Back to Basics

September is back to school season, and my wife and I couldn’t be happier. All four of our children, 19, 17, 15 and 5(!) are in school and adjusting to the new routine. It’s an exciting time of year, when old skills get refreshed and new ones introduced. And whether in the classroom or on the sports field, the initial focus is on the basics. As countless football coaches are reminding their players, performing well is about executing on the fundamentals – basics like footwork, blocking, and tackling.

What are comparable investing basics, and how can a refresher help as investors begin the historically volatile fall season? Here are three suggestions and thoughts on each (numbers two and three will be explored in subsequent posts).

  1. An investment is a claim on future cash flows, everything else is speculation
  2. Simplicity is elegant, in investing it’s essential
  3. It pays to know oneself

The first is obvious but not always appreciated. An investment, whether a stock, bond, or real estate, is something that is expected to generate a cash payout in the future. That cash payout, or return, can take the form of a dividend, interest income, or even price appreciation. The value of the investment should be based on the amount of the expected cash and when it will be received. We know intuitively that the more certain a cash flow and the sooner it will be received, the lower risk it is.

Consequently, an investor in a 1-month US Treasury bill takes virtually no risk. The amount that will be received is fixed, the time horizon is short, and the likelihood of the US government defaulting on the payment is negligible.

An investor in a biotech or technology company with no earnings, by comparison, faces uncertainty in every aspect. The amount of the future cash payment, what form it will take, when it will be received, and the likelihood of it being paid at all are unknown.

So how can an investor in this situation determine if they are paying a fair price? The fact of the matter is that they can’t. The value of the asset is essentially what someone else is willing to pay for it. Wall Street analysts have numerous metrics they use to try to estimate future earnings power, but these are really just guesses – and often optimistic ones.

It’s the difference between investing and speculating. One is based on an analysis of future cash flows and the other is based on hope. While there is nothing inherently wrong with speculating, it pays for an investor to know the difference.

And speculation in 2021 has taken hope to a whole new level. Investors put money into vehicles called Special Purpose Acquisition Companies (SPACs) that purchase private companies and take them public via reverse mergers. The SPACs often purchase early-stage companies without earnings (and sometimes without revenues). Investors who put money into SPACs don’t just lack clarity on future cash flows, they buy without knowing what companies the SPAC will ultimately bring public!

Prudent investing entails understanding and following the cash flows. It’s a fundamental precept that can keep investors out of trouble in hope-filled markets.