Why is Cash the King when investing? 4

Toronto just got smashed by massive snow storms. It snowed 3 days ago, again 2 days ago, then again last night. What the heck. Welcome to Canada where snow never stops all winter long.

This one enjoyed the snowstorms in Toronto.

and this one

As usual, one of my favorite time of the week- Saturday morning reading through this week finance and investing related articles with a hot cup of coffee that melts my body throughout in this freaking snowstorm.

I follow some investing blogs and super-investors that show consistently good performances over time. Since I have only been investing for a little more than 2 years now, still got lots to learn from them. I have seen some good ones, bad ones, terrible ones and terrific ones. The information is out there, we just need to learn how to sort out bad apples against the good ones.

Francois Rochon from Giverny Capital

Today, I want to introduce you Francois Rochon.

He is a Montreal or Quebec based portfolio manager that manages Giverny Capital. His performance has been pretty good.

He is admired by one of my favorite bloggers, Penetrator who is pretty funny and seem to be good at what he is doing.

When you take a look at what Francoi has in his investment holding, I notice some great names.

Berkshire hathaway 17.7%

LKQ corps 8.4%

Carmax 8.4%

Bank of Ozark 8.1%

Disney 7.2%

Berkshire is a very stable/ great investment for anyone. LKQ’s growth has been pretty well as well. Not to mention Disney.

He seems to like stocks with huge moats or have some growth perspective.

Carmax

I heard a lot about Carmax lately which is the largest used car dealerships in USA. Basically what I do when I find stocks that are mentioned often, I quickly go through its summary of financials before digging further into financial statements, MD&A and other filings and investigate further about competitive advantages and insider ownership etc…

Let’s see the snapshot on Carmax.

Can you see its revenue growth? Its revenue has grown from 7.4B to 15B for 10 years and its EPS tripled during the same period. Even in 2008-2009 crisis, the company still made positive net income. A very good sign.

ROE

Ok, let’s move on to my next typical criteria. ROE, looks solid. It is ranged anywhere between 18- 20. . That tells us something right?

Wait a minute, do you remember how I typically analyze ROE? Take a look at my previous post if you do not remember. (point #7)

11 most important Warren Buffett’s stock picking tips, especially 7th one.

I break down the ROE into three parts. This is called Dupont Analysis.

ROE= Margin x Asset Turnover x Leverage= (Net Income/Sales )  x (Sales / Assets) x ( Assets / Equity)

It tells us how ROE is achieved. Through high margin or great asset turnover? or through using lots of borrowed money?

Take a look at how Carmax’s ROE was achieved.

Its net margin seems to be improving from 2.6% to 3.95% which is a good sign

Asset turnover

but its asset turnover has deteriorated from 4.42 to 1.04. That means, the management has been getting inefficient in utilizing its assets. They used to make $4.42 by using $1 of asset but now they only make $1.04 by using $1 of assets. Let me put in context so that you understand. Person A used to make $44 by using 1 hour of his labour as a senior police officer of Toronto but 10 years later, he retired and he only makes $10.4 by using 1 hour of his labour as a security in my condo building. What the hell. Can you see how terrible this story got? Deteriorating asset turnover is the first warning sign (but not deal breaker) for me.

Leverage

What about leverage? Did you notice that it has been over leveraging itself to reach ROE of 20?

Its leverage was only 1.51 but now 5.06. Unless its in finance industry where companies borrow money cheaply and lend at higher rates, I would take a serious look at stocks that are overly leveraged like Carmax.

Basically leverage of 5.06 means, if all my assets are valued at $5.06 then $4.06 of them were bought from borrowed money and only $1 is from shareholders.

I always think leverage of 2 or lower is a good and safe indicator for me but anything higher than 3, I would probably walk away. High leverage is the second warning sign for me.

Now my favorite- CASH FLOW

what about cash flow? One second, this looks very odd.

The company has been making solid net incomes and EPS last 10 years but the operating cash flow is all over the place. What the heck. It has lost more money than it has made over last 10 years. Is it true? Let’s take a look at google finance

That was true.

Negative operating and free cash flow is a huge turnoff.

As you probably know, I used to be an auditor and now an accountant working in the startup. I have been managing many companies cash flows for a while and let me tell you one of the most important truths. Accounting (net income, revenue, expense etc…) can be manipulated so easily by management but they cannot manipulate cash flows.

Another thing that you should know is you cannot run companies with earnings and revenues but cash flows.

So when net income and revenue look great but actual cash flow is terrible and on top of that, it is not one or two years but over 10 years or so then I get the hell out no matter how much the stock is loved by millions of so called investors and portfolio managers.

I would rather buy other cyclical (for example, Linamar) that actually make money and not lose money with solid balance sheets.

For companies that make solid cash flows and for some reason markets does not like the industries bringing down the stock prices, then I would seriously consider buying more but if I was Carmax shareholder by any chance and the stock price is down for other reasons and shows negative cash flow of $500M to $1B then I would never buy more but sell and never look back.

See the performance difference (Carmax has been pretty good so far but I will never buy because of too much leverage and terrible cash flow. This will never be my forever stock) Even with huge moat of Carmax. I really stay very far away from the stock.

You do not run companies with earnings but cash flows.

Again let me put into context.

Let’s say you purchased a condo unit for $400K hoping that the price will go up and rented out to a tenant.

However after paying mortgage and maintenance, you lose $500 per month which make you borrow more money every month to make up for it. You are still hopeful and speculating that you will sell it for much higher than what you paid for to pay for all borrowed money and make some gain out of it. That’s the story of Carmax at least from an accounting standpoint. So be cautious because Carmax story may not turn into a good ending. I could be wrong but solid cash flow is always right. 🙂

Cash flow is the king.

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