The Stock Market Cash Flow

by Andy Tanner

  Our third investing option is hedging. In the real estate world it is known as insurance. You put a hedge into your liability column because it doesn’t increase your net worth or provide you with income. It is simply a purchase that protects you if something bad happens to your primary investment.

  In Robert’s book, Unfair Advantage: The Power of Financial Education, he asked me about the biggest difference between professional and amateur investors. I said that amateurs are always going for the capital gain, and professionals go for cash flow. Amateurs are always trying to hedge or protect themselves with diversification, but professionals use contracts like insurance.

  Capital Gain or Cash Flow?

  That simple example with real estate applies to stocks in the same way. Maybe you want to buy Acme…and you buy it at $100 a share. And maybe you sell it at $200. Now your net worth’s gone up. You have more money than you did before. Your assets have grown, but Acme has not given you any income; there’s no cash flow from it.

  But suppose you buy a stock that pays you a regular dividend. Now you own an asset that is also adding to your cash flow without you having to do a thing for it. With enough assets like this, you can eventually have the income to do whatever you like—right now or in retirement. In my opinion, that should be the overall goal of investing: freedom of choice and lifestyle.

  Today’s typical retirement plans, such as the 401(k), don’t provide us with cash flow. Instead, the focus is usually trying to build a net worth that is large enough to support retirement—and that is very hard to do. Many people are concerned that their money will run out before their time on earth does.

  Many mutual funds are not created to provide us with cash flow. Instead, they simply add—or sometimes subtract—from our net worth. But they are not giving us income.

  For some new investors, this is a difficult concept to understand. We are trained by the media and Wall Street to equate net worth growth with investing success. But let’s look at a familiar situation that illustrates why net worth may not be the best investing goal.

  Suppose you have $4,000 each month in your expense column. You’ve got a $4,000 nut to crack each month. Well, having your net worth go up and down isn’t really going to matter. You need to cover these expenses every month. You need income-producing assets to produce cash that helps crack this nut. If you can get $4,000 in cash flow coming from assets, you can be independent of a job. Now, that’s a goal!

  That is wealth. Wealth is when you have passive income to crack that $4,000 nut, rather than making $4,000 of active income from a job each month.

  I believe the key to wealth is cash flow. If someone has a high net worth, he or she may be rich but may still have to work. You can be rich in net worth and not be able to pay your bills. You can have a million dollars in a 401K and not be able to crack your monthly-expenses nut for the rest of your life. But with passive income that exceeds expenses, then you’ve become independently wealthy. In other words, you have enough wealth to be independent from having to work.

  Hedging

  Now let’s take a quick look at hedging, which is essentially buying insurance on investments. When I buy an investment such as a house, I certainly don’t want to lose that investment. No matter the reason behind my purchase, it’s important to protect it. If the house burns down, the insurance I have bought guarantees that my investment will be safe. If I bought the house to live in, the insurance will pay for a new one to be built. If I bought it for capital gains, then the structure will be restored so I can sell it in the future. And if I bought it for cash flow, I can get renters back into it fairly quickly.

  Buying insurance doesn’t put money in my pocket. It’s an expense. But smart investors protect their investments with insurance. We’ll talk more about this later in this book when we get to the Fourth Pillar—risk management.

  The Personal Financial Statement

  All these lessons we have been learning are especially applicable to the most important fundamental analysis of all—your own personal financial statement. This is why so many investors still walk with a spring in their step when the data on the corporate level, and especially the sovereign level, looks grim. Unlike looking at fundamentals on the corporate and sovereign levels, you get to make polices for yourself, at the personal level. Many people like to complain about the government policies of their country or the corporate policies of a company. But you rarely see folks evaluating their personal financial policies. This is a perfect time to once again remind ourselves of a key point we introduced early in the chapter:

  Why does the U.S. financial statement look so bad? Fiscal and monetary policy. Why does a company financial statement look so good at the same moment? Corporate policy. So why does your financial statement look the way it does? You guessed it: personal financial policy.

  If you want to change or improve your financial statement, then change your policy. For example, when it comes to income, you can choose a policy of working for money or a policy of having money work for you. When it comes to financial education, you can choose a policy of ignorance and hoping for the best, or a policy of education and actively seeking the best. In fact, as you look at the numbers in your financial statement, each number has a lot to do with your personal financial policies. Ask yourself what your policy is on the part of the financial statement. For example, when it comes to income, is your policy to work for money or have money work for you? Most often an upgrade in lifestyle requires an increase in expenses. Is your policy to cover expense increases by acquiring assets or hoping for a raise? Examine each of the following elements of your financial statement and reflect on your policy for each one.

  •Income

  •Expenses

  •Cash Flow (income minus expenses)

  •Assets

  •Liabilities

  •Equity or net worth (assets minus liabilities)

  •Credit score

  •Buying power

  Buying Power and Education

  There are really only two constraints on any of us when it comes to getting rich:

  1.Do we have the ability to intelligently recognize a solid asset?

  2.Do we have the resources to seize opportunity?

  In other words, it really comes down to smarts and buying power. Without either of those two things, we could be facing other investing tragedies:

  “I could have bought some Google shares when the company first went public—had I only known!”

  or

  “I knew that gold was likely to double in value, but I had no money to buy it”

  What is your buying power number? In other words, how large of an asset could you buy today? Ken McElroy might be the best Rich Dad Advisor to demonstrate this. If Kenny’s buying power were limited to his savings account, he might miss out on many opportunities. So he has built tremendous relationships with other investors and banks to harness buying power. He is a master at raising capital and is never constrained by using his own money. Pause for a moment and reflect on the following statement:

  The rich invest as if they have no money.

  In fact the ultimate goal for the super-wealthy is to never invest with their own money. They are masters of leverage and raising capital.

  If Robert or Ken lost everything they had, I’m confident they would be back on top very quickly because how they invest would not change.

  When you do a fundamental analysis on your personal financial statement, be specific about your buying power and seek to grow that number in cash, credit, relationships, or other forms of funding. What is your policy when it comes to buying power? Cutting up you credit cards decreases your buying power. Or is your policy to use credit wisely? Kim Kiyosaki used a credit card for the down payment on her first rental property—a property that generated cash flow from day one.

  As you look at your own situation, it’s common to ask yourself this question:

  Which of these numbers should I improve?

  Are you oper
ating at a deficit? Is your net worth negative? Is your income dependent upon a job? Are you making payments for mortgages, loans, and taxes? Is your credit poor? For some, the decision will be to overcome a deficit and become cash-flow-positive. Others may want to increase their buying power and education. And there are many other strategies that an investor could address. These decisions become your policies.

  If we look at a financial statement that is weak and want to improve it, what part of the financial statement should we work on? Almost invariably, people believe that if they earn more money their problems will be solved. “If I only made more money, I would be better off,” is something we frequently hear.

  The two most common ways of getting more money boil down to “Get a job” and “Live small.” These are policies.

  If you want more money, get a job. That’s a common way of thinking. Get a job, get a second job, work harder, work longer, and increase your active income. In any case, your expenses are going to remain the same. If your policy is to pay those expenses by getting a job, or a second job, then you are always going to need that job, and that second job. If I’m going to work at a job as my source of income, I’m always going to have to have a job to make my payments on food, clothing, health, and shelter. I don’t see how getting a job helps the long-term issue of expenses.

  The other common way of thinking I see is living small. “Act your wage,” I’ve heard it said. Cut expenses, clip coupons, buy less, lower your standard of living. This idea is not creative nor illuminating. It requires no financial education, only discipline. Well, I don’t like that idea, because now I have to live under the standard of my job, which means my job will dictate my lifestyle and I can never improve upon it. Everything I do in my life will now be under that umbrella and the limitation of a job. If my job is not an abundant thing, then I can’t have abundance in my life. And I have to do things like clipping coupons, and going without. That policy reduces my standard of living. It’s a goal to ‘live smaller.’ I don’t like that idea. Giving up one thing I like to pay for something else I like is nonsensical to me.

  You must decide who you are and what side of the CASHFLOW quadrant will guide your personal financial policies.

  Clipping coupons and cutting up your credit cards? That’s not what investing is about.

  As investors, our goal is to generate a passive income stream that is greater than our expenses and to grow our cash flow.

  To achieve these higher goals, you will adopt policies that are often completely the opposite of what you were taught by your parents and your teachers in school. Our policy should be to increase our buying power, not reduce it. Our policy would be to quit a job and improve our investing education. That is a sharp contrast to the gurus who say to cut up your credit cards!

  Conclusion

  In this chapter, you started to develop a foundational understanding of fundamentals. Now you understand that virtually any type of organization has a balance sheet and income statement you can analyze to determine its financial health. As you invest, you can analyze a government, a corporation, or even yourself.

  Remember to discuss what you’re reading and learning with someone or to teach a loved one what you’ve learned.

  Throughout this book I’ll remind you to evaluate yourself on the Education Continuum.

  When it comes to fundamental analysis, have you become more aware of what is possible? Are you now more competent with some of these skills and strategies? Do you feel a desire to seek out mentors and other education sources to become proficient?

  In the next chapter we will be looking at the second pillar of investing: technical analysis. This will give you additional skills and insights you can use.

  Remember: the ultimate goal is to gain this knowledge so you can move along the Education Continuum in your quest to become a proficient investor. Rome wasn’t built in a day, and neither is your wealth. Take the time to learn these foundational skills and you’ll be well on your way to creating your own investing income.

  Chapter Summary

  Let’s review some of the important points of Chapter Four:

  1.Investors can do fundamental analysis on three kinds of entities: sovereign, corporate, and personal.

  When we look at the financial statements of any of the three entity types, we can get a sense of the strength of the entity and its value.

  2.The financial statement looks the way it does because of policy.

  Certainly, natural disasters such as earthquakes and tsunamis, or political factors such as terrorist attacks, can have an impact on some economies. However, you will generally find that the reason the financial statement looks the way it does is because of the policies made by the leadership of the organization—whether it’s a nation, or a company, or a household.

  3.Sovereign fundamentals are affected by fiscal policy and monetary policy.

  When we look at the numbers on a financial statement—income, expenses, debt, and deficits—these numbers are usually determined by fiscal policy such as taxation and spending. Central banks such as the Federal Reserve or the European Central Bank dictate monetary policy. As they manipulate currency supply they attempt to have an impact on the country’s economy or gross domestic product.

  4.Policy plus demographics equals the future.

  As we seek to see what might happen in the future, we don’t really need a crystal ball. Because when we apply the policies of the country—or even a corporation—to a certain demographic, the future becomes more clear and complete with dates and deadlines.

  5.One of the most important numbers in sovereign fundamental analysis is the debt/GDP ratio.

  This one simple number gives us huge insight into the financial strength or weakness of any country.

  6.Good or bad news is less important than how you are positioned.

  Some people become fearful or angry when they look at nations or corporations that are floundering on the brink of disaster. True investors are more concerned with how they are positioned and how their personal financial statement will be affected. The truth is that within every tragedy there is an opportunity for those who are financially educated and prepared to benefit.

  7.Corporate fundamental analysis helps us with valuation.

  Price by itself in the stock market really doesn’t mean very much. That’s because price alone does not reflect the value we will receive. By conducting a corporate fundamental analysis, we can have a much clearer picture of a company.

  8.The important numbers that incorporate fundamental analysis are the P/E ratio and the PEG ratio.

  These numbers bring better meaning to the price of the stock because we can see what kind of earnings and growth the company is giving us for our money. It also helps us make comparisons to others in the market to see if we feel comfortable with what we are receiving.

  9.If you don’t like how the fundamentals look, then change the policy.

  Countries in dire financial straits (such as Greece) have gotten there because of poor fiscal policy and monetary policy. Countries on the verge of financial catastrophe (such as the United States) will only avoid certain collapse by major and drastic changes in their policy. The same is true for corporate policy. Meg Whitman, who became the CEO of Hewlett-Packard, conducted a fundamental analysis on the company and determined that she needed to eliminate 27,000 jobs. That’s changing corporate policy.

  But the most important policy is your personal financial policy, and it’s the one you can control. If you want to change your personal fundamentals, then change your personal financial policies.

  10.The two limiting factors for buying assets are education and buying power.

  In order to put an asset in your asset column, you’ll need to determine if the asset is a good deal among the many bad deals you will encounter. Also, you will need to have the financial resources to seize the opportunity.

  11.Your new policies might be the opposite of what your parents taught you in school or what today’s
financial gurus start saying.

  Chapter Five

  Pillar 2: Technical Analysis

  With fundamental analysis we looked at numbers from the financial statement to determine financial health. Technical analysis requires that we learn how to read charts to see the story they tell.

  Fundamental analysis tells us the strength of an entity. Technical analysis tells us the strength of the market. The stock market goes up based on supply and demand. The real estate market goes up based on supply and demand; the price of anything goes up based on supply and demand.

  At its core, you are going to be studying feelings. How do you feel about stocks, how do you feel about this house, how do you feel about technology? If you like it, you’ll buy it. Technical analysis studies what people want: supply and demand.

  A stock chart does not tell me very much about the company. It doesn’t tell me what the company makes. It doesn’t tell me what the company does. It doesn’t tell me whether it’s profitable or not. It doesn’t tell me whether it is growing or shrinking. It simply tells you what the price is and has been. That is just supply and demand. It’s a history of how people have felt about the price in the past and how they feel about it today.

  In this chapter on technical analysis, you will discover:

  •How to read a chart, starting with some of the most basic elements, some of the more introductory concerns when people start chart-reading

  •How to analyze the behavior of some sample stocks from the charts to apply what you have learned to your own stocks

  •How to use the computer, leveraging the technology to look for and identify signals