The high priest of value investing himself, Benjamin Graham, taught us that, “investing is most successful when it is most business like.” That makes sense because investing in stocks is, quite literally, the act of buying an ownership stake in businesses. Whether you own 100% of the shares of a local jewelry store in your hometown, or 1,000/4,405,893,150th of The Coca-Cola Company based on its total shares outstanding in the last 10-K filing, the end result is much the same: There are only three ways you can make money from your stock.
This simple distinction makes it easier to spot flaws in an investment portfolio because it changes your behavior. You suddenly demand a margin of safety in your purchases because you expect to be compensated for the different types of risk to which you are exposing yourself and your family. You require evidence based on facts rather than hope for high growth assumption rather than getting swept away in the euphoria of crowds. During stock market crashes, you can remain rational and buy ownership positions in quality companies at bargain prices despite everyone else rushing for the exit in panic. You seek to understand things such as how the firm generations its underlying cash flow, what types of assets makeup the balance sheet, and whether management is following capital allocation and dividend policies that are friendly to you and other owners.
If you don't currently treat your stocks like this, I urge you consider a paradigm shift. On my personal blog, I've spent the past few years driving home the concept by running case studies of stocks as viewed through the lens of business-like investing; looking at the long-term results generated by holding ownership stakes in businesses as diverse as Chevron, General Mills, McDonald's, Clorox, Hershey's, Nestle, Colgate-Palmolive, Procter & Gamble, Coca-Cola, Tiffany & Company, and the now-bankrupt Eastman Kodak.
Despite being the best long-term performing asset class, I don't think everyone should invest in stock. In fact,you don't have to own stocks to get rich. Plenty of other people have done it by investing in real estate or specializing in something like oil wells or intellectual property. If you aren't capable of business-like investing in even its most basic form - reading an annual reportand understanding simple concepts such as how to analyze an income statement - it's the equivalent of driving blind in a snowstorm. What rational person would do such a thing? It's insanity. Instead, consider throwing in the towel and investing in a low-cost index fund that buys a widely diversified basket of stocks; something like the Vanguard S&P 500 fund operating at a rock-bottom mutual fund expense ratio.
To help you understand some of the finer points of what it means to practice business-like investing, let's dive in and look at specifics. It might help clarify the importance of what I am saying.
1. Business-Like Investors Don't Confuse Cash Flow with Profits
Cash flow is all-important. Without the ability to meet your financial obligations when they come due, you won’t be around to play the game. However, a business-like investor must never forget that, at the end of the day, once basic liquidity needs are met, net profit (more specifically, the return on capital employed), reigns supreme. There are plenty of businesses that look like they are making money when they are, in fact, bleeding the owners dry.
Imagine you own a successful furniture business structured as a limited liability company. Over the past decade, you’ve built up a comfortable working capital position in the form of increased inventory. Your storefront has expanded and the showroom now holds thousands of individual pieces of merchandise.
One day, you realize that you’ve grown tired of the industry. You think it’s boring, you’re weary of dealing with the same people, and you think that you'd rather bake cookies for a living. After discussing it with your spouse, you make the decision to shuttle the furniture store, liquidate the inventory, and open your own bakery. You inform the store manager of your decision, and instruct him to discount all of the merchandise heavily. You then place ads in the local papers and on the news channel advertising a “going out of business” sale.
The week of the sale arrives. There is a tremendous customer turnout and you are generating tons of cash; far more than you’ve seen in the normal course of business. You reinvest little of this in new inventory for the business (you are liquidating, after all). Instead, you use it to begin preparations on your new venture; moving expenses, paying down some personal debt, buying a new home, and such.
Here’s the problem: Unless you have an excellent bookkeeping system, you won’t have a clue how you fared in real economic terms from the liquidation. If you were an accountant by training and knew the specific identification method, you could simply plug in the sales figures to your software and instantly calculate the profit. If, however, you are like many small businesses and you are more entrepreneur than financier, you may not be aware of the cost associated with each of the items you are selling. The result? The dining room table you sold for $60, marked down from $130, actually cost you $75 three years prior! On an accrual basis, you’ve experienced a very real loss of $15 on that sale. Yet, the check you wrote to pay for that merchandise is long forgotten, the cash in your hand is not.
The larger the business, the more significant the problem. You could experience a drastic shrinkage in real net worth while thinking you are making a tremendous amount of money. The torrents of cash coming into your life mask economic reality, placing your finances in an extremely vulnerable position. I personally know a married couple who mismanaged their business so poorly that they spent half-a-million dollars in retail value inventory over several years after their sales had fallen off a cliff, thinking they were still making money. As the products on the shelf in the store began to decline in both quantity and quality, this led to a death spiral that caused them to go from generating more than $2,000,000 in per annum inflation-adjusted sales to practically nothing. In the end, they wiped out nearly 25 years of work and a company that was paying them six-figures a year because they didn't understand the accrual concept.
The Bottom Line? Business-Like Investors Think About Profitability and Return on Capital
Cash flow alone is necessary but not sufficient. It's possible to experience positive cash flow while you lose purchasing power and march yourself towards bankruptcy court. Look at the property and casualty insurance industry before the asbestos claims drove a lot of companies out of business. These firms were bringing in millions of dollars a month but didn't understand the cost of the product they had sold, which eventually caught up with them.
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