Money and the Self-Employed: Part I- Starting Out

As I have alluded to several times, I am self-employed in the business of advising other businesses.

With no safety net of a regular salary, I have learned first hand on how to handle personal and business finances. Given that entrepreneurship is increasingly becoming a life choice for many, it would be opportune to share some of my experiences on the relationship between self-employment and personal finance (with equal application to those who are salaried employees):

Fact: Being Self-Employed takes a lot more money than you think (if you are employed, substitute business with a house)

Comment: I would make the analogy that creating a business is like buying a house. It takes a lot of money to start one and it continues to demand money all the time.

Things you can do:

1. Budget, budget, budget. Figure out how much money you will require to start the business- do a financial projection on projected fixed costs (rent, utilities, salaries etc.) until you have enough sales for the business to pay its fixed costs. Got that figure? Now add it by 15-20% (speak to any contractor and a reno costs 15% more than the budget, the same should apply to starting a business).
   
   
2. Decide on the amount of money that you will NOT use in your business. Personal observation teaches me that owner-managers will pour good money after bad into a business even if it is beyond the point of salvaging. Put aside money you will NOT use in the business and have the self-discipline not to touch it (put it in a separate high-interest bank account). The amount should be at least 2-3 months of your personal fixed expenses such as mortgage payments/rent, utility bills etc. (most guides say 3-6 months of your monthly salary which is a little unrealistic). If you do not have this money, start saving NOW and start the business when you have those funds. It provides a great cushion that you will not deplete all your money if things don't work out.
   
   
3. Improve your credit score and get access to multiple sources of credit before you start your business. Banks lend money to small businesses based on the owner-manager's credit score not the business' financial health. I have been told that banks continue to demand personal guarantees from owner-managers who operate businesses with 20 plus years of healthy financial performance. Improve your credit score while you are still an employee. Obtain your credit score for free here or here. Correct any errors on your report or pay off as many late accounts as possible. Attempt to obtain lines of credit with favourable interest rates from your bank (banks love giving these out to anyone with a healthy credit score)- these are much cheaper sources of credit than credit cards and they can be obtained more easily while you have steady income. Once you obtain the line of credit, draw down on it even if you don't need the money and pay it off immediately- this will increase your credit score. The point is that people lend money based on your credit score so take steps to increase it now while you are an employee and have steady income to draw on. I have seen too many people who defaulted on their student loan, started a business and found no one would lend them money because of their past sins.
   

Investing in Stock- what I am keeping my eye on

So having shared what I look at, these stocks are on my watch list in no particular order (please note that this is not investment advice nor solicitation to purchase any of the stocks below, please conduct your own research before making any investments):

1. Corby Distilleries Limited (TSX: CDL.A): The 2nd largest spirits maker in Canada (they produce Lamb's Palm Breeze, Beefeater, Kahlua). Alcohol is a regulated industry (you have to have rights to produce booze by country; the largest province in Canada, Ontario, owns most of the distribution channels preventing price competition), is in a recession proof industry, has no long term debt and pays regular dividends as well as a special dividend from all the surplus cash it has; and
   
   
2. Johnson and Johnson (NYSE: JNJ): Producers of many house-hold medicines and consumer staples (Tylenol, Bengay, Acuvue contact lens), increasing dividend payments, many of their products are patent protected (which means there is no price competition until the patent expires), net cash flow from operating activities has increased year over year and the stock is trading below its Jan. 1 price providing a buying opportunity.
   

Investing in Stock- a summary

I hope you noticed a few things about my list of what I look for in stock investing:

1. The non-technical factors outnumber the technical factors- at the end of the day, its all about the KISS principle with me. If a company is doing well on main street (the non-technical analysis), the technical analysis, as a general rule (there's always exceptions), should follow. For example, when was the last time you shopped at the Gap? I have not bought a lot there for years compared to the 1990's and neither have a lot of my friends and family (how many khaki's can a guy have?). Look at Gap's stock price- its really struggling.
   
   
2. My technical factors focus on cash- how much its paying out in dividends, how much free cash it has and how well it makes use of investor's cash. I readily admit that this is influenced by what I do. Businesses with more cash perform better than businesses with less cash (the painfully obvious observation of the day!). Think of your house-hold: the more free cash you have, the greater your options right? Its the same with publicly traded stock-the market rewards companies that knows how to generate and pay out cash.
   
   
3. There is no rocket science involved in my analysis. Anyone can apply these factors. Do not let the investment industry fool you into thinking you cannot do this.
   

Investing in Stock: Technical Analysis #3

Look for company's with high return on equity (ROE) ratios

ROE means how well a company is using your investment- in other words, for every dollar you invest, how much can the company make? The higher the number, the better.

I am not going to attempt to break down how ROE is calculated. It is way beyond my high-school math. Most companies or investment research will publish ROE's so look for it in their public releases or in company research provided by investment banks.

As a rough guide, any non-financial company (so anything other than banks, insurance companies etc.) that can generate ROE over 10% is good. However, if the company has a high ROE and a lot of debt, be careful; like any household, growth based on excessive debt is not a good thing.

If you find a company that is doing both technical analysis #2 and #3 well, what you have is a company that can invest your money well (high ROE) and generates a lot of free cash with your money (increasing net cash provided by operating activities). If there is a lot of free cash, the company is hopefully paying an increasing dividend which, on the balance of probabilities, leads to above market return on investment (see rule #1).

Investing in Stock: Technical Analysis #2

Invest in a company with increasing "net cash provided by operating activities"
Before I explain my logic, here is my 30 second crash course on reading financial statements. There are three types of statements every publicly traded company produces:

1. Balance sheet: balances assets against liabilities (the difference is the total equity in the company)
   
2. Income statement: basically a profit/loss statement
3. Statement of cash flow: tells you how much cash the company is generating (or losing) year over year

Under the statement of cash flow, there is a line called "net cash provided by operating activities." In plain English this means how much cash the company is taking in vs. how much it is paying out (a positive number obviously means the company is taking in more cash than its paying out and vice versa if it is a negative number).

Balance sheets can be hard to read because there are line items such as goodwill or intangible assets which are hard to value or subjective (for example, how much is the name Coca-Cola worth?).

Income statements can be hard to read because there can be tax entries (such as depreciation) and one time items (a business is sold, inventory is liquidated) which makes it hard to determine the true profit of a company. As anyone who runs a business knows, a sale can be booked but the revenue never collected or not collected in whole or in a timely manner. However, the sale (subject to any bad debt write-offs) are booked as income.

Cash is cash. It is hard to manipulate the accounting on cash received. If the net cash provided by operating activities is increasing, this means the company has a lot of cash on hand. Cash allows a company to increase dividends, buy back stock, purchase competitors, invest in R&D- all the good stuff a growing company should be doing.

My favourite book on stock marketing investing is Morningstar's "The Five Rules for Successful Stock Investing" and to quote from it: "the statement of cash flow is the true touchstone for corporate value creation because it shows how much cash a company is generating from year to year- and cash is what counts"

As much as I hate reading financial statements, I make it easy on myself and go right to the net cash provided by operating activities line. It usually sheds a lot of light into how a company is performing.

Investing in Stock: Technical Analysis #1

If in doubt, buy a dividend stock, preferably a growing dividend stock.

Proof is in the pudding; dividend stocks beat the market and growing dividend stocks do even better. The following is courtesy of RBC Capital Markets

S&P 500 Total Return: Last 10 Years (to Feb. 15, 2007)

S&P 500 Non-Dividend Payers: 6.3%
S&P 500 Total Return: 8.0%
S&P 500 Dividend Payers: 8.5%
S&P 500 Dividend Growers: 9.1%


TSX Total Return: Last 10 Years (to Feb. 15, 2007)

TSX Non-Dividend Payers: 2.7%
TSX Total Return: 8.5%
TSX Dividend Payers: 14.2%
TSX Dividend Growers: 15.5%

Common Sense Analysis #1- explained much better than me

I found this quote on-line from www.money.com. Fortune Magazine reporter Katie Benner interviwed the managers of Hodges Fund (5 year annualized return of 18.8% according to Moringstar).

In response to a question about investing strategies for a unpredictable 2007 market, the fund manager answers:

"We're a big proponent of pricing power. What allows a company to maintain or even increase its prices is a lack of competition, high barriers to entry and good demand. PC makers can never have pricing power because there's too much competition. Instead, we focus on businesses like railroads and steel, where there used to be a ton of competitors and now there are just three or four."

I note that the examples given, railroads and steel, are in regulated industries (you can't just put a train on the tracks without telling someone and steel is subject to pricing regulations and quotas). Its nice to have someone confirm my common sense analysis.