One of the hallmarks of the greatest ever investors in the world is their unerring ability to shut out all of the stock market noise and focus on investing in great companies.
Earnings forecasts, interest rates, inflation, recession, GDP (Gross domestic product), price-earnings ratios, stock market crashes etc, etc. The unrelenting noise of the stock market. It’s enough to drive you insane.
The problem is that the so-called “experts” discussing all of this noise appear to be so knowledgeable and convincing it can be difficult to not be influenced by them. Much like the news generally. You think you should watch the news but do you ever really learn what is going on in the world or is it just noise? I am reminded of the famous Mark Twain quote “If you don’t read the newspaper, you’re uninformed. If you read the newspaper, you’re mis-informed.”
What I have discovered is that if you invest in great companies and ignore the noise you get great long term returns. In the short term though you may be very disappointed. However, that’s because the market can be very irrational over the short term.
So what you need to focus on is the company’s performance as a business rather than its stock market performance. What this means is studiously reading the company’s annual report and accounts. It’s a goldmine of information. There are a number of things you should be looking for but two of the most important figures are the company’s free cash flow and its return on investment. These 2 figures alone tell you a lot about the company but not everything.
The company’s free cash flow represents the cash it has generated from its trading activities after deducting the cost of any capital expenditure. The beauty of free cash flow is that it cannot be masked unlike a host of other ratios, figures and statistics which can be manipulated and estimated. Cash from operations cannot be hidden or manipulated, unlike accounting profits. Free cash flow is the closest measure to the profits per the accounts and it is also more dependable.
A good example of this is Enron which overstated its profits for many years. A study of its free cash flow showed that it regularly overstated its profits year after year. The accounting profits were significantly higher than its free cash flow each year. It should have been a clear and obvious warning sign but the stock market noise was greater. It resulted in one of the largest and most spectacular corporate crashes in US stock market history. The Enron scandal drew attention to accounting and corporate fraud as its shareholders lost $74 billion in the four years leading up to its bankruptcy, and its employees lost billions in pension benefits.
The other important ratio to pay attention to is the return on investment. Return on investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.
Return on investment is important because highly successful companies achieve high return on investment from their free cash flow by re-investing their surplus cash very well.
Amazon is a classic example of this strategy. In Jeff Bezos’s very first annual report to Amazon’s shareholders, he explained that Amazon would focus on cash flow rather than accounting profits and reinvestment into the business. I cannot think of a finer example of a business that has encapsulated the virtues of free cash flow and high return on investment. It works!
Of course, there are a number of other factors to consider when assessing companies yet I maintain these are 2 of the most important factors which it is crucial not to ignore. You know it makes sense.*
* The value of investments and the income derived from them may fall as well as rise. You may not get back what you invest. This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and HM Revenue and Customs practice. Levels and bases of tax relief are subject to change. This blog is based on my own observations and opinions.
