The Stock Market Cash Flow Page 7
To their detriment, many investors develop fundamental and technical criteria that limit them only to capital gains. Moreover, many limit their toolbox to bullish strategies only. As a college athlete, I had to learn many different offensive schemes and had many plays in my playbook that could address many different situations. I would take what the defense gave me and find ways to win, no matter what.
The same can be said of taking what the market gives you—be it a trend up, down, or sideways—and addressing it.
By learning different ways to position yourself for cash flow (or even a capital gain, for that matter), you are beginning to understand that there are opportunities for profit no matter what the market does.
Some of what you will learn in the section on Cash Flow:
1.How to get a capital gain when the market goes up
2.How to get a capital gain when the market goes down
3.How to get leverage without using debt
4.How the stock and option markets can work together to generate cash flow
Pillar 4: Risk Management
Whether you invest in real estate, stocks, or any other asset class, you have to remember: Things can change suddenly.
If the market crashes and your retirement is lost, do you have a plan B?
If you save money and the dollar crashes, what will you do?
If there is a flood and your home is lost, do you have insurance?
No matter what you do, there are always some things that are beyond your control and others you can always control. Risk management is using the things you can control to deal with those you can’t. I can’t control the flood, but I can control whether or not I buy insurance.
The Relationship Between Risk and Control
You might want to pause for a moment and consider this key point: Risk is related to control.
Whenever someone is about to invest money or use debt as an investment lever, they would be wise to consider how much control they have over the outcome of the investment. The question of control is equally important for people who have placed large amounts of money into traditional retirement plans that are broadly diversified across the markets. How much control do they have over the outcome? It is a sobering question to consider.
An investor has no control over the first two pillars we discussed, fundamental analysis and technical analysis. When we look at a company’s numbers, we understand that its performance is beyond our control. We don’t make the day-to-day decisions inside the company. We are not out there selling its products. We may own some shares of the company, but we have little to no impact on company policy. Likewise, when we look at the chart of that company’s stock and see the trend of the share price of the stock, we realize that the direction of the stock price is beyond our control as well.
No matter how badly you might want the price of the stock to go up, it’s completely out of your control. The same is true with the company’s earnings. We can’t control these things any more than we can control the weather or the lottery.
Remember that the first two pillars, fundamental analysis and technical analysis, are about gathering and analyzing information—not about controlling that information.
Things You Can Control
After you’ve gleaned some vital information by conducting a fundamental analysis (looking at the financial strength of a company) and technical analysis (looking at the supply and demand for that stock), it’s time to consider a cash flow strategy and how you want to manage the risk associated with that strategy. Again, you have no control over the first two pillars. But you have total control and full responsibility for your actions with the last two pillars.
In other words, you really can’t control what the weather’s going to be, but you do get to choose how you’ll deal with it. You can’t control a hurricane that’s coming your way. But if you gather information that shows a hurricane is coming, you can benefit from that information and begin selling emergency supplies to those who need them. You can also manage your risk by purchasing insurance to protect your own home. These actions are entirely up to you. The same is true with your cash-flow investing.
You also control the level of your financial education. In Chapter One we discussed the importance of investors becoming serious students. It is entirely up to you how far you want to go with each of the 4 Pillars of Investing. That’s very good news. Because if we realize that our lifestyle goals are related to our money goals, and that our money goals are achieved when we reach our education goals, then the 4 Pillars of Investing become a clear pathway to success. We now know what to study and what to work on. We know how to grow our very own orange trees with endless supplies of delicious fruit.
Some of what you will learn in the section on risk:
1.You will learn about many different kinds of risks investors face.
2.You will expand your financial vocabulary.
3.You will learn about exit strategies.
4.You will learn about hedges.
5.You will learn about position sizing.
The 4 Pillars in the Education Continuum
Paper assets are a great place to start learning the 4 Pillars because of its advantage in scalability and liquidity. But it would be a grave mistake, for example, to think that real estate investors do not need to understand technical analysis in their day-to-day business. I have heard Rich Dad Advisor Ken McElroy declare many times that his real estate business is a trend business. The 4 Pillars offer a foundation for any financial education.
Now that you have a basic understanding of each of the four pillars, it’s time to become more aware of what they are. It’s time to begin to become more competent in each pillar. As you desire to become more competent, your mind will automatically search for mentors and ways you can practice to become more and more proficient because of the law of attraction. Because this is simply how your brain works naturally.
Focusing on your education goals more clearly identifies the people and the opportunities that will help you achieve your goals. This increased focus and desire to identify solutions will give you the feeling that these people and opportunities are being drawn to you.
As you study the 4 Pillars of Investing, I encourage you to think about your progress in each pillar along the Education Continuum. It’s a good way to evaluate where you are in your learning. There’s a big difference between being aware of what a financial statement is and being proficient in conducting a fundamental analysis of that statement. There’s a big difference between being aware of technical analysis and being proficient in reading stock charts. The process of moving toward proficiency in the Education Continuum is even more important with the last two pillars: cash flow and risk management. Because this is where your decisions and actions will directly impact your profits.
Cash flow strategies and risk management are double-edged swords: You can do the most good for yourself, but also the most harm. As investors, our goal is proficiency with these pillars. As you take this journey, enjoy the discovery of each pillar and remember that success is the natural order of things. Just let it happen.
Chapter Summary
Let’s review some of the important points of Chapter Three:
1.Fundamental analysis helps us know the financial strength of an entity.
A financial statement reveals the financial fitness of an entity. You can use those numbers to see its value, diagnose its problems, and better forecast the future.
2.Technical analysis helps us identify trends.
By reading stock charts we can identify trends. We can see changes in supply and demand. We can see patterns that tell us what is likely to happen next. We can see warning signals in the market.
3.Cash Flow strategies are how we choose to position ourselves to profit.
Learning all the cash flow and capital gain strategies gives you the opportunity to take what the market gives you and have profit potential in any market—be it up, down, or sideways—instead of being at its mercy.<
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4.Risk management is about dealing with the unexpected.
Every serious investor needs countermeasures to deal with the unexpected or to protect themself when they’re wrong.
5.The 4 Pillars are not just for stock investors, they are for all investors.
No matter the assets class, proficiency in the 4 Pillars makes for better decision-making!
Chapter Four
Pillar 1: Fundamental Analysis
When you buy stock you become an owner of the company. It makes sense then that if you are an owner, you should have a good idea about the financial condition of your company. That’s why the first step on your journey toward generating reliable capital gains and cash flow from your investments is to learn about fundamental analysis.
Again, fundamental analysis is the process of looking at certain numbers to determine the health of an entity. The numbers you look at to determine that health are found on the financial statement.
It doesn’t matter if the entity is a person, a family, a church, a company, a school, or even a nation. And it all begins with the financial statement. By looking at a financial statement, I can see the whole sum and substance of an entity. I can see its strengths and weaknesses. I can compare it to any other entity. I can do this for an organization with money flowing through it. I can do it for an entity on the verge of economic collapse. The whole story is in the numbers.
Financial statements tell us what we need to know about a business without ever setting foot in that business. They tell us what we need to know about a charity, even if we don’t know its values or mission. They tell us what we need to know about a country without us ever knowing anything about its politics. They tell us about a family…without the need to ever meeting them.
A financial statement is the heart and soul of fundamental analysis
In the Rich Dad series of books there are a lot of references to financial statements. Many of the stories that Robert tells are about the lessons from his rich dad, lessons triggered by Robert showing him his financial statements. Rich dad didn’t need to physically visit Robert’s business for an on-site inspection. He didn’t need to know all about the products or who was on the management team. Yet Robert’s rich dad was able to make a quick and accurate evaluation about the strength of the business. “Your business has financial cancer,” rich dad would sometimes say to Robert. He could make that evaluation by looking at the company’s financial statement and nothing more. When he looked at the financial statement and made his prognosis, rich dad was conducting a fundamental analysis. Now it’s time for you to learn to do the same thing.
Below is a picture of a financial statement that most every student with the Rich Dad context is familiar with. We’ll be using pictures like this throughout the book, so let’s have a look at it and see what it means.
The Income Statement
You can divide a basic financial statement into two simple parts that anyone can understand. There’s the income statement, where we show the income (I) coming in and the expenses (E) going out. When you write a check, that money is going out of your account as an expense. When you deposit a paycheck or a dividend check, that is money coming into your account as income. With these two numbers we can easily calculate cash flow—simply by subtracting the expenses from the income. As you will see, sometimes cash flow is positive and sometimes it is negative.
Cash Flow = Income - Expenses
The Balance Sheet
The second half of the financial statement is a balance sheet. Traditionally, the asset column (A) is the list of all the things you own, and shows how much all those things are worth. As you probably know by now, in the Rich Dad world we also expect our assets to provide us with income. The liability column (L) is a list of how much you owe and to whom. Simply put, let’s say that assets put money in our pocket and liabilities take money out.
From there, we add up the value of all the assets and subtract our total liabilities. The resulting number is the equity. Sometimes you will hear people refer to equity as net worth.
Equity = Assets - Liabilities
People who have a limited financial education will often crow about their net worth and ask you about yours. But as you will soon see, net worth is typically an overrated number and is much less important than cash flow.
At this point we have our first six numbers to use in our fundamental analysis:
1.Income
2.Expenses
3.Cash flow
4.Assets
5.Liabilities
6.Equity (net worth)
Did you see how simple that was? With just a little basic math, we are able to generate those numbers.
The most important number so far is cash flow, of course. If we are analyzing a sovereign nation, the cash flow situation will tell us if that country’s government is financially solvent or not. For a company, the cash flow number helps us understand if the company is currently making money. And for an individual, the cash flow helps us understand if that person is living within their means.
Let’s look a little deeper into these three types of financial statements:
You can easily get a basic understanding of these statements without an accounting degree. At this point, we’re not interested in going through every little detail with a fine-tooth comb. By understanding just a few basic numbers, you will be able to make a quick overall assessment of any of these types of entities just like rich dad could.
The Relationship Between Financial Statements and Policy
There’s a law in physics that says the velocity of a body remains constant unless the body is acted upon by an external force. It sounds like fancy language from Einstein or some PhD, but what it means is that if something is standing still, it has to get smacked to make it move, and if something is moving, it has to get smacked to change its direction. That’s called a force.
In the world of economics, one of the most powerful forces is any kind of policy made by a government. A policy is simply a decision that leads to a course of action.
It’s amazing to see how a few words issued by a government as policy can have a massive impact on its financial status. For example, the terrorist attacks inflicted on the United States on September 11, 2001 were horrific events. They also had an impact on the financial health of the country. The truth is that these attacks and events like them have much less of an impact than the country’s policies. It was actually the fiscal policies that set the stage for and, possibly, triggered the financial crisis that overtook the United States and much of the world.
Today’s uncertain and turbulent financial situation is clearly the result of foolish and undisciplined fiscal and monetary policies introduced by the Congress and Federal Reserve in the wake of 9/11. Their policies left all of us seriously exposed to potential trouble.
Former Comptroller General David Walker has said:
“I would argue that the most serious threat to the United States is not someone hiding in a cave in Afghanistan or Pakistan, but own our fiscal irresponsibility.”
Financial hard times have come and gone throughout history. They occur from time to time in every society. But what can a person do to weather these financial storms? What can a business do? And what can a government do?
When a person, a company, or a government declares bankruptcy it is often a result of poor policy. And it’s often the consequences of those earlier policy decisions that are now affecting them in very troubling ways. On the other hand, those who are able to survive these storms are typically those who have made solid financial policies. Their decisions have placed them in a good enough position to absorb getting smacked without being pushed seriously off course.
In the next few pages you are going to discover for yourself that policy is the strongest factor influencing any financial statement. You will also see that the fastest way to improve a financial statement is to improve the policies that support it. When I hear stories of Robert’s rich dad giving him candid and of
ten severe feedback, he was really critiquing Robert’s business practices—his corporate policies. It was these policies that caused problems that appeared in the financial statement. Robert often does the same for me today, and I welcome his feedback.
The relationship between policy and fundamental analysis is inseparable. A weakness in a financial statement points to weakness in policy. Hence, the B-I Triangle, which illustrated the 8 Integrities of a Business, is built around having a passionate mission, capable leadership, and a strong team.
Robert writes extensively about the B-I Triangle. It’s a diagram his rich dad used to teach him about the eight critical elements, or integrities, that make up a business. If any of these elements are weak, the business is destined for failure. If any are having problems, those problems will likely show up as weak numbers on the financial statement.
It is the leaders, the team members, and the mission that dictate policy. Adherence to that policy, be it good or bad, will determine what the financial statement will look like.
We are going to start our study of fundamental analysis by looking at the policies that affect sovereign nations. When it comes to sovereign nations, the strength or weakness of their financial statements is the result of fiscal and monetary policies.
Sovereign Fundamental Analysis
I spend a lot of my time focusing on sovereign fundamentals. The reason is simple: I believe that everything that happens financially at both the corporate and personal levels often occurs under the umbrella of the health of sovereign nations. The policies they are making, and the consequences of those policies, affect us every single day.
My home country is the United States, so let’s begin by doing a basic fundamental analysis on the U.S.A. at the time I was writing this book. These numbers, of course, will change over time. But regardless of where the numbers go in the future, this process will show you how you can do a sovereign fundamental analysis for yourself at any point in time. What’s important is the understanding of how to conduct a fundamental analysis and read a financial statement.