish, because earnings are one of the easiest numbers to manipulate. Though a lot of the specifics are rather obtuse to synthesize, Taparia's main point is that in his role as a money manager he disregards conventional matrices like revenue and net income because they are too easy to muddle.

How? You can sell merchandise on credit and book it as revenue before you see a dime. You can pay suppliers on credit to avoid having to list it as an expense. You can hide inventory (he relates the anecdote of a well-known bottling company that famously used to load up trucks with merchandise on December 31 every year in order to hide inventory and beat estimates by a penny) in any number of ways, and you can hide long-term debt levels by eschewing property mortgages in favour of much more costly, yet balance-sheet friendly, leases. And at the end of the day, you post a scintillating net income, and watch your stock tick up accordingly.

But cash flow - literally, how much cash is coming in and out of the business at any given time - paints a much clearer picture of how solid the company's financial ground is. There's obviously much more to it than that, and all investors should of course do their due diligence before even thinking of buying a stock. But from where I'm sitting, cash flow is one factor that just got bumped to the top of my list.


The Dividend Guy said...

This is a great post - cashflow is king. It does not matter how good earnings are, if the company is buring cash too quickly they are dead.

I have added you to my blogroll.

GIV said...

Thanks, dividend guy. Yours is one of my favourite PFblogs, so I'm honoured to get the link.