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: Common Sense Analysis Part 5

Do not invest any money you are not willing to lose

After all that non-technical analysis, you still have to be willing to lose it all if things don't go well. Buffet's first rule for stock investing is "don't lose money" but it pre-supposes the assumption that you will invest in the first place.

If you are going to invest then Buffet's rule is the golden one but before I make that decision, I ask myself at this point in time am I financially ready to lose money. If I am then I follow Buffet's rule (hope for the best, expect the worse). If I am not, then I sit on the sidelines.

Investing in Stock: Common Sense Analysis Part 1

I have posted for approximately a month now and you must be asking: when is he going to say something about what he invests in?

Ok, ok- here goes. For reasons I'll explain later, I invest in stock and not real estate. I tend to look for two things before investing in anything: (1) common sense analysis and (2) technical analysis. With respect to the common sense analysis, I tend to look for certain things (in multiple parts).

Investing in a business that is highly regulated

By this I mean you have to obtain permission from some regulator to enter into the industry, make changes or leave. Regulation limits the number of players in the industry and creates a high barrier to entry. High barriers to entry limit the number of competitors, a limited number of competitors avoid price wars (typically the best way to gain market share is be the lowest price competitor), lower prices means less profit, less profit means lower share price/less cash flow to pay dividends.

Think about industries that are heavily regulated: banks, insurance companies, utilities (electricity, pipelines, telephones)- they are all typically good stocks to buy.

Now think about industries with have very little regulation: restaurants, retail & technology- all very boom and bust businesses (if you have invested in the Gap, you know what I mean).

For this reason, my two largest stock holdings are TD Canada Trust and Transcanada Pipeline- heavily regulated industries where competition is limited and pricing relatively secure (this is not an endorsement to buy these stocks, please do your own research before investing).

Investing Mistake #2

The following is a quote from an Associated Press article of March 9:

"In the week of the market's Feb. 27 sell off, when the major stock market indexes surrendered their gains for the year, investors pulled an estimated $3.84 billion from global mutual funds that invest in stocks and dumped $1.35 billion into bond funds, according to Trim Tabs Investment Research."

Here's a perfect example of how a rational decision about money is being driven by emotions and not rationality. Head says "buy low, sell high"; heart reads the news, panics and sells equity based securities when the market is going down.

Lesson to be learned: When the market starts to fall let your head, and not your heart, make the decisions.

Or, for fans of the Hitchhiker's Guide to the Galaxy- DON'T PANIC.

For the record, I have increased my bond holdings- but from cash not from selling equity. I intend to make some interest income then buy some boring old cash machine stocks near the bottom (its sheltered in my retirement account so the interest is also earned tax free).

If anyone is reading about the collapse of the subprime mortgage lenders in the United States today, breathe deeply, sleep on it and please talk to a professional before you do anything rash.

Oh yeah- DON'T PANIC.