Wednesday, October 08, 2008

Focus on cashflow and not capital gain

When people say they do investing, there is a tendency for most people to focus on the capital gain that each investment will bring in. Eg. Ah Beng buys SGX at $3, today is $6, so his perceived capital gain is 100% and he is happy like a bird. Or Ah Gou buys a property at District 10 for $1mn in 2006 and today it is valued at $2mn, his capital gain is again 100% and he goes and buy a Ferrari. This is very natural and it's got to do with our primitive wiring and we cannot easily re-wire our brains.

However as long as we don't sell and lock in whatever gains, there is no cashflow coming into our pockets. And in most cases, it is actually not to our advantage to lock in the gains. Take the example of Ah Gou's house, if he sells, he gets his $2mn but the a similar house in District 10 will now cost $3mn. So he has to downgrade. And for Ah Beng, he sells and lock in his gain, but now he needs to find something else than to park his money, and in this market, it is difficult to find things that are safe.

Furthermore, price that Mr Market dictates has nothing to do with the true value or the intrinsic value of the asset. ie Mr Market may say that SGX can sell for $6, but it is really worth $6? And so did Ah Beng really double his money? Again the Mr Property Market says Ah Gou's house can sell for $2mn but is it really worth $2mn? If we cannot be sure, then why do we always look at our portfolio value at the end of the month and go smiling when Mr Market says your portfolio is up 10% this mth or down 20% next mth?

So instead of looking at the at the absolute price of the asset as dictated by Mr Market, perhaps the better way to look at investment is the real cashflow that it can generate for us. For stocks, since most people go for capital gain, there may be very little cashflow to talk about. Unless you keep buying and selling stocks and make sure some cash in generated every year or every quarter. However that means you need to be very good at market timing and studies have shown that most people sucked at market timing. So at some point in time, one should think about how to extract stable cashflow out of the portfolio regularly in order to enjoy some of the fruits. I mean no point holding on to stock certificates until you are dead right?

Assuming that your portfolio have grown substantially large over many years, one way would be to slowly sell some shares (assuming that they are infinitely divisible) as one approaches retirement so that cashflow can be generated and support a meaningful lifestyle. Another more realistic way would be to have a good % of dividend stocks that will generate some cashflow even if you don't sell any holdings.

Warren Buffett probably knows this better than anybody and that is probably what he has been doing this for 50 years. I estimated that Berkshire's stable of companies can generate USD 6-8bn of cash every year on an asset size (not original capital amt!) of roughly 220bn, so that's a 4% cash yield, on current asset size. Of course he can buy 100% of the company and demand all cash generated to go to him. That's not quite possible for us lah.

Nevertheless, at some point in time, when we are closing on retirement, we need to focus on how much cash the portfolio can generate every year. And personally I don't think it is wrong to practise that now, even though we may be 20-30 yrs away from retirement. I would be quite happy if my portfolio can have a cash yield of 2-3%pa for a start.

As for property, needless to say, the focus should be on how much rental the property can fetch, instead of thinking whether you can sell this property for $1,100psf after you bought it for $1,000psf. As a rule of thumb, I think we should only buy properties that can generate a sustainable rental yield of 5% over long period of time.

The focus on capital gain also means that we have to constantly buy and sell in order to lock in profits and find new buys. Now value investors do not like to play this game of buying and selling too frequently. It does not fit their investment philosophy and it serves only to make brokers happy. So they focus on cashflow. When thinking about the next investment, ask whether the investment can generate you good cashflow yield over a long time horizon, not whether you can sell at a 10% profit in 1 mth's time.
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